The U.S. Internal Revenue Service has finally issued proposed regulations - (REG-105476-18) governing withholding on dispositions of non-publicly traded partnership interests by non-U.S. persons as required under section 1446(f) of the U.S. Internal Revenue Code (“the Code”). Section 1446(f), was added to the Code under the Tax Cuts and Jobs Act (TCJA) of 2017, but prior to issuance of the proposed regulations, the IRS had only published interim guidance in Notice 2018-29 on this withholding requirement. Refer to our prior coverage here. The IRS and Treasury have now issued proposed regulations covering 1446(f) withholding in greater detail which should be helpful to both buyers and sellers of partnership interests held by non-U.S. persons. These proposed regulations largely follow the interim guidance from Notice 2018-29, albeit with some adjustments to numeric thresholds. Significant updates from Notice 2018-29 are highlighted below.
Since 1991, the IRS has held that all or a portion of the gain on the disposition of a partnership interest by a foreign person, when the partnership is engaged in a U.S. trade or business, is itself treated as effectively connected with a U.S. trade or business, i.e., that it is so-called “ECI gain.” After the IRS lost this position in Tax Court, Congress codified this rule as part of the TCJA. To enforce this liability, Congress also provided for withholding on foreign sellers of partnership interests, generally equal to 10% of the amount realized on the transaction (including liability shifts, if applicable), by the purchaser of the interest – what we will refer to here as “1446(f) withholding.” Early in 2018, withholding on dispositions of publicly traded partnership interests was generally suspended by Notice 2018-08.
Stricter criteria to avoid withholding
Under Notice 2018-29, a transferor could avoid withholding on the disposition of a covered partnership interest by certifying that less than 25% of their total gain (if any) on such disposition would be considered ECI gain. The proposed regulations continue that exception, but decrease the threshold to 10%, to reduce the risk of under withholding. A related exception, also found in Notice 2018-29, allowed a foreign transferor to avoid withholding by certifying that they would recognize no gain at all (ECI or otherwise) on the disposition of their partnership interest, and thus also avoid withholding. The proposed regulations clarify that a transferor must also recognize no ordinary gain under section 751 (the “hot asset” rules) to qualify for the exception.
In addition to these exceptions, based on the gain to be recognized by the transferring partner, another exception in Notice 2018-29 provided an exception from withholding if a transferring partner received an income allocation for the prior three full years, and less than 25% of the allocated income was effectively connected income. The proposed regulations also reduce this threshold to 10% and impose other restrictions on claiming the exception.
As under Notice 2018-29, the transferor must provide a certification to the transferee establishing its eligibility for these and other exceptions from withholding, to qualify. The receiving transferee must have no knowledge, or reason to know, that the certifications are incorrect before actually applying reduced withholding.
Additional rules if transferee fails to withhold
Section 1446(f)(4) provides that, if a transferee fails to comply with their withholding requirement, then the partnership itself must withhold on any distributions made to the transferee. To avoid this withholding, a transferee must certify to the partnership that it has complied with its withholding obligations, and must also provide copies of any certifications relied on in applying a reduced rate of withholding. Notably, the partnership must apply its own knowledge (or reason to know) standards to these certifications, which may differ from the transferee’s standards. Therefore, it is advisable that a transferee also check with the partnership before relying on a certification provided by a transferor.
Other provisions of the proposed regulations
In addition to the above highlighted provisions, the proposed regulations also provide rules covering:
- Distributions from partnerships treated as withholdable transfer payments
- Determination of a partner’s liability shares to be included in amount realized
- Rules governing reliance on tax treaties, including strict procedures on how treaty claims must be made
- Special rules for withholding by brokers in the case of publicly traded partnerships
- Coordination rules with section 1445 withholding (governing withholding on disposition of U.S. real property interests)
Generally, these regulations are proposed to be effective 60 days after their finalization. However, taxpayers may choose to rely on many of the provisions now, or alternatively, continue to rely on Notice 2018-29 (and Notice 2018-08, in the case of publicly traded partnerships).
For more information on RSM’s global information reporting and withholding services, please reference our prior alert here.