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Final Regs Allow Six Exceptions to Section 1446(f) Withholding

Posted on Apr. 5, 2021

Section 1446(f) of the IRC (added by the Tax Cuts and Jobs Act) requires taxpayers to withhold tax on the transfer of a partnership interest described in section 864(c)(8) — that is, interest in a partnership that earns income effectively connected to a U.S. trade or business.

Proposed regs under section 1446(f) were published on May 13, 2019 (REG-105476-18), and final regs were published on November 30, 2020 (T.D. 9926). The final regs retain the basic approach and structure of the proposed regs, requiring withholding on the transfer of a partnership interest unless an exception or adjustment to withholding applies. Reg. section 1.1446(f)-2(b) offers six exceptions.

The TCJA also added section 864(c)(8). It affects foreign partners of partnerships that earn effectively connected income. Accompanying proposed regs were published on December 27, 2018 (REG-113604-18). They provide rules for determining the amount of gain or loss on the transfer of a partnership interest that is treated as effectively connected with a U.S. business. Final regs were published under section 864(c)(8) on November 6, 2020 (T.D. 9919).

Sections 1446(f) and 864(c)(8)

The section 1446(a) general rule imposes a withholding tax on partnerships that have effectively connected taxable income allocable under section 704 to a foreign partner. The withholding tax is equal to the applicable percentage of the partnership’s effectively connected taxable income that is allocable to foreign partners. Section 1446(e) defines foreign partner as any partner who is not a U.S. person.

The applicable percentage is the highest tax rate in section 11(b) for foreign corporate partners and section 1 for foreign partners that are not corporations.

Section 1446(f)(1)-(6) provides special rules for withholding on dispositions of partnership interests. If any portion of any gain on the disposition of a partnership interest is treated under section 864(c)(8) as ECI, the acquirer (transferee) is required to deduct and withhold a tax equal to 10 percent of the amount realized on the disposition.

Section 1446(f)(2) provides an exception to the transferee’s withholding requirement if the transferor furnishes a non-foreign affidavit. The affidavit must state under penalty of perjury that the transferor is not a foreign person and must include the transferor’s taxpayer identification number.

The withholding exception does not apply when the transferor furnishes a false affidavit, meaning the transferee has actual knowledge that the affidavit is false, or the transferee receives a notice (as described in section 1445(d)) from a transferor’s agent or its own agent that the affidavit or statement is false.

The exception also does not apply when the Treasury secretary requires the transferee to furnish a copy of the affidavit or statement and the transferee fails to do so.

Section 1446(f)(3) gives Treasury the authority to prescribe a reduced withholding amount at the request of the transferor or transferee if it determines that substituting a reduced amount would not jeopardize collection of the tax.

Under section 1446(f)(4), a partnership is required to withhold amounts that are not withheld by the transferee. If a transferee fails to withhold the required amount, the partnership is required to deduct and withhold the tax from distributions to the transferee.

Section 1446(f)(5) provides that terms found in both sections 1446(f) and 1445 use the section 1445 meaning.

The section 864(c)(8)(A) general rule applies when a nonresident alien individual or foreign corporation owns an interest in a partnership engaged in a U.S. trade or business. Gain or loss on the sale or exchange of the partnership interest is treated as ECI to the extent it does not exceed the amount described in section 864(c)(8)(B).

The amount treated as ECI depends on whether the owner has gain or loss. If there is gain, the ECI is the partner’s distributive share of the gain amount that would have been ECI if the partnership had sold all its assets at their fair market values as of the date of the sale or exchange of the partnership interest, or zero if no gain on a deemed sale would have been ECI.

If there is loss on the sale or exchange of the partnership interest, the effectively connected loss is the partner’s distributive share of the amount of loss on the deemed sale described above that would have been effectively connected, or zero if no loss on the deemed sale would have been effectively connected.

A partner’s distributive share of gain or loss on the deemed sale is determined in the same manner as the partner’s distributive share of the non-separately stated taxable income or loss of the partnership.

The final section 1446(f) regs consist of new reg. section 1.1446-1 through -5. The regs contain guidance for withholding, reporting, and paying the section 1446(f) withholding tax:

  • reg. section 1.1446(f)-1 contains an overview, definitions, and general rules;

  • reg. section 1.1446(f)-2 provides more specific withholding rules for the transfer of non-publicly traded partnership interests under section 1446(f)(1), including exceptions to the withholding obligation;

  • reg. section 1.1446(f)-3 provides rules that apply when section 1446(f)(4) requires a partnership to withhold distributions made to the transferee because the transferee failed to withhold;

  • reg. section 1.1446(f)-4 provides special rules for the sale, exchange, or disposition of PTP interests when the withholding obligation is generally imposed on brokers that act on behalf of the transferor; and

  • reg. section 1.1446(f)-5 addresses liability for failure to withhold under section 1446(f), including the liability of a transferor’s or transferee’s agent.

