Key guidance for foreign partners holding interests in partnerships that are engaged in a U.S. trade or business (USTB) was released on May 7, 2019, in the form of proposed regulations under Internal Revenue Code Section 1446(f). Section 1446(f) imposes a withholding obligation on the purchaser of an interest in a partnership that is engaged in a USTB. Many components of these proposed rules appear to fall on the “taxpayer-friendly” side by comparison to analogous rules and procedures prescribed under the Foreign Investment in Real Property Tax Act (FIRPTA), which imposes a similar withholding regime on a foreign person’s disposition of a U.S. real property interest.

More specifically, the IRS and Treasury clarified the exemptions for certain partners and certain transactions and confirmed that a reduced (or zero) withholding rate may be applied without obtaining written approval from the IRS (as is required in many FIRTPA transactions). Additionally, the updated “de minimis” exceptions may provide a broader exemption for foreign partners that have received allocations of $1 million or less in effectively connected taxable income (ECTI) for each of the three immediately preceding taxable years, as well as for disposition of interests in partnerships with less than 10 percent effectively connected assets.

Background

As Alvarez & Marsal Taxand previously reported in “An Ode to Grecian Magnesite,” released on July 17, 2018, the introduction of Section 1446(f) and revisions to Section 864(c) flipped the short-lived Tax Court ruling upside down by confirming that a foreign partner’s gain on the sale of an interest in a partnership engaged in a USTB was not “effectively connected” with that USTB. Section 864(c) was revised to conform to the IRS’ position that gain from a foreign partner’s sale of a partnership interest with a USTB is treated in part as effectively connected gain subject to U.S. tax.

To enforce collection of this tax, Section 1446(f) was introduced and generally provides that if any portion of the gain on any disposition of an interest in a partnership is treated under Section 864(c) as effectively connected with the conduct of a USTB, then the transferee must deduct and withhold from the purchase price a tax equal to 10 percent of the amount realized on the disposition. For many years before Grecian Magnesite, many tax practitioners believed there was a defensible position that such gain was not effectively connected to the partnership’s USTB (despite the IRS’ stated position to the contrary) on the basis that an interest in a partnership is an asset separate and distinct from the business or assets of the partnership itself (the so-called “entity” approach). That position lost its viability because of the changes discussed above, which were introduced with the Tax Cuts and Jobs Act of 2017.

Many of the proposed procedures for withholding under Section 1446(f) piggyback on the FIRPTA rules (under Section 1445). Notice 2018-29, which provided temporary guidance prior to the recent release of the proposed regulations, required taxpayers to follow the payment and reporting procedures under Section 1445 for the purpose of applying Section 1446(f). Thus, a transferee in a Section 1446(f) transaction would generally pay and report the required withholding using:

1. Forms 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interest, and
2. Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests.

Under the proposed regulations, Form 8288-A will be replaced by Form 8288-C, Statement of Withholding Under Section 1446(f)(4) for Withholding on Dispositions by Foreign Persons of Partnership Interests. While the IRS has not yet said so, it may be expected that the title of Form 8288 (specifically referencing “Real Property”) may ultimately be adjusted to better reflect the applicability of Section 1446(f) as well as Section 1445.

Both the existing regulations under Section 1445 and the proposed regulations under Section 1446(f) contain exceptions to the general withholding rules. For example, both sets of rules exempt a transferor that certifies to a transferee that either the transferor is not a foreign person, and/or the relevant transaction is subject to certain non-recognition rules. In the case of a claim of non-foreign status, no approval is needed from the IRS to exempt the transaction from withholding. In the case of non-recognition procedures, only some types of transactions require IRS approval.

Certification of Maximum Tax Liability Procedures

One major distinction between Section 1445 procedures and Section 1446(f) procedures lies in the “reduced withholding” procedures in the case of a transaction in which the withholding tax (10 percent under 1446(f) and 15 percent under Section 1445) would result in a liability greater than a transferor’s anticipated U.S. tax liability from the transaction.

Under Treasury Regulation Section 1.1445-6, a transferee or transferor in a FIRPTA transaction may submit an application to the IRS on Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests to request approval for either a reduced withholding amount (e.g., below the statutory 15 percent rate) or a complete exemption in the case where a transaction is not expected to result in any gain. The application for reduced withholding generally must include a calculation of the maximum tax that could be imposed on the disposition, as well as a statement signed by the transferor under penalties of perjury that the calculation and all supporting evidence are true and correct to the best knowledge of the applicant. The calculation must be accompanied by a litany of supporting documentation to support the computation.

While the IRS suggests it will act to approve the application within 90 days of submission, it is not uncommon for the FIRTPA office to follow up with requests for additional information, causing the processing time to extend well beyond 90 days. The extended lead time needed to obtain the IRS approval often greatly complicates real estate transactions involving foreign sellers. If and once the IRS approves the reduced withholding, it will issue a certificate authorizing the transferor to reduce or eliminate withholding. Because it is not practical in many cases to obtain the certificate prior to the closing date, the FIRPTA regulations allow for “escrow procedures” which, while helpful in terms of providing more flexibility in the timing of a transaction, add complexity to the flow of funds in many transactions and generally contribute to increased closing costs.

