Firm Suggests Guidance for Publicly Traded Partnership Issues

May 21, 2018

Lafayette G. “Chip” Harter
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

Marjorie Rollinson
Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: Recommendation for Guidance Under Sections 864(c)(8) and 1446(f) of the Internal Revenue Code to Address Issues Concerning Publicly Traded Partnerships

Dear Mr. Harter and Ms. Rollinson:

On behalf of The Blackstone Group L.P, enclosed is a memorandum outlining our recommendation for guidance under Sections 864(c)(8) and 1446(f) of the Internal Revenue Code of 1986, as amended, to address issues concerning publicly traded partnerships (“PTPs”) and their partners. As more fully described in the enclosed memorandum, the new rules contained in Sections 864(c)(8) and 1446(f) create a number of significant practical problems for PTPs, their partners, and securities brokers. The enclosed memorandum lays out a fair and administrable regime to address those problems.

We would be happy to discuss the recommendations with you or your staff if that would be helpful. If you have any questions, please do not hesitate to call me at (202) 371-7130, or my colleagues Brian Krause at (212) 735-2087 or Nick Gianou at (312) 407-0504. We appreciate your assistance with this matter.

Very truly yours,

Paul W. Oosterhuis
Skadden, Arps, Slate, Meagher & Flom, LLP
Washington, DC

Enclosures

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Recommendation Submitted by The Blackstone Group L.P, for Guidance Under Sections 864(c)(8) and 1446(f) of the Code

I. Introduction

This memorandum outlines our recommendation for guidance under Sections 864(c)(8) and 1446(f) of the Internal Revenue Code of 1986, as amended (the “Code”),¹ to address issues concerning publicly traded partnerships (“PTPs”) and their partners.

Under Section 864(c)(8), enacted by the Tax Cuts and Jobs Act of 2017, P.L. 115-97 (the “TCJA”), all or a portion of the gain recognized by a foreign person on the sale or exchange of an interest in partnership is treated as “effectively connected income” (“ECI”), and is therefore subject to tax at the rates applicable to U.S. persons, if the partnership is engaged in a U.S. trade or business. The portion of the gain treated as ECI under this rule is based on the amount of ECI that would be allocated to the foreign partner upon a sale of the partnership's assets. To enforce the tax imposed by Section 864(c)(8), the TCJA also includes a new withholding rule, codified in Section 1446(f), that requires the buyer of such a partnership interest to withhold 10% of the amount realized on the sale.

A literal application of these provisions — especially the withholding provisions of Section 1446(f) — would create a number of significant practical problems for PTPs, their partners, and securities brokers. In fact, literal compliance would in many respects be impossible. For example, the typical buyer of a PTP interest purchases its interest on a securities exchange in a transaction in which it does not even know the identity of the seller.

In Notice 2018-8, 2018-4 I.R.B. (Jan. 2, 2018), Treasury, recognizing the difficulties in applying Section 1446(f) to PTPs, fully exempted PTPs and their partners from Section 1446(f) withholding. The recommendations set forth in this memorandum would address the foregoing issues while maintaining the government's ability to collect the appropriate amount of taxes from sales of PTP interests. The recommendations consist of the following six key aspects, the first five of which relate to withholding and the sixth of which relates to the calculation of the substantive tax:

Each of these recommendations is discussed in more detail below.

II. Outline of Recommendations

A. Recommendation #1: Withholding by Seller's Broker

1. Description of Recommendation #1

In the case of any transfer of interests in a PTP that is not exempt from withholding, the seller's broker will have the sole obligation to withhold. Accordingly, neither the buyer nor the buyer's broker will have any withholding obligation, nor will the PTP have secondary withholding liability if seller's broker fails to withhold.

2. Rationale for Recommendation #1

Section 1446(f)(6) grants Treasury broad — almost plenary — regulatory authority, including the express authority to create exceptions to the withholding requirement: “The Secretary shall prescribe such regulations or other guidance as may be necessary to carry out the purposes of this subsection, including regulations providing for exceptions from the provisions of this subsection.”

Recommendation #1 allocates the withholding responsibility to the only party who knows the identity of the seller. In fact, Congress expressly stated in the TCJA conference report that Treasury's regulatory authority could be used to require seller's broker to effect any withholding in the case of a PTP.

In addition, requiring a seller's broker to withhold is the only administrable solution for PTPs because no other party will be in a position to know the identity and non-foreign status of the seller when a PTP unit is sold on a securities exchange. Neither the buyer nor its broker would have this information. Accordingly, it would be unfair to impose withholding liability on the buyer or the buyer's broker, or to impose secondary withholding liability on the PTP as a result of any under-withholding.

