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Practitioners Urge Broad Changes to Partnership Withholding Regs

Posted on Sep. 16, 2019

If the IRS and Treasury heed advice from commentators on proposed regs regarding withholding on transfers of partnership interests, the finalized rules may look considerably different than originally envisioned.

The comment period for the proposed regs (REG-105476-18) closed in July and reveals how taxpayers and practitioners are trying to make the best out of the government’s aggressive approach to taxing partnership interests transferred by foreign persons. Lawmakers modified these rules via the Tax Cuts and Jobs Act after the July 2017 decision in Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, 149 T.C. 63 (2017).

In Grecian Magnesite the U.S. Tax Court blew a hole in the IRS’s long-standing aggregate approach to partnerships. The court ruled that a foreign partner redeeming a partnership interest in a U.S. limited liability company had foreign-source gain not subject to U.S. tax. The D.C. Circuit upheld the ruling in June in Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, No. 17-1268 (D.C. Cir. 2019).

The government quickly regrouped and implemented section 864(c)(8) under the TCJA, which treats gain from a transfer of a foreign partner’s partnership interest as effectively connected to a U.S. trade or business and imposes tax liability on the gain.

The provision is bolstered by a new withholding regime in section 1446(f) that obligates transferees to withhold 10 percent of the amount realized, subject to several exceptions. Treasury issued proposed regs on May 7, and commentators have floated proposals to tighten the regs. Several loom large. Commentators have indicated that they want expanded withholding exceptions, some potential safe harbors, and reduced opportunities for overwithholding.

More Exceptions to Withholding

Under the proposed section 1446(f) regs, transferees can skip withholding if they rely on any of six types of certifications issued by the transferor or the partnership, unless the transferee has actual knowledge that those certifications are incorrect or unreliable. The exceptions are:

  • the transferor certifies that it is non-foreign;

  • the transferor certifies that it would not realize gain on the transfer;

  • the partnership certifies that its net effectively connected gain, if it sold all assets at fair market value, would be less than 10 percent of the total net gain;

  • the transferor certifies that it was a partner in the three immediately preceding tax years and its allocable share of effectively connected taxable income was less than 10 percent of its total distributive share of the partnership’s net income for that year (and less than $1 million);

  • the transferor certifies that a nonrecognition provision applies to the gain; or

  • there is no tax liability under a treaty.

Commentators diverge on specific feedback, but they all think that Treasury and the IRS can expand those exceptions in various ways.

Comments from the New York State Bar Association Tax Section target the three-year exception, which does not apply in cases in which the transferor did not have a distributive income allocation in the previous three years.

Disallowing the exemption for foreign investors that do not directly recognize any effectively connected income or effectively connected loss is counterintuitive to the NYSBA tax section. A lack of inclusions is a “meaningful indicator” that the partnership lacks an interest in an entity with U.S. trade or business or holds it through a blocker corporation, according to NYSBA. From a compliance standpoint, NYSBA believes that a withholding should not require extensive input from the partnership if there’s no ECI being generated for non-U.S. investors, and does not need three years of proof to demonstrate that the partnership did not generate substantial ECI.

NYSBA’s suggestion is that an exception should be created for non-U.S. transferors that:

  • hold the applicable partnership interest long enough to receive at least one Schedule K-1;

  • have not been allocated recent amounts of gross ECI or gross effectively connected loss from the partnership unless it is a de minimis amount (this could be within the past five tax years or so); and

  • have no knowledge that the partnership is engaged in a U.S. trade or business that is reasonably expected to generate future ECI for the transferor.

Another NYSBA suggestion is to exempt a non-U.S. transferor from withholding if it holds the partnership interest in question in connection with a U.S. trade or business and it files documentation with the IRS such as a Form
W-8ECI. In a similar vein, the Managed Funds Association is requesting that IRS and Treasury exempt foreign partnerships that file an IRS Form W-8IMY as a withholding foreign partnership.

In comments, the Managed Funds Association also pointed out that indirect foreign partners appear to be excluded from withholding tax look-through exceptions, which seemingly apply to direct partnership interests, and should be expanded to instances in which indirect partners can prove their eligibility.

Irrespective of the proposed exceptions, the American Bar Association’s Section of Taxation wants the government to implement additional rules to ensure that a transferee is not penalized if it fails to withhold in any of the following situations:

  • the transferor did not realize gain (and did not realize ordinary income under section 751);

  • none of the gain (and none of the ordinary income under section 751) realized by the transferor is section 864(c)(8) ECI;

  • under a nonrecognition provision, none of the section 864(c)(8) ECI realized in connection with the transfer was recognized; or

  • the transferor is not a foreign person.

Then there’s the question of withholding in cases in which the transfer could not generate ECI under section 864(c)(8). Both the ABA tax section and NYSBA say withholding should be excluded, but for different reasons. The ABA tax section’s reasoning is that the exception would cover every disposition of an interest in a partnership that is not engaged in a trade or business within the United States, also known as a “never ETBUS partnership.”

The ABA tax section says the policy reasons are compelling: “Unless an exception applies to transfers of Never ETBUS Partnership Interests, the vast majority of transfers of partnership interests, worldwide, will result in a technical failure to withhold under the U.S. tax laws,” it says. “Such a harsh result would seem inconsistent with the purposes of section 1446(f), as well as unproductive from a foreign relations perspective.”

NYSBA’s rationale, on the other hand, is that a withholding agent cannot prove that a tax has been paid if there is no tax due.