Foreign partners -- meet Proposed Regulation Section 1.1446(f)-2(c)(4). While Notice 2018-29 did suggest that reduced withholding procedures would apply to Section 1446(f) transactions, it was not clear what these procedures would look like and whether the IRS and Treasury might decide to require application procedures similar to those that apply to FIRPTA transactions discussed above. The proposed regulations under Section 1446(f), however, adopt a more taxpayer-friendly approach by allowing the transferor to certify its maximum tax liability under Section 864(c)(8) under specified procedures without IRS’ review and approval. Compliance with these procedures will ease some of the administrative hurdles and timing constraints associated with a foreign person’s sale of a partnership interest that falls within the scope of these rules.

The certification provided to the transferee must include the following information:

• A statement that the transferor is either a nonresident alien individual, a foreign corporation, or a foreign partnership;
• The transferor's adjusted basis in the transferred interest on the determination date;
• The transferor's amount realized on the determination date;
• Whether the transferor remains a partner immediately after the transfer;
• A statement of the amount of outside ordinary gain and outside capital gain that would be recognized and treated as effectively connected gain on the determination date (effectively connected gain under the Section 864 regulations);
• A statement of the transferor's maximum tax liability with respect to the gain on the determination date;
• A representation by the transferor that the transferor determined the amounts described above based on a “Partnership Statement” (defined below), and
• A representation from the transferor that it has provided the transferee with a copy of the Partnership Statement.

The Partnership Statement should include the partnership's name, address, and TIN; and the transferor's aggregate deemed sale effectively connected ordinary gain (if any) and aggregate deemed sale effectively connected capital gain, (if any), in each case, on the determination date. These amounts are determined pursuant to Treasury Regulations 1.864(c)(8)-1 and effectively require the partnership to determine hypothetical ordinary and capital gain or loss on a deemed disposition of its assets and compare that gain to the transferor partner’s outside ordinary and capital gain for the purpose of making certain adjustments. As can be seen, the overall rules for determining the net effectively connected gain (both capital and ordinary) can be quite complex and clearly require the active participation of the partnership. Where only a portion of the income or gain from a disposition of the interest would be subject to tax under Section 864(c)(8) because of a non-recognition provision or a treaty, additional procedures apply.

When the transferor provides the transferee with the required information under the certification procedure, the transferee can withhold based on the transferor’s maximum tax liability. That maximum tax liability is equal to the transferor’s effectively connected gain multiplied by the highest rate of tax for each type of income or gain.

Other Exemptions:

While the above exception is important because it allows the parties to avoid deferring a foreign partner’s receipt of cash on the sale (e.g., until returns are filed), there are some other important exceptions that should be highlighted:

1. Treaty Exception – In rare cases, a partner may certify that a disposition is exempt from withholding tax under a tax treaty. This might be the case, for example, where it has been determined that a partnership does not have a Permanent Establishment (“PE”) (but does have a USTB) and the transferor qualifies for the benefits of a tax treaty that allows the U.S. to tax only gain attributable to a PE. The certification to the transferee must be made on Form W8-BEN or W8-BEN-E and a copy of the certification must be filed with the IRS by the 30th day after the date of transfer.
2. De Minimis Rule for ECTI Assets – To ease the burden on partnerships where only a small percentage of partnership assets produce “effectively connected” income, an exception is allowed where the partnership certifies that the amount of net effectively connected gain resulting from the deemed sale would be less than 10 percent of the total net gain. This percentage was set at 25 percent in Notice 2018-29. The proposed regulations allow the effectively connected gain to be calculated as of the determination date.
3. De Minimis Rule for ECTI Allocations – Replacing a 3-year test previously set forth in Notice 2018-29, the proposed regulations adopt a more practical approach. A de minimis rule is introduced providing that no withholding is required if the transferor certifies to the transferee that the transferor was at all times a partner in the partnership for the immediate prior taxable year and the two preceding taxable years, and that the transferor's allocable share of effectively connected taxable income for each of those taxable years was less than 10 percent of the transferor's total distributive share of the partnership's net income for that year. In addition, a transferor must certify that, in each of the three preceding taxable years, the transferor's allocable share of ECTI (including ECTI allocated to certain persons related to the transferor) was less than $1 million and that the transferor filed U.S. tax returns and paid tax on the ECTI.

In addition to the matters covered in this article, it should be noted that the proposed regulations contain other complex rules to be aware of and further guidance on how to apply Section 1446(f) in the case of publicly traded partnerships (PTPs). All withholding on PTPs was previously suspended under Notice 2018-29.

Alvarez & Marsal Says:

While the Certification of Maximum Tax Liability Procedures and revised de minimis rules provide some flexibility and relief to foreign partners, the highly complex certifications required under the procedures and exceptions create significant risk for transferees, transferors, and the partnership itself. Navigating these rules will require sophisticated computations related to both inside and outside basis. A foreign partner must also be aware that complying with procedures that reduce or eliminate withholding do not absolve the partner from filing a U.S. tax return and paying the appropriate U.S. tax on the effectively connected gain.