B. Recommendation #2: Exemption from Withholding for Small Holders in Certain Eligible PTPs

1. Description of Recommendation #2

Withholding would not apply if all of the following requirements are satisfied:

• PTP Status. The partnership must be a PTP whose units are “regularly traded on an established securities market” within the meaning of FIRPTA.

• Small Holder. The seller must have owned less than 5% (by value) of the PTP at all times during the shorter of (i) the five-year period ending on the date of sale and (ii) the seller's holding period. For purposes of this requirement, anyone who has not had on file, at any time during the five-year period ending on the date of sale, an SEC form 13-D or 13-G showing 5% ownership would be presumed to be a less-than-5% holder, absent the withholding agent's actual knowledge to the contrary.

• 25% ECI Thresholds. The PTP would have to satisfy one of the two 25% ECI thresholds contained in section 6.03 or 6.04 of Notice 2018-29, 2018-16 I.R.B. (Apr. 2, 2018), as modified below. Under this requirement, either (i) if the PTP had sold all of its assets at their FMV, the amount of gain that would have been ECI to the seller would be less than 25% of the total gain allocated to the seller (the “25% Hypothetical Gain Threshold”), or (ii) for each of the last three taxable years, the amount of ECI allocated to the PTP's partners was less than 25% of the total distributive share of income allocated to the PTP's partners (the “25% Three-Year ECI Threshold”).

  • As in Notice 2018-29, this test is disjunctive, so that a PTP need only qualify under one, but not both, of the thresholds.

  • The 25% Gain Threshold would be tested under the proposed quarterly reporting rules described in Recommendation #6 below (except based on the most recently completed quarterly information, rather than using averages for transfers occurring within a quarter).

  • The 25% Three-Year ECI Threshold would be determined based on aggregate partnership-level income information that the PTP publishes annually at the time its K-1s are delivered,² rather than on the allocations to the particular selling partner during the preceding three years. Accordingly, individual differences in allocations between different sellers — which could be caused by differing basis step-ups under Section 743, by required allocations under Section 704(c), or simply by the fact that the sellers sold at different times during the taxable year — would be ignored. However, in order to ensure that the 25% Three-Year ECI Threshold is applied equitably, it would apply only to PTPs that allocate each item of 704(b) income or loss substantially pro rata among all partners, meaning that it would not apply to PTPs that have special allocations of any material item of income or loss.

  • In accordance with Notice 2018-29, gain treated as ECI under FIRPTA would be included in the numerator under each of the foregoing tests.

2. Rationale for Recommendation #2

As described above, Congress granted Treasury broad regulatory authority, including to create exceptions to the withholding requirement. The exception in Recommendation #2 is a narrowly tailored exemption within the scope of that grant of regulatory authority. As a result of the following limitations, it provides relief from withholding in the most administratively burdensome cases that involve relatively small amounts of potential tax revenue.

• Small Holders. Recommendation #2 only exempts small (less-than-5%) investors. This is appropriate because imposing withholding obligations on transfers by all investors, no matter how small, places a significant administrative burden on withholding agents (i.e., sellers' brokers under Recommendation #1). These are transfers that, for any PTP, may happen hundreds, if not thousands, of times a day and often in very small amounts per trade. Brokers are likely to have a very difficult time updating their internal systems to permit them to withhold at that frequency and on trades of that size. By contrast, trades by large shareholders are likely to be much less frequent and more easily tracked.

  Moreover, 5% is an appropriate threshold for defining “small” investors for this purpose. First, under Sections 897 and 1445 (the closest analogy to new Sections 864(c)(8) and 1446(f)), a less-than-5% holder of a PTP is wholly exempt from taxation under FIRPTA, regardless of the amount of U.S. real property owned by the PTP — a rule that, we note, is not expressed in the statute but instead is an exemption created by Treasury pursuant to its regulatory authority (by analogy to the rule for publicly traded corporations).

  In addition, the 5% standard is used in other analogous Code sections³ and, perhaps more importantly, is the relevant threshold for SEC reporting purposes, which is the only way as a practical matter that any withholding agent can even determine ownership percentages in a public company.