An earlier article focused on the definitions and general rules in reg. section 1.1446(f)-1 and liability for failure to withhold in reg. section 1.1446(f)-5 (Tax Notes Int’l, Mar. 29, 2021, p. 1635). This article will focus on the six exceptions to the withholding obligation in reg. section 1.1446(f)-2(b). Future articles will address withholding mechanics for transfers of non-PTP and PTP interests and partnership withholding on distributions to transferees.

Like most of the rules, these six exceptions take effect for transactions on or after January 29. Withholding requirements in reg. section 1.1446(f)-3 and -4 for partnerships under section 1446(f)(4) and for transfers of PTP interests have a later effective date for transfers occurring on or after January 1, 2022.

Reg. Section 1.1446(f)-2(b)

Unless an exception to withholding applies, section 1446(f)(1) requires a transferee to withhold a tax equal to 10 percent of the amount realized on any transfer of a partnership interest. Reg. section 1.1446(f)-2 contains guidance on the exceptions.

A transferee will not know whether a transfer causes gain treated as ECI under section 864(c)(8) without receiving information from the transferor or the partnership. The regs therefore require that the transferee presume a transfer is subject to withholding unless it obtains a certification from the transferor establishing that an exception applies. If the partnership is the transferee because it makes a distribution, it can rely on information in its books and records to make this determination. A transferee that relies on a certification (or the partnership transferee that relies on its books and records) will not be subject to withholding tax liability even if the transfer causes gain under section 864(c)(8).

These rules do not apply to a transfer of a PTP interest that is carried out through one or more brokers, including a distribution related to a PTP interest held in an account with a broker. Rules addressing these PTP transfers are in reg. section 1.1446(f)-4.

Reg. section 1.1446(f)-2(a) implements the general section 1446(f)(1) rule by requiring a transferee to withhold a tax equal to 10 percent of the amount realized on any transfer of a partnership interest (other than PTP interest) unless an exception to withholding applies under reg. section 1.1446(f)-2(b) (or an adjustment to withholding applies under reg. section 1.1446(f)-2(c)).

Reg. section 1.1446(f)-2(b)(1)-(7) provides six exceptions to withholding. A transferee is not required to withhold if it relies on a certification or its books and records. A transferee may not rely on a certification, however, if it has actual knowledge that the certification is incorrect or unreliable. Moreover, a partnership that is a transferee because it makes a distribution may not rely on its books and records if it knows, or has reason to know, that the information is incorrect or unreliable.

The six exceptions to withholding in reg. section 1.1446(f)-2(b)(2)-(7) are:

  • transferor certification of non-foreign status;

  • transferor certification of no realized gain;

  • partnership certification of less than 10 percent effectively connected gain;

  • transferor certification of less than 10 percent ECI;

  • transferor certification of a nonrecognition transaction; and

  • transferor certification of tax treaty benefits.

The six examples are described below along with taxpayers’ comments to the proposed regs versions of the exceptions. The responses of Treasury and the IRS to the taxpayer comments clarifies the intended application and effects of the exceptions.

Transferor certification of non-foreign status. A transferee may rely on a certification of non-foreign status from the transferor that states that the transferor is not a foreign person, states the transferor’s name, TIN, and address, and is signed under penalties of perjury. A certification of non-foreign status includes a valid Form W-9 (“Request for Taxpayer Identification Number and Certification”). A transferee may rely on a valid Form W-9 from the transferor that it already possesses if the form meets these requirements.

A commentator suggested that this exception be expanded to match similar rules in reg. sections 1.1445-2(b) and 1.1446-1(c)(3) that allow taxpayers to rely on a means other than certification to ascertain the transferor’s non-foreign status.

Treasury and the IRS acknowledged that these regs do allow this, but they also provide that the transferee or partnership remains liable under section 1461 if their reliance on the transferor’s non-foreign status is incorrect.

The liability provisions in reg. section 1.1446(f)-5(b) provide similar flexibility, because they allow a transferee that did not rely on a certification of non-foreign status to nonetheless show that the transferor had no gain subject to tax under section 864(c)(8) because the transferor was not a foreign person. Therefore, the exception was not expanded.

