In 2017, tax legislation was enacted to provide that (x) gain or loss derived by a non-US person on the sale or exchange of an interest in a partnership engaged in a U.S. trade or business is treated as effectively connected gain or loss and subject to U.S. tax (“ECI”) and (y) a transferee of such an interest must withhold 10 percent of the amount realized on the transfer (“ECI Withholding Tax”) (unless an exception applies). In the event a transferee fails to properly withhold on the transfer of a partnership interest, the partnership is required to deduct and withhold an amount equal to the under withheld amount (plus interest) from future distributions that would otherwise be payable to such transferee (“Backstop Withholding”).
In 2020, the IRS published final regulations (“Final Regulations”) implementing these new partnership ECI and withholding rules, including rules regarding Backstop Withholding. In 2021, in response to taxpayer feedback, the IRS announced that it would defer the applicability date of the Backstop Withholding rule to January 1, 2023.
As of January 1, 2023, Backstop Withholding is required where the transferee of a partnership interest does not establish that it either properly withheld ECI Withholding Tax or was not required to withhold ECI Withholding Tax with respect to payments made by the transferee to the transferor of a partnership interest. As described in greater detail below, Backstop Withholding applies to distributions from the partnership to an under-withholding transferee until the amount not previously withheld, plus interest, is recovered. These new rules are of particular import for fund sponsors because if a transferee fails to withhold, the fund itself becomes responsible.
The Backstop Withholding rules include new certification requirements with respect to the transferee and the underlying partnership. For transfers of partnership interests going forward, transferees are now required to certify to the underlying partnership the extent to which it satisfied its obligation to withhold no later than 10 days after the transfer (a “Transferee Certification”). The Transferee Certification must either include a copy of IRS Form 8288-A (a statement of withholding form) that the transferee files with respect to the transfer, or state the amount realized and the amount withheld on the transfer. The Transferee Certification must also include any certifications that the transferee relied on to apply an exception to withholding (or to determine the amount withheld).
As noted above, if a transferee fails to withhold or provide a Transferee Certification, the partnership must withhold on future distributions with respect to the transferred interest. To determine the amount of its withholding obligation, the partnership may rely on the Transferee Certification, unless the partnership knows, or has reason to know, that the Transferee Certification is incorrect or unreliable. A partnership is not required to withhold on future distributions if the partnership receives a Transferee Certification and the Transferee Certification states that an applicable exception to withholding applies or that the transferee withheld the full amount required to be withheld.
To the extent a partnership is required to withhold on distributions to a transferee, the partnership must begin withholding on the later of 30 days after the transfer or 15 days after the partnership has actual knowledge that the transfer occurred. The partnership must withhold the full amount of each distribution to the transferee until it has withheld 10% of the amount realized on the transfer (reduced by any amounts withheld by the transferee) plus interest. Interest is computed using the same formula applied to interest on the underpayment of tax and is payable between the date that is 20 days after the date of transfer and the date on which the tax is paid to the IRS. As mentioned above, the partnership may cease withholding on distributions to the transferee when it pays the amount required to be withheld or when the transferee provides the partnership with a Transferee Certification.
These newly effective regulations will require additional consideration as to reporting and withholding obligations by private funds. Fund sponsors should review and update form assignment and assumption agreements and modify transfer agreements to require transferee’s to provide the partnership with a timely Transferee Certification. In addition, fund sponsors should consider updating any relevant transfer party tax representation and indemnity provisions in their form transfer agreements to take into account the application of these rules and protect the interests of the fund. Please reach out to your Weil Tax contacts if you have questions or would like to discuss how these regulations may impact your specific circumstances.