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On May 7, 2019, the IRS released proposed regulations ([REG-105476-18], Doc. 2019-17878) under Section 1446(f) (the Proposed Regulations), which generally subject a non-U.S. partner of a partnership that is engaged in the conduct of a U.S. trade or business to U.S. federal income tax withholding to the extent of any gain realized on the disposition of its partnership interest. These withholding rules relate to legislation enacted as part of the Tax Cuts and Jobs Act of 2017 to overturn the Tax Court’s taxpayer-favorable decision in Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017). The legislation provides that gain on the sale of a non-U.S. partner’s interest in a partnership will be treated as effectively connected to a U.S. trade or business (ECI) to the same extent as such partner’s distributive share of the gain or loss that would have been recognized had the partnership sold its underlying assets at fair market value.
Under Section 1446(f)(1), a transferee of a partnership interest must withhold tax equal to 10 percent of the amount realized on any disposition when such disposition results in ECI gain for the transferor (note that in the event the transferee fails to withhold, the partnership itself must deduct and withhold the tax and interest from distributions to the transferee). The Proposed Regulations implement this withholding requirement while incorporating (with modifications) many aspects of the temporary withholding guidance provided by the IRS in Notice 2018-29, 2018-16 IRB 495 (the Notice). The Proposed Regulations include six specific exceptions to this withholding requirement. To eliminate the required withholding, the transferor (or the partnership itself in the case of the last exception below) must deliver one of the following certificates:
- A transferor’s certificate (i) of non-foreign status (which may now be satisfied by the delivery of a valid Form W-9); (ii) asserting that no gain was realized on the sale; (iii) subject to certain additional conditions, stating that the transferor has been a partner for at least three years and that its share of ECI for each of those years was less than 10% (reduced from 25% under the Notice) of its total distributive share and less than $1,000,000 in each such year; (iv) stating that the transfer is subject to a nonrecognition provision of the Code; or (v) asserting that it is exempt from tax by reason of the application of the benefits of an income tax treaty; or
- The partnership provides the transferee a certificate stating that upon a hypothetical sale of its assets, net ECI gain would be less than 10% (reduced from 25% under the Notice) of its total gain.
With the Proposed Regulations, the IRS sought to clarify and ease the administrative burdens of implementing the withholding requirements under Section 1446(f), yet it remains easy to imagine scenarios where the enumerated exemptions fall short of providing comfort or clarity to a non-U.S. partner, its transferee or the partnership itself. For example, where a non-U.S. partner not resident in a treaty jurisdiction disposes of its partnership interest in a gain recognition transaction, only two of the six exemptions from withholding are potentially available. This could be a common situation facing private investment funds with non-U.S. partners and could become especially burdensome in the context of significant secondary transfers or transactions involving private investment funds.
In such circumstances, either a non-U.S. partner transferor would be required to deliver the certificate concerning its share of the partnership’s ECI over the preceding three year period (which necessarily depends on the partner having been a partner for at least that duration) or the partnership could deliver a certificate regarding its hypothetical net ECI gain—something a private investment fund that was formed before these rules were promulgated may not be inclined to do.
The Proposed Regulations do not officially apply until they are finally adopted by the Treasury, therefore, until such time, taxpayers may choose to either apply the Proposed Regulations now or continue to rely on the prior guidance under the Notice (which, for purposes of some of the exceptions above, is more generous than the Proposed Regulations).