This post is the first of three installments providing an overview of recent proposed regulations under section 1446(f) that address withholding on certain sales of partnership interests by foreign partners of a partnerships engaged in the conduct of a U.S. trade or business (a “U.S. trade or business”). Sections 864(c)(8) and 1446(f) were adopted as part of tax reform.  Section 864(c)(8) was enacted to reverse the holding of the Tax Court in Grecian Magnesite Mining v. Commissioner, which was affirmed by the U.S. Court of Appeals for the DC Circuit.  This post focuses on which party is required to withhold under section 1446(f). The second post focuses on determining the appropriate amount to withhold. Finally, the third post focuses on the withholding requirements and the “backstop withholding” rules.

On May 7, 2019, the IRS issued proposed regulations under section 1446(f), which imposes a withholding tax on transfers of partnership interests by foreign persons in partnerships that are engaged in a U.S. trade or business. Section 1446(f) is intended to be an enforcement mechanism for the substantive tax that is imposed by section 864(c)(8). Section 864(c)(8) provides that gain or loss derived by a foreign person on the sale or exchange of a partnership interest of a partnership that is engaged in a U.S. trade or business is treated as “effectively connected gain or loss” to the extent such gain or loss would result if the partnership had sold all of its assets at their fair market value (i.e., a deemed sale) as of the date of the sale or exchange of such interest.

Section 1446(f) and its regulations directly affect foreign persons that recognize gain or loss from the sale or exchange of an interest in a partnership that is engaged in a U.S. trade or business (the “transferor”), the persons that acquire those interests (generally known as the “transferee”), and also partnerships that, directly or indirectly, have foreign persons as partners.

Importantly, if the proposed regulations are issued in final form, such regulations would end the temporary suspension on withholding for transfers of interests in publicly traded partnerships (“PTPs”) implemented by Notice 2018-8. The proposed regulations also modify rules under Notice 2018-29 that currently apply to transfers of non-PTPs interests. Finally, the proposed regulations would also end the suspension of the partnership withholding requirement under section 1446(f)(4) implemented by Notice 2018-29.

Who Is Required to Withhold?

Section 1446(f)(1) requires the transferee to deduct and withhold a 10% tax on the “amount realized” on a transfer that results in effectively connected gain.

Transfers and Transferees

The proposed regulations under section 864(c)(8) provide that a “transfer” means a sale, exchange or other disposition of an interest in a partnership. Importantly, a transfer also includes a distribution from a partnership to a partner to the extent that gain or loss is recognized on the distribution. Thus, where a partnership distributes money to a partner in excess of the partner’s basis in the partnership, the excess is treated as a gain under section 731(a)(1). In such a case, the transferee is the partnership.

Special Rules for PTPs

A transfer of an interest in a PTP, defined in section 7704(b), presents unique issues because the transferee generally does not know the identity of the transferor since the sale is typically effected through brokers. In these circumstances, the transferee is not required to withhold, and the withholding obligation is instead imposed on certain brokers involved in the transfer, which typically include (i) brokers that receive proceeds from the sale and act on behalf of the transferor, as well as (ii) clearing organizations that effect a transfer of a PTP on behalf of the transferor.

If a transfer of a PTP is effected through multiple brokers, a broker that pays the amount realized to a foreign broker is required to withhold unless either (i) the foreign broker is a U.S. branch that has elected to be treated as a U.S. person for withholding tax purposes, or (ii) the foreign broker is a qualified intermediary (often referred to as “QI”) that assumes primary withholding responsibility.

If the transfer of a PTP interest is not effected through one or more brokers, the PTP rules do not apply, and the general rules are imposed.

Exceptions to Withholding (Non-PTPs)

The proposed regulations provide six exceptions to withholding and allow the transferee to rely on certain certifications that it receives from the transferor or partnership, unless it has actual knowledge that the certifications are incorrect or unreliable. When the partnership is the transferee because it makes a distribution, it may rely on its own books and records, unless it knows, or has reason to know, that the information is incorrect or unreliable.

The exceptions, outlined below, generally follow the exceptions in Notice 2018-29 but have been revised to have more stringent thresholds.

    1. Documentation of U.S. Status — Section 1446(f)(2) provides that a withholding requirement does not apply if the transferor furnishes an affidavit providing a U.S. taxpayer identification number and stating it is not a foreign person. The proposed regulations clarify that a certification by the transferor of its U.S. status on Form W-9 is sufficient proof that the transferor is a U.S. person and is exempt from withholding.
    2. Documentation of Treaty Exemption Claim — A transferor may also certify that it is not subject to tax on any gain from the transfer pursuant to an income tax treaty by providing a Form W-8BEN or Form W-8BEN-E.
    3. Certification of No Realized Gain — The transferor may provide the transferee with a certification that the transferor would not realize any gain on the transfer of the partnership interest, which includes the recognition of any ordinary income arising under section 751(a) and the related regulations. Assets under section 751(a) include assets that produce ordinary income, such as unrealized receivables and inventory items, which are referred to as “hot assets.” Thus, the transferor is precluded from issuing a certification if the transferor is required to realize any ordinary income under section 751(a), even if the transferor would realize an overall loss on the transfer.
    4. Certification of a De Minimis Effectively Connected Gain — The partnership may provide the transferee with a certification that if the partnership sold all of its assets at fair market value, the amount of net effectively connected gain would be less than 10% of the total gain. The proposed regulations lowered the threshold provided in Notice 2018-29 from 25% to 10%.
    5. Certification on De Minimis Effectively Connected Taxable Income (“ECTI”) — The transferor may provide the transferee with a certification that (i) the transferor was at all times a partner in the partnership for the immediately prior taxable year and the two taxable years that precede it, (ii) the transferor’s distributive share of effectively connected income during each of the previous three years was less than 10% of the transferor’s total distributive share of net income in each years, and (iii) the transferor’s allocable share of ECTI for each year was less than $1 million. The proposed regulations lowered the threshold provided in Notice 2018-29 from 25% to 10%.
    6. Certification of a Nonrecognition Transaction —The transferee may rely on a certification from the transferor that a nonrecognition provision applies to all of the gain realized on the transfer.

 Exceptions to Withholding (PTPs)

 The proposed regulations provide five exceptions to withholding that apply to the transfer of a PTP interest.

    1. Documentation of U.S. Status — The broker may rely on a transferor’s certification of its U.S. status by obtaining a Form W-9 or a valid substitute form.
    2. Documentation of Treaty Exemption Claim — A broker may also rely on a certification from the transferor that it is not subject to tax on any gain from the transfer pursuant to an income tax treaty by providing a Form W-8BEN or Form W-8BEN-E.
    3. Qualified Notice of a De Minimis Effectively Connected Gain — A broker may rely on a qualified notice that provides that if the PTP sold all of its assets at fair market value, the amount of net effectively connected gain would be less than 10% of the total gain. Unlike the exception that applies for non-PTPs, this rule requires a PTP to designate a date for this purpose that generally occurs within the most recent calendar quarter.
    4. Qualified Notice of Distribution Amount — A special rule applies to distributions by PTPs that requires the transferee-partnership to withhold only if the distribution made is greater than its net income since its last distribution and as long as the partnership publishes a qualified notice to that effect. Accordingly, a broker is not required to withhold if a qualified notice posted by a PTP indicates that the distribution does not exceed the net income the partnership earned since the record date of the partnership’s last distribution.
    5. Backup Withholding — To prevent double withholding, a broker is not required to withhold if it is already applying backup withholding under section 3406 when a payment is treated as being made to a non-exempt U.S. recipient.