On October 7, 2020, the IRS released final regulations [TD 9926] (the “Final Regulations”) under Section 1446(f) of the Internal Revenue Code of 1986 (the “Code”), 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. Subject to certain clarifications and modifications summarized below, the Final Regulations largely adopt the approach and exceptions previously laid out by the IRS in the Proposed Regulations issued May 7, 2019, discussed previously here.

Basic Withholding Requirement

Under Section 864(c)(8) of the Code gain on the sale of a non-U.S. partner’s interest in a partnership will generally 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 discussed previously here. Section 1446(f)(1) of the Code implements the associated withholding requirement with respect to such gain by providing that a transferee of a partnership interest (or the partnership itself, should the transferee fail to do so) must generally withhold tax equal to 10 percent of the amount realized on any disposition when such disposition results in ECI gain for the transferor. The Final Regulations implement this withholding requirement by adopting the basic approach and structure of the Proposed Regulations with certain modifications. Generally speaking, withholding is required upon any transfer of a partnership interest unless a specific exception or adjustment to the required withholding applies. A transferee must therefore presume withholding is required unless it receives a certification from the transferor claiming one of the enumerated exceptions applies.

Final Exceptions to Withholding

The Final Regulations adopt the exceptions established in the Proposed Regulations with certain modifications. Notably, the exception to withholding where a partnership itself can deliver a certificate stating that upon a hypothetical sale of its assets, net ECI gain would be less than 10% of the partnership’s total gain has been modified to refer to the transferor’s distributive share of such net ECI gain. Thus, a transferee may rely on a certificate that the transferor’s distributive share of net ECI gain from the partnership would be less than 10% of the transferor’s distributive share of the total net gain from the partnership. This change would appear to potentially make it more likely that a partnership could deliver such a certification in connection with a partnership interest transfer.

The Final Regulations also modify the exception for the delivery of a transferor’s certificate that states that, subject to certain additional conditions, the transferor has been a partner for at least three years and that its share of net ECI for each of those years was less than 10% of its total distributive share. The Final Regulations now look to gross amounts of income, rather than net amounts of income, for purposes of determining whether the transferor’s distributive share of ECI was less than 10% of the transferor’s total distributive share of income from the partnership.

The Final Regulations add a new exception to withholding if the partnership certifies to the transferee that it was not engaged in a trade or business within the United States at any time during the taxable year of the partnership through the date of transfer. This exception could be particularly helpful for transfers of partnership interests in partnerships, like private investment funds that make an investment in portfolio companies that are engaged in a United States trade or business indirectly through blocker corporations.

Finally, regardless of the potential application of any of the specific withholding exceptions, the Final Regulations clarify that any person (including the partnership itself) required to withhold under Section 1446(f) of the Code is not liable for failure to withhold, or any interest, penalties, or additions to tax, if it establishes to the satisfaction of the Commissioner that the transferor had no gain under Section 864(c)(8) of the Code subject to tax on the transfer.

Partnership Level Withholding

Under Section 1446(f)(4) of the Code where a transferee fails to withhold any required amount under Section 1446(f)(1) of the Code the partnership itself must effectuate the withholding by offsetting distributions to the transferee in the amount of the required withholding (and any interest). The Final Regulations largely adopt the mechanical rules established by the Proposed Regulations in respect of this secondary withholding obligation by the partnership without change, other than now allowing the transferee, rather than the partnership, to obtain a refund of overwithholding, if any. 

Applicability

Subject to certain exceptions, including for the application of certain rules in the publicly traded partnership context, the Final Regulations are generally applicable to transfers that occur on or after 60 days following publication in the Federal Register. Furthermore, to give partnerships time to implement withholding, the requirement for partnership level withholding under Section 1446(f)(4) of the Code only applies to transfers that occur on or after January 1, 2022. The Final Regulations also obsolete previously issued IRS guidance in this context, including Notice 2018-29, 2018-16 IRB 495.