• ECI Threshold. The 25% ECI thresholds described above ensure that small holders will have a withholding exemption only for PTPs whose assets would not, or tend not to, give rise to significant Section 864(c)(8) substantive tax. By definition, the 25% Hypothetical Gain Threshold would apply only where a relatively small portion of the seller's gain would be taxed as ECI under Section 864(c)(8). Similarly, the 25% Three-Year ECI Threshold serves as a simple and useful proxy for the 25% Hypothetical Gain Threshold: if only a small percentage of the seller's historical income allocations have consisted of ECI, it suggests that only a relatively small portion of the partnership's assets are ECI-generating assets, which in turn suggests that gain on the sale of the partnership's assets would likely generate relatively small amounts of ECI. In both cases, the thresholds are the same as those used in the IRS's own guidance for non-traded partnerships in Notice 2018-29. And although Treasury in Notice 2018-29 expressed an intent to reduce the 25% threshold to something lower in the case of non-traded partnerships, it is appropriate to retain the higher 25% threshold for PTPs because Recommendation #2 is much narrower than Notice 2018-29. In particular, Recommendation #2 applies only to less-than-5% holders, whose frequent but small trades present unique practical challenges for withholding agents while generating only modest amounts of tax under Section 864(c)(8).

C. Recommendation #3: No Withholding on PTP Distributions

1. Description of Recommendation #3

No withholding under Section 1446(f) would be required on distributions by a PTP to a foreign partner, even if the distribution exceeds the partner's outside basis such that the partner is treated as recognizing gain on the disposition of the partnership interest under Section 731. This exemption would exempt both the PTP itself and the distributee's broker from withholding and would apply regardless of whether the PTP satisfies the ECI threshold above and regardless of the size of the holder's interest in the PTP.

2. Rationale for Recommendation #3

For the same reasons noted for Recommendation #2, Recommendation #3 is a limited exemption that is well within the scope of Treasury's regulatory authority. Applying the Section 1446(f) withholding regime to PTP distributions is inadministrable because neither PTPs nor a distributee's broker will have the information necessary to determine whether a distribution will trigger gain and thus a withholding obligation under Section 1446(f).

PTPs generally do not know who the recipient of any particular distribution is because they simply pay the brokers that hold their publicly traded units, who are then responsible for remitting the distribution in the right amounts to the relevant beneficial owners. Because the PTP will not even know who the recipient of any particular distribution is, the PTP will not be able to determine the tax basis of any particular partner. For this reason, PTPs generally do not make investor-specific withholding determinations under other withholding regimes, such as Section 1446(a) withholding. Instead, they publicly post a “qualified notice” for each distribution that describes the portion of the distribution that is allocable to ECI, from which brokers can determine the amount of withholding on an investor-by-investor basis.

Similarly, although brokers know the identity of the beneficial owners of the units and are more likely to have investor-level information, they generally will not have all the information or expertise necessary to calculate a partner's basis in its PTP interest at the time of the distribution. For example, outside basis is adjusted for current year allocations of income or loss and changes in partnership liabilities, which amounts will not be available to the broker in real time. Moreover, PTPs would be unable to provide brokers with the information necessary for brokers to calculate the beneficial owner's tax basis in the units at the time of the distribution. The adjustments that must be made to the owner's cost basis to determine its adjusted basis depend on when the unit was purchased. A PTP would need to provide brokers with monthly adjustments dating back to the PTP's formation and continue providing monthly adjustment information going forward, which would not be practical for the PTP or the brokers. Furthermore, because of the frequency of the trades in their units, PTPs typically use a proration (rather than “closing of the books”) method under Section 706 under which they prorate their aggregate tax items over each day of the taxable year and allocate the items to holders of their equity on those days, taking into account applicable simplifying conventions (e.g., monthly conventions under which a sale that occurs in a month is deemed to occur at the beginning or end of that month). Because of this allocation method, PTPs are unable to determine how much income is allocated to particular unitholders until the end of their taxable year.

D. Recommendation #4: Section 752 Liabilities Based on Latest K-1 or Quarterly PTP Reporting in Calculating the Amount of Withholding

1. Description of Recommendation #4

In the case of any transfer of interests in a PTP that is not exempt from withholding, the portion of the amount realized on the sale that is attributable to the seller's share of liabilities under Section 752 would be determined, for purposes Section 1446(f), in a manner similar to the rules of section 7 of Notice 2018-29, with slight modifications. Accordingly, the Section 752 per unit liability allocation would be deemed to be the liability allocation shown on the last K-1 delivered to the seller, which the seller would be obligated to provide its broker. Unlike Notice 2018-29, there would be no requirement under this prong that the K-1 relate to a taxable year that closed within 10 months of the transfer. For example, a broker withholding on a sale occurring in December 2019 could rely on the allocation shown in the K-1 for the taxable year ended December 31, 2018.