Transferor certification of no realized gain. Generally, a transferee (other than a partnership that is a transferee because it makes a distribution) may rely on a certification from the transferor stating that the transfer of the partnership interest would not result in any realized gain to the transferor as of the determination date (defined in reg. section 1.1446(f)-1(c)(4) and set forth below), including ordinary income arising under section 751 and reg. section 1.751-1 (from unrealized receivables and inventory).

A transferor may also rely on a certification from the partnership stating that the transfer of the partnership interest would not result in any ordinary income arising under section 751 and reg. section 1.751-1 to the transferor as of the determination date. This certification from the partnership must be attached to any certification of no realized gain provided by the transferor to the transferee.

A partnership that is a transferee because it makes a distribution may rely on its books and records, or on a certification from the transferor, to determine that the distribution would not result in any realized gain to the transferor as of the determination date.

Reg. section 1.1446(f)-1(c)(4) provides that a transfer’s determination date must be:

  • the date of the transfer;

  • any date 60 days or less before the date of the transfer; or

  • the date that is the later of:

A partner transferor that owns 50 percent or more of the partnership’s capital, profits, deductions, or losses within 12 months before the determination date (a controlling partner) cannot use the third determination date above.

A commentator suggested that a transferor realizing an overall loss should be eligible for this exception, even if the transferor realizes ordinary income under section 751 and regs. Treasury and the IRS concluded that this result is inconsistent with the basic computation of outside gain or loss in reg. section 1.864(c)(8)-1(b)(2).

Section 741 provides that a sale or exchange of a partnership interest causes capital gain or loss to the transferor partner except as otherwise provided in section 751 (relating to unrealized receivables and inventory items). The regs preamble clarifies, however, that the amount of gain or loss under section 741 (before application of section 751) is not a limit on the amount of effectively connected gain or loss.

Because a transferor can realize ordinary income under section 751 that is ECI under section 864(c)(8), even if the transferor realizes an overall loss on the transfer of the partnership interest, it would be inappropriate for this exception to apply solely because the transferor does not realize an overall gain.

A commentator pointed out that many transferors would be unable to use this exception even if they would otherwise qualify, because transferors need information from the partnership regarding its section 751 property and the associated deemed sale calculations. Therefore, a transferor may not have the information necessary to use the exception.

To address these concerns, the final regs modified the proposed regs’ version of the exception to provide that a transferor may rely on a partnership certification that, as of the determination date, the partnership interest transfer would not result in any section 751 ordinary income. This approach is consistent with the rest of the withholding exceptions that generally allow facts related to the applicability of the exception to be determined as of the determination date.

Partnership certification of less than 10 percent effectively connected gain. Generally, a transferee (other than a partnership that is a transferee because it makes a distribution) may rely on one of two alternative certifications from the partnership stating either that ECI is less than 10 percent of total gain or that the partnership is not engaged in a U.S. trade or business.

First, the partnership may certify that, if the partnership sold all assets at FMV as of the determination date in the manner described in reg. section 1.864(c)(8)-1(c), either:

  • the partnership would have no gain that would have been ECI or, if the partnership would have net gain that is ECI, it would be less than 10 percent of the total net gain; or

  • the transferor would not have a distributive share of net gain from the partnership that would have been ECI or, if the transferor would have a share of gain that is ECI, it would be less than 10 percent of the transferor’s share of the total net gain.

Second, the partnership can certify that it was not engaged in a U.S. trade or business at any time during the tax year of the partnership through the date of transfer.

A partnership that is a transferee because it makes a distribution may rely on its books and records to determine that the first type of certification is satisfied as of the determination date, or that the second type of certification is satisfied for the tax year of the partnership through the date of transfer.

A commentator suggested that this exception should refer to the transferor’s distributive share of net effectively connected gain, rather than the aggregate amount of net effectively connected gain that would be realized by the partnership upon a section 864(c)(8) deemed sale. This exception should also take into account the transferor’s eligibility for benefits under a tax treaty (although the maximum tax liability certification in reg. section 1.1446(f)-2(c)(4) could provide the same result).

The final regs partly adopted this comment, because they provide that a transferee may rely on a partnership certification stating that the transferor’s distributive share of net effectively connected gain from a deemed sale would be either zero or less than 10 percent of the transferor’s distributive share of the total net gain. This modification applies to situations in which the transferor would not have a distributive share of net effectively connected gain (including by reason of having a share of effectively connected loss).

The final regs do not adopt the suggestion on treaty eligibility because existing exceptions and adjustments adequately address that concern via an exception to withholding when a treaty claim covers all gain from the transfer. Moreover, as the commentator acknowledged, the rules in reg. section 1.1446(f)-2(c) allow modified amount realized procedures for foreign partnership transferors and adjustments to the amount withheld based on the transferor’s maximum tax liability.

