By offering six exceptions to withholding on transfers of partnership interests, Treasury tried to be generous. The proposed regs (REG-105476-18) provided rules for the withholding regime, but there are still significant issues to be addressed before the regime is fully workable. Part of the problem Treasury and the IRS face is that the statute the withholding regime implements isn’t as airtight as it should be.
The best bet for foreign transferors of interests in partnerships that are engaged in U.S. trades or businesses is to figure out a way to qualify for one of the six exceptions to withholding detailed in the proposed regulations. But doing that might not be so simple, because while the exceptions cover a range of situations, they aren’t always broad.
The reason for sections 864(c)(8) and 1446(f) goes back to Rev. Rul. 91-32, 1991-1 C.B. 107, in which the IRS explained that a foreign partner that transfers its interest in a partnership engaged in a trade or business in the United States has effectively connected income to the extent its gain or loss is attributable to ECI property of the partnership. That ruling was roundly criticized, but it stood until the Tax Court rejected its interpretation in Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, 149 T.C. 63 (2017), aff’d, No. 17-1268 (D.C. Cir. June 11, 2019).
In the Tax Cuts and Jobs Act, Congress overturned the Tax Court’s holding in section 864(c)(8) to provide that gain or loss of a foreign partner from a transfer of an interest in a partnership is generally treated as ECI to the extent the partner would have had ECI if the partnership had sold all its assets at fair market value on the date of the transfer. Treasury issued proposed regulations on section 864(c)(8) (REG-113604-18) on December 27, 2018.
One of the chief problems with implementing section 864(c)(8) is that foreign partners will need information from the partnerships in which they hold interests in order to compute the amount treated as ECI, which may sometimes be challenging to obtain. The proposed rules require a transferor to inform the partnership within 30 days of the transfer and provide information on the date of the transfer.
“The infrastructure required for a partnership to deal with [section 1446(f)] is going to be complicated,” said Peter Connors of Orrick Herrington & Sutcliffe LLP. Partnerships could be reluctant to give certifications to transferors out of concern that they might be effectively shifting the tax liability to the partnership even though it belongs to the partner. And partnerships may be reluctant to calculate the gain from the deemed sale. Connors said the regulations must be modified or the market must develop a mechanism for returning the liability to the partner-transferor so that the partnership isn’t potentially liable if the information used for the calculation later changes or is found to have been mistaken.
Section 1446(f) enforces section 864(c)(8) by adding a withholding requirement for sales, exchanges, and other dispositions after December 31, 2017. If there’s any amount treated as ECI on the deemed sale, 10 percent of the amount realized on the disposition of the partnership interest must be withheld by the transferee unless the transferor gives the transferee an affidavit stating that the transferor isn’t a foreign person and provides its U.S. taxpayer identification number. Treasury has express authority to provide exceptions to withholding, which it did in the proposed regulations. The partnership will be on the hook if the transferee doesn’t withhold, although the partnership’s liability for that purpose is suspended until the final regulations are issued.
Following enactment of the TCJA, Treasury issued Notice 2018-8, 2018-7 IRB 352, on December 29, 2017, which temporarily suspended the withholding requirement for dispositions of specific interests in publicly traded partnerships. Notice 2018-29, 2018-16 IRB 495, later provided leeway for taxpayers to use the rules under the 1980 Foreign Investment in Real Property Tax Act. The proposed regulations under section 1446(f) were published on May 13 and largely reflect taxpayer comments on Notice 2018-29, although taxpayers are still likely to encounter difficulties in implementing withholding.
The proposed section 1446(f) rules add the six exceptions to withholding and explain how to determine and adjust the amount to be withheld. The exceptions allow transferees to rely on certifications from transferors or partnerships unless they know that the certifications are incorrect.
The six exceptions are (1) certification that the transferor has non-foreign status; (2) certification that the transferor wouldn’t realize gain on the transfer of the partnership interest; (3) certification from the partnership that the net effectively connected gain from the deemed sale at FMV would be less than 10 percent of total net gain; (4) when the transferor was a partner for the three prior tax years and its allocable share of ECI for each year was less than 10 percent of its total distributive share of the partnership’s net income for that year and less than $1 million; (5) when a nonrecognition provision applies to all the gain realized on the transfer; and (6) certification that the transferor isn’t subject to tax on the gain under a treaty.
Those exceptions were mostly previewed in Notice 2018-29, but they are likely to be further refined. Treasury and the IRS signaled that the three-year rule is being studied to determine whether modifications might be appropriate. The concern is that loosening it might invite noncompliance. The number and breadth of the exceptions seem generous, but qualifying for one of them might be more difficult than it appears.
Refining the Exceptions
Because several of the exceptions require specific facts that aren’t always available — such as an applicable nonrecognition provision or treaty provision — most taxpayers will likely look to the exception for certification by the partnership that the net effectively connected gain from the deemed sale would be less than 10 percent of total net gain and the three-year exception to prevent withholding. “To say that the hypothetical gain is less than 10 percent of the total gain requires a judgment call by the partnership, and not every case on ECI is crystal clear, because it’s a very factual issue,” Connors said.
Obtaining the necessary information to make that determination could be difficult, particularly for owners of smaller interests in partnerships. “When a partnership has to do something, that’s going to require a certain amount of due diligence, which may entail involving outside professionals,” Connors said. This means that for portfolio investors in particular, getting information out of partnerships they have invested in will likely be a challenge. The solution in future rules might be to focus on the transferor side because it doesn’t require any action from other parties, Connors said.
The withholding requirement also has the unfortunate effect of punishing foreign taxpayers who have been compliant with U.S. tax rules, said Stuart L. Rosow of Proskauer Rose LLP. If a foreign corporation doing business in the United States and regularly filing tax returns and paying tax here sells an interest in a partnership engaged in a U.S. business, it’s unclear why there should be withholding, he said. Rosow suggested that there be an exception for situations in which the transferor certifies that it has filed all applicable U.S. tax returns, has paid its taxes, and will file a return, because the IRS can easily check whether the taxpayer has been filing returns and making estimated tax payments.
There may be more room for taxpayers to fit into the exception to withholding in the three-year rule, because the transferor (rather than the partnership) can provide the certification that the ECI has been less than 10 percent of its distributive share. Connors said that while the requirement that the partner be a partner for three years before the transfer might not cover that many situations, the government might want to avoid a shorter time frame to lessen the likelihood of gamesmanship.
One issue the final regulations should consider addressing is potential abuses through nontaxable transactions, Rosow said. For example, if a partnership distributes the ECI property from a U.S. trade or business to a taxable U.S. partner in redemption of its interest and then the foreign partner sells its partnership interest, there wouldn’t be ECI and the partnership wouldn’t be engaged in a U.S. trade or business. “There are a variety of these techniques that could be used to avoid tax, and the regulations ought to address those issues,” he said. However, because of the way the statute is drafted, Treasury might not think it has the authority to write specific antiabuse rules regarding the use of nontaxable transactions to avoid the application of section 864(c)(8), Rosow said. He added that other antiabuse rules, including the partnership rules, might not apply well in this situation.