Last July, foreign investors rejoiced at the Tax Court’s ruling in Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, which held that gains or losses on sales of partnership interests should be treated as gains or losses on the sales of capital assets. While the Service did not formally announce whether it would follow the Tax Court’s decision in Grecian Magnesite, the decision was considered a favorable ruling for taxpayers. We explained the potential impact in “Tax Court’s Grecian Formula Combs in Colorable Claims for Refunds by Foreign Taxpayers.”
Unfortunately, it turns out that the Tax Court’s ruling’s apparent positive impact did not survive tax reform. The Tax Cuts and Jobs Act (TCJA) ushered in new and significant changes to international taxation, including a provision that supersedes the Tax Court’s decision in Grecian Magnesite through the interplay of amended Sections 864(c)(8) and 1446(f). As with many aspects of tax reform, there is very little guidance on the scope of these sections, prompting a request for guidance. Thus, this article aims to help navigate how these sections apply, and the effect of these new rules on foreign investors (as well as to domestic withholding agents).
The sale, exchange, or other disposition (collectively “disposition”) of a partnership interest held by a foreign person may trigger the newly enacted withholding and filing requirements. The TCJA expanded the prior withholding regime on the disposition of partnership interests by foreign persons to include all partnership assets that can be connected to a U.S. trade or business (i.e., “effectively connected”). Amended Section 864(c)(8) of the Internal Revenue Code (the “Code”) specifies that effectively connected income includes the gain or loss on the sale of an interest in a partnership that is engaged in a U.S. trade or business. The amount of gain or loss deemed effectively connected, however, cannot exceed the gain or loss a partner might receive if the partnership had sold all of its assets at their fair market value.
Section 1446(f) generally provides that, if any portion of the gain (if any) on any disposition of an interest in a partnership would be treated under Section 864(c)(8) as effectively connected with the conduct of a trade or business within the U.S., the transferee shall be required to deduct and withhold a tax equal to 10 percent of the amount realized on the disposition. Therefore, foreign persons who hold interests in a partnership will not only be subject to withholding on the disposition of their partnership interests connected to U.S. real property interests, but also any effectively connected partnership interests. However, the withholding regime will not apply to dispositions of certain publicly traded partnership interest.
Treasury has not yet issued regulations instructing taxpayers on the manner to comply with the new withholding and filing requirements. Instead, the Internal Revenue Service (IRS) published Notice 2018-29 on April 2, 2018, to act as a temporary guide on the general Section 1446(f) withholding and reporting procedures. Notice 2018-29 covers many of the concerns foreign partners may face when attempting to comply with this new withholding regime. A few of the notable topics addressed include the required forms and procedures to file and withhold, exceptions to withholding, the treatment of nonrecognition transactions, substantiating a partner’s partnership liability, and substantiating the return of basis from the partnership.
Notice 2018-29 explains that until the Section 1446(f) specific regulations are issued, foreign partners are expected to adhere to the Section 1445 rules and related regulations when complying with the Section 1446(f) withholding and reporting obligations. For example, the transferee has twenty days from the date of the disposition of a partnership interest to report the transfer and remit the tax withheld to the IRS. To report and transmit the amount withheld, the transferee would file Form 8288 (U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests). Foreign partners who wish to receive credit on the amount withheld under Section 1446 should file Form 8288-A (Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests). It is important to note that “Section 1446(f)(1) Withholding” must be written at the top of both Form 8288 and 8288-A to differentiate which type of disposition is being reported to the IRS. However, the IRS will not issue a withholding certificate as specified under Section 1446(f)(3) until the regulations are published (i.e. taxpayers may not apply for reduced withholding until such time).
Nonetheless, foreign partners may be eligible for relief from the Section 1446 withholding regime if one of the following four exceptions applies to their disposition of a partnership interest, provided the transferor makes the appropriate certification to the transferee under penalty of perjury:
- The first exception is available if the transferor is able to provide an affidavit to the transferee certifying that the transferor is not a foreign person;
- The second exception applies if the transferor can certify that the disposition of its partnership interest will not result in realized gain;
- The third exception pertains to a disposition in which the transferor can certify that for each of the three prior taxable years its share of effectively connected taxable income was less than 25 percent of their total distributive share of income for that year; and
- The fourth exception would be relevant if a transferor can certify that the amount of effectively connected gain that would result from the sale by the partnership of all of their assets at their fair market value would be less than twenty-five percent of the total gain.
In addition, the Treasury Department and the IRS intend to issue regulations addressing situations where withholding under Section 1445(e)(5) or Treas. Reg. Section 1.1445-11T(d)(1) with respect to the amount realized, as well as under Section 1446(f)(1) may apply, providing that the taxpayer will be subject to the payment and reporting requirements of Section 1445 only, and not Section 1446(f)(1), with respect to such amount. However, this rule applies only if the transferor has not obtained a withholding certificate that is provided for in the last sentence of Treas. Reg. Section 1.1445-11T(d)(1). Conversely, if the transferor has obtained such a withholding certificate, the transferee must withhold the greater of the amounts required under Section 1445(e)(5) or Section 1446(f)(1). Under these circumstances, a transferee that has complied with the withholding requirements under either Section 1445(e)(5) or Section 1446(f)(1), as applicable, will be deemed to satisfy the other withholding requirement.
Treasury and the IRS are still analyzing how to approach the application of these new rules to nonrecognition transactions. Until a decision is reached, withholding is not required in a transaction in which no gain or loss is recognized.
Calculating the amount realized on the disposition of a partnership interest for purposes of Section 1446(f) requires the determination of a transferor’s share of partnership liabilities. Section 7 of Notice 2018-29 provides transferees with two potential forms of evidencing the transferor’s share of partnership liabilities, whereby transferees may utilize a transferor’s most recently issued Form 1065 Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc.) or a certification from the partnership confirming the amount of the transferor’s share of partnership liabilities.
Treasury and the IRS will also release regulations permitting partnerships to rely on the partnership’s own books and records or on the distribute partner’s certification when calculating whether the partnership distribution will exceed the partner’s basis in its partnership interest, provided that the partnership does not know or have reason to know that its books and records, or the distributee partner's certification, is incorrect and the partnership retains a record of the documentation relied upon to establish the partner's basis for the appropriate period.
Alvarez & Marsal Taxand Says:
In light of the new law, foreign investors will need to plan and model out potential tax and withholding issues prior to disposing of an interest in a partnership that may be engaged in a U.S. trade or business. Now, more than ever, with the incomplete guidance, it is imperative to look at all possible outcomes and consider the viability of various interpretations if contemplating a partnership disposition.
With such a large focus on the outbound aspects of international tax after the passage of the TCJA, it is important to note that these changes significantly affect the way that foreign investors structure and dispose of their U.S. investments. With little in the way of guidance, it is important to stay on top of how these new withholding requirements (and the exceptions thereto) affect foreign investors and their existing structures.