Section 864(c)(8) applies only to transfers of interests in partnerships that are engaged in a U.S. trade or business. A commentator suggested that the final regs coordinate section 1446(f)(1) withholding with the rule in section 864(c)(8) regs by clarifying that this exception applies to situations in which the partnership would not have effectively connected gain as of the determination date but for section 897(a) (relating to U.S. real property).

Accordingly, the regs allow a transferee to rely on a partnership certification that it is not engaged in a U.S. trade or business at any time during the tax year through the date of the transfer — the period beginning on the first date of the partnership’s tax year in which the transfer occurs and ending on the date of the transfer.

While this modification addresses a scenario in which the partnership holds only foreign business assets and U.S. real property not part of a trade or business, it also applies to any situation in which a partnership is not conducting a U.S. trade or business regardless of whether the partnership holds U.S. real property. As for partnerships conducting a U.S. trade or business that hold U.S. real property, deemed sale gain attributable to U.S. real property continues to be treated as effectively connected gain for purposes of the 10 percent prong of the exception.

Transferor certification of less than 10 percent ECI. Generally, a transferee (other than a partnership that is a transferee because it makes a distribution) may rely on a four-part certification from the transferor stating that:

  • the transferor was a partner in the partnership throughout the lookback period described below;

  • the transferor’s distributive share of gross ECI from the partnership, as reported on Schedule K-1 to Form 1065 (or other statement required under reg. section 1.6031(b)-1T), including any gross ECI included in the distributive share of a partner related to the transferor under sections 267(b) or 707(b)(1), was less than $1 million for each of the tax years within the lookback period;

  • the transferor’s distributive share of gross ECI from the partnership, as reported on Schedule K-1 (or other statement) for each of the tax years within the lookback period was less than 10 percent of the transferor’s total share of gross income from the partnership for that year; and

  • the transferor’s distributive share of income or gain from the partnership that is ECI or deductions or losses allocated and apportioned to ECI in each of the tax years within the lookback period has been:

    • reported on a federal income tax return (either filed by the transferor or, if the transferor is a partnership, filed by its direct or indirect foreign partners);

    • the tax return was filed on or before the due date (including extensions); and

    • all tax due has been timely paid to the IRS (provided that filing the return was required when the transferor furnished the certification).

Reg. section 1.1446(f)-2(b)(5)(ii) provides guidance on the transferor’s lookback period, which is generally the transferor’s immediately prior tax year and the two preceding tax years.

The transferor’s immediately prior tax year is the transferor’s most recent tax year with or within which a tax year of the partnership ended and for which a Schedule K-1 was due or furnished before the transfer. A transferee may not rely on a certification that is provided before the transferor’s receipt of the Schedule K-1 described above.

A transferor that did not have a distributive share of gross income in any year during the lookback period cannot provide the four-part certification to the transferee necessary to claim this exception from withholding.

A partnership that is a transferee by making a distribution may rely on its books and records to determine that the first three requirements of the certification have been satisfied (subject to the limits of the lookback period and transferor income share). The partnership must also obtain a representation from the transferor stating that the fourth requirement in the certification has been satisfied.

Commentators explained that some partnership investments are structured so that a foreign partner will not have an allocable share of ECI or effectively connected loss under the partnership agreement. If that foreign partner transfers its partnership interest, it would not qualify for this exception because it would not receive a Form 8805 (“Foreign Partner’s Information Statement of Section 1446 Withholding Tax”) nor have an effectively connected loss.

For situations in which a foreign partner is allocated effectively connected items, the exception should look to gross rather than net amount allocations to reflect the partnership’s capacity to produce ECI or effectively connected gain, because this would be a more accurate proxy for section 864(c)(8) consequences.

For example, a partnership may generate significant losses or deductions resulting in small amounts of net ECI, but still hold assets with significant built-in gain treated as effectively connected gain on a deemed sale. In that case, the transferor should be able to use this exception.

A commentator also suggested allowing this exception even if the transferor was not a partner for the entire lookback period, as long as the transferor was a partner long enough to receive at least one Schedule K-1.

The final regs were modified to allow a transferor to qualify for the exception if its distributive share of gross ECI from the partnership for each tax year within the lookback period was less than $1 million and less than 10 percent of the transferor’s total distributive share of gross income from the partnership, with both amounts reflected on a Schedule K-1. Because this exception looks to the transferor’s share of ECI rather than its allocable share of effectively connected taxable income, a transferor that is not allocated any ECI or loss in any year can still use this exception even if has not received a Form 8805 for that year.