Securities traders are concerned about delivery versus payment (DVP) and cash on delivery (COD) transactions involving brokers and how they fit within the proposed regime. If one or more brokers are involved in a publicly traded partnership interest transfer, then one of the brokers is obligated to withhold. If the other broker is a foreign person, the domestic broker is expected to withhold. Within this universe, brokers involved in DVP and COD transactions would be expected to withhold. The Securities Industry and Financial Markets Association (SIFMA) says both scenarios should be exempted, because withholding could cause trades to fail or be subject to considerable overwithholding. If the full amount of proceeds is not delivered to the seller or transferor in a DVP or COD transaction, the trade is unsuccessful and the securities go back to the seller/transferor’s broker and the money goes back to the buyer/transferee. Information reporting and withholding rules allow a DVP/COD exception under reg. section 1.6045-1(c)(3)(iii), according to the organization.

When might withholding be appropriate? When the transferor is foreign, and can be identified as such by the transferor’s custodial broker, who could be domestic or foreign. That would make circumstances more streamlined than envisioned under the proposed regs, which as written, require withholding irrespective of whether the transferring partner is domestic or foreign, according to SIFMA. The organization’s suggestion is that withholding should be executed by the custodial broker.

Excessive Withholding Concerns

Commentators are concerned that competing withholding rules in section 1446(a) and (f) could lead to overwithholding because the proposed regulations do not explain how the two provisions should be balanced. The general sentiment expressed by SIFMA, NYSBA, and the ABA tax section is that section 1446(f) withholding should not apply if section 1446(a) withholding already applies. Section 1446(a) imposes withholding on partnership income that is allocated while 1446(f) imposes it in instances in which a partner realizes gain after receiving a disposition that exceeds its basis in the partnership interest.

SIFMA’s specific advice is that 1446(f) withholding should not apply in cases in which sections 1441, 1442, 1443, or 1446(a) already apply, because withholdings on a distribution are enough. NYSBA’s specific advice is a coordination rule in which both 1446(a) and 1446(f) potentially can apply, but amounts withheld under 1446(f) reduce liabilities under section 1446(a) dollar for dollar. If Treasury isn’t interested in that approach, NYSBA suggests a different rule, in which a publicly traded partnership’s distributions are exempt from withholding under section 1446(f) to the extent they are subject to withholding under section 1446(a), and vice versa.

The ABA tax section’s withholding concerns are somewhat different. Its worry is that the proposed regulations are potentially overbroad because they seem to impose a general withholding obligation on partnership interest transfers whenever the proposed exceptions do not apply, even in cases in which withholding would not be required under section 1446(f)(1).

Backstop Withholding Proposals

Under the proposed regs, a partnership is obligated to withhold on distributions to a transferee when that transferee fails to withhold, under section 1.1446(f)-3(a)(1). A publicly traded partnership that issues a false qualified notice about the withholding exceptions that are available to a transferee is also obligated to withhold under the proposed rules. SIFMA wonders whether all false errors fall under this backstop withholding rule, or only willfully false statements, and requests clarity on that point. Regardless, the organization thinks backstop withholding should be eliminated for publicly traded partnership distributions and instead an information return penalty should apply, because in the alternative, some publicly traded partnerships will react overcautiously and refuse to issue qualified notices to avoid any errors or false notices.

The ABA tax section also notes several concerns with backstop withholding, especially in cases in which the transferee complied with its obligations, but inadvertently received false information. The tax section cites potential cases in which the transferee complied with its obligations and properly relied on the transferor’s certification, believing it was correct and reliable, and declined to withhold. In actuality, the certification was incorrect, and the transferee’s partnership knew (based on information unavailable to the transferee) or should have known. The government says secondary withholding is required. The tax section believes that partnerships should not have to conduct secondary withholding under section 1446(f)(4) on distributions to such “fully compliant transferees” because the transferees acted properly.

The tax section also points out that a partnership’s reliance on the transferee certification seems optional, because the proposed regs say that a partnership “may” rely on the certification. This could cause partnerships to decide to withhold on distributions as they see fit, a “powerful weapon” that could be abused and used to draw concessions from a transferee.

“Unless steps are taken to protect transferees of partnership interests from such unnecessary secondary withholding, well-informed transferees are likely to conclude that the only way to protect themselves from a burdensome secondary withholding cost that likely will never be recovered is to withhold the maximum possible amount under section 1446(f)(1) on all transfers,” the submission says. “In each such case, the transferor would be forced to claim a credit for the amount withheld and to seek a refund. This approach would be burdensome not only for transferors but for the Service as well.”

Another option is to allow a transferee to claim a refund after secondary withholding, an approach advocated by NYSBA and the Managed Funds Association. The proposed regulations establish that a partnership may claim a refund on behalf of a transferee, but NYSBA believes that partnerships may not have an incentive to collect such a refund, and believes that transferees may be able to collect the proper information to facilitate refunds if necessary.

Broker-Intermediated Transfer Withholding

Brokers that facilitate transfers of interests in publicly traded partnerships are subject to separate withholding rules under the proposed regs because the transferee might not know the identity of the transferor. Under the proposed regs, the withholding obligation falls on brokers that receive proceeds from the sale and act on behalf of the transferor. But the transferee might be subject to secondary withholding in instances in which the broker failed to withhold because of a faulty qualified notice, and that liability remains even after the initial transferee disposed of the interest. NYSBA believes that might discourage publicly traded partnerships from issuing qualified notices, which could subject non-U.S. transferors to unnecessary withholding. NYSBA says the rule should be struck from the final regs. It also advocates that the government include in the final regs specific rules or presumptions on which brokers can rely when deciding whether withholding is necessary.

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