Withholding Tax on Foreign Person’s Disposition of Partnership Interest
Internal Revenue Code (IRC) Section 864(c)(8), originally enacted pursuant to the 2017 Tax Cut and Jobs Act (TCJA), subjected foreign persons to U.S. tax on gain (or loss) from the sale, exchange, or redemption of interest in a USTB partnership. A USTB partnership, for this purpose, is a partnership that is engaged in a trade or business in the U.S. A foreign person, for this purpose, is either an individual, foreign partnership, or a foreign corporation. The tax is imposed to the extent gain or loss from the sale of a USTB partnership would be an effectively connected (”EC”) gain or loss to the partnership, had it sold all its assets at fair market value on the date of the transfer of the partnership interest by the foreign person.
The TCJA also enacted a new IRC Section 1446(f) as an enforcement mechanism to collect tax in such a transfer. IRC Section 1446(f) requires that the transferee deduct and withhold 10% of the amount realized. Temporary guidance for this withholding requirement was issued in IRS Notice 2018-29. The final regulations under IRC Section 1446(f) were released on October 7, 2020, and are discussed below.
IRC Section 1446(f)
The final regulations provide a mechanism for the applicability of IRC Section 1446(f) to publicly traded partnerships (“PTP”). In general, the broker effecting the transfer of a PTP interest is required to withhold. The PTP withholding rules are effective January 1, 2022. Prior to January 1, 2022, PTPs are not subject to withholding.
Exceptions to Withholding
The regulations provide several exceptions to the withholding requirements and are applicable effective January 1, 2022. (For years prior to January 1, 2022, the taxpayer has a choice to apply either the proposed regulations or Notice 2018-29.)
The following exceptions remained unchanged, with the provision that the IRS has promised to make some procedural changes by revising forms required for certification. Thus, no withholding is required if the transferor certifies that:
- The transferor is a U.S. person as opposed to a foreign person.
- U.S. tax treaty exempts the transferor from 1446(f) withholding.
- No gain is realized including no ordinary gain related to “hot assets,” e.g., inventory.
- No gain is recognized due to applicable provision of the tax code.
Two other exceptions to withholding popularly known as “10% effectively connected income exception” and “less than 10% effectively connected gain exception” were modified substantially by the final regulations. While there are many nuances to these exceptions, simply put, the modifications were intended largely to ease the ability to utilize the exception in the absence of a specific tax form (e.g., Form 8805) required under the proposed regulations, and/or to use K-1 data in providing the required certification.
Coordination of Withholding Rules under IRC Section 1446(f) and IRC Section 1445
Under final regulations, if a partnership certifies that it is not a USTB partnership in a current taxable year, a transfer of partnership interest is not subject to IRC Section 1446(f) withholding requirements, even if the partnership realizes effectively connected gain in a sale of United States real property (because such withholding will be covered under IRC Section 1445).
Definitions of Transferee, Transfer, and Amount Realized
The final regulations treat deemed sale or exchange of a partnership interest under disguised sale rules (applicable to partnerships under the Internal Revenue Code) as transfer and the contributing partner as a transferee for IRC Section 1446(f) purposes. The amount realized calculation need not include the transferor’s reduction in partnership liabilities, if the amount otherwise to be withheld would exceed the amount realized (without taking into account decrease in the transferor’s share of partnership liabilities).
Modified Amount Realized for Transfers by Foreign Partnerships
The final regulations follow the modified amount realized approach of the proposed regulation in a tiered partnership structure where the foreign partnership is the transferor. Under this approach, the transferee of the USTB partnership interest is allowed to withhold IRC Section 1446(f) tax on the modified amount that is certified by the transferor foreign partnership. The final regulations may also allow modification to the amount realized in case where a foreign partnership transferor has a direct or indirect partner not subject to tax on 864(c)(8) transfer under an applicable U.S. income tax treaty. (The proposed regulations allowed modification only in a case where the transferor foreign partnership had U.S. partners.) To utilize modified amount realized, the transferor foreign partnership must provide to the transferee a certification on Form W8-IMY and/or W-8BEN or Form W-8BEN-E.
Partnership’s Obligation to Withhold Where Transferee Fails to Withhold and Refund Claim for Excess Withholding
Under proposed regulations, if the transferee partner did not meet its IRC Section 1446(f) tax withholding obligation, the USTB partnership was required to meet this obligation by withholding from future distributions to the transferee partner. While the final regulations continue to apply this rule, it provides an additional rule where the USTB partnership does not have to withhold where it has a proper certification of non-foreign status of the transferor partner. The final regulations also allow the transferee, rather than the partnership, to seek refund of IRC Section 1446(f) over-withholding.