This exception also adopts the suggestion to look to gross rather than net amounts of income to determine whether the transferor’s distributive share of ECI was less than 10 percent of the transferor’s total distributive share of partnership income. This change is intended to provide a more accurate section 864(c)(8) proxy.

The exception was modified to state that a transferor cannot provide the certification required for this exception if the transferor did not have a distributive share of gross income in each of the relevant years. A transferor will generally be able to use this exception even if it is allocated a share of net loss.

The final regs do not adopt the suggestion regarding the holding period because reducing a transferor’s required length of time to be a partner for the exception would not provide an indication of the amount of the transferor’s effectively connected gain realized in connection with the transfer.

Transferor certification of a nonrecognition transaction. Generally, a transferee may rely on a certification from the transferor stating that the transferor is not required to recognize any gain or loss on the transfer under a nonrecognition provision of the code. The certification must describe the transfer and provide the law and facts supporting the certification.

This exception to withholding does not apply if only a portion of the gain realized on the transfer is subject to a nonrecognition provision. However, reg. section 1.1446(f)-2(c)(4)(v) addresses a transferor’s claim for partial nonrecognition.

Transferor certification of tax treaty benefits. Generally, a transferee may rely on a certification from the transferor stating that the transferor is not subject to tax on any gain from the transfer under an income tax treaty between the United States and a foreign country.

The transferor makes the certification on a withholding certificate, either a Form W-8BEN (“Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals)”), or Form W-8BEN-E (“Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities)”). The withholding certificate must meet the requirements for validity in reg. section 1.1446-1(c)(2)(iv) (or an applicable substitute form that meets the requirements in reg. section 1.1446-1(c)(5)) and that contains the information necessary to support the claim for treaty benefits.

A transferee may rely on a certification of treaty benefits only if, within 30 days after the date of the transfer, the transferee mails a copy of the certification to the IRS at the address provided in reg. section 1.1445-1(g)(10), together with a cover letter providing the name, TIN, and address of the transferee and the partnership in which an interest was transferred.

As with the nonrecognition transaction exception, this exception does not apply if treaty benefits apply to only a portion of the gain from the transfer. However, reg. section 1.1446(f)-2(c)(4)(vi) addresses situations in which treaty benefits apply to only a portion of the gain.

A transferor claiming treaty benefits for all gain from the transfer must use this exception in reg. section 1.1446(f)-2(b)(7) and not any other exception or determination procedure in reg. section 1.1446(f)-2(b) and (c) to claim an exception to withholding because of treaty benefits.

Commentators requested clarification on the information required to be provided on Forms W-8BEN and W-8BEN-E to claim treaty benefits. The IRS will revise the instructions to Forms W-8BEN and W-8BEN-E to describe the required information. Moreover, these final regs allow a transferor to use the withholding certificate as the certification.

Miscellaneous Issues

The regs’ preamble addresses several withholding exception issues identified in the comments to the proposed regs, like disguised sales, withholding by foreign partnerships and foreign trusts, and earn-outpayments.

Disguised sales. A commentator requested an exception from section 1446(f) withholding for transactions that form and fund a partnership, and for redemptions and admissions of new partners that could be characterized as disguised sales of partnership interests. The final regs did not adopt the recommendation because a contributing partner acquiring a partnership interest from a foreign person should have a withholding obligation. Moreover, adding an exception to withholding would require a determination of what constitutes a disguised sale and that issue is outside the scope of the regs.

Foreign partnerships and trusts. Commentators also requested an exception to withholding for transferor foreign partnerships and foreign trusts that have entered into agreements with the IRS to assume primary withholding and reporting responsibilities on behalf of their partners, owners, or beneficiaries. The concern was that duplicative withholding would occur for partners absent an exception for these transferors that assume withholding under section 1446(f).

A rule allowing these transferors to assume withholding under section 1446(f) would create complexity and require coordination with the provisions for withholding and reporting in the agreements between these transferors and the IRS. The rule would not have a sufficiently material impact on transferors that would justify the allocation of resources necessary to provide guidance. Any concerns regarding duplicative withholding were already addressed in the regs by rules in reg. section 1.1446(f)-2(e) allowing a foreign partnership to credit any withholding under section 1446(f) against its section 1446(a) withholding liability.

Earn-out payments. A commentator noted that a transfer of a partnership interest may be subject to an earn-out provision that entitles the transferor to future payments. The commentator requested clarification that these future payments will be allowed a withholding exception to the extent that the original transfer qualified for a withholding exception. Any exception to withholding in the final regs eliminated any requirement to withhold on the amount realized from the transfer of a partnership interest. If an exception applies at the time of the transfer, it will also apply to any future payment made to the transferor.

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