2. Rationale for Recommendation #4

It is generally very difficult for brokers to obtain accurate, up-to-date information on the amount of Section 752 liabilities that give rise to amount realized in a sale of the PTP units. In fact, in Notice 2018-29, Treasury recognized as much even in the case of private partnerships and provided relief thereto in a manner similar to Recommendation #4. The slight variations between Recommendation #4 and Notice 2018-29, which relate primarily to the length of time for which a K-1 can serve as a valid indicator of liability allocations, are appropriate in light of the added difficulties in managing this issue with respect to a PTP.

E. Recommendation #5: Form W-9 as Non-Foreign Certificate

1. Description of Recommendation #5

Section 1446(f)(2) creates an exemption to withholding where the buyer of the partnership interest has received from the seller a certificate, signed under penalties of perjury, attesting to the seller's taxpayer identification number (“TIN”) and status as a non-foreign person. In the case of any transfer of interests that is not exempt under the recommendations described above, the seller's broker would be permitted to treat itself as having received a non-foreign certificate that complies with Section 1446(f)(2) (thereby exempting the broker from withholding) if the broker has on file a valid Form W-9 from the seller.

2. Rationale for Recommendation #5

Treasury has already approved this approach for non-traded partnerships in Notice 2018-29, and for good reason. A Form W-9 contains all the information required by Section 1446(f)(2) for a non-foreign certificate — TIN and non-foreign status certified under penalties of perjury — and is a form that brokers already collect from their customers. It would be unnecessarily burdensome to require brokers to modify their systems to demand separate non-foreign certificates from their clients when their existing systems and procedures would just as easily produce the same information through a W-9.

F. Recommendation #6: Calculation of Section 864(c)(8) Substantive Tax Based on Quarterly PTP Reporting

1. Description of Recommendation #6

Within 45 days after the end of each quarter of the PTP's taxable year, the PTP would be required to publish asset value and basis information with respect to its assets as of the end of such quarter (with the enterprise value of the PTP for purposes of determining asset value determined by a 30-day volume weighted average price beginning 15 days before quarter end). A partner who sold its interests between quarter ends would then determine its Section 864(c)(8) tax by using the average basis and value figures between the two quarters, weighted based on how many days into the quarter the sale occurred. The IRS and the foreign holder would be bound to the quarterly information reported by the PTP as long as it was determined in good faith by the general partner of the PTP.

2. Rationale for Recommendation #6

Section 864(c)(8) grants Treasury broad authority to implement the substantive tax: “The Secretary shall prescribe such regulations or other guidance as the Secretary determines appropriate for the application of this paragraph, including [in non-recognition transactions].” A literal application of Section 864(c)(8) would require a partnership to determine the built-in gain in its ECI assets every time a transfer is made. For most PTPs, this is impossible given the high volume of daily trades made on securities exchanges. Instead, PTPs should be permitted to produce this information periodically, with the fiscal quarter being an appropriate increment. Given that PTPs are typically required to do quarterly valuations for purposes of their audited, SEC-reported financial statements, quarterly reporting has two advantages: (i) it minimizes the additional burden on PTPs by allowing them to “piggyback” off the work they already do for their financial statements, and (ii) it will tend to produce reliable information that has undergone independent scrutiny as part of the financial statement audit.

Although quarterly information will be imperfect for sales of partnership interests that occur between quarters, a PTP will often simply not have a better indicator of value than its most recent quarterly “mark.” The proposal also has other advantages that outweigh the cost of any imprecision in the quarterly values reported by a PTP. The clarity and certainty provided by Recommendation #6 would significantly limit disagreements over valuation issues, which would otherwise consume significant time and resources for both taxpayers and the IRS.

III. Conclusion

The various recommendations set forth in the proposal above are necessary to produce a fair and administrable tax and withholding regime for PTPs and their investors and brokers. If the proposal (or similar proposals) are not adopted, withholding agents either will take significant withholding tax exposure or, more likely, will significantly over-withhold out of caution. In addition to simply being unfair, this will be very disruptive to the capital markets for PTP interests. PTPs provide retail investors with the opportunity to invest in a broader array of asset classes that would otherwise generally be available only to institutional and wealthy individual investors, for whom investment in private equity and hedge funds is possible. Retail investors would avoid investments in PTPs if they could potentially be held liable for the taxes of other investors merely because they purchased PTP interests through their brokerage accounts.