By: Jerald David August, Chair, Fox Rothschild LLP International Taxation and Wealth Planning Group
The Internal Revenue Service recently issued proposed regulations, REG-10476-18, 2019-27 IRB 63, with respect to withholding and information reporting for certain dispositions of partnership interests by non-US persons who are partners in a partnership that is engaged in the conduct of a US trade or business. Under the Tax Cuts and Jobs Act, P.L. 115-97, section 864(c)(8) of the Code was amended to reverse the holding of the Tax Court in Grecian Magnesite Mining, Industrial & Shipping Co. v. Comm’r, 149 TC No. 3 (2017), which held that a foreign corporation’s gain on the sale of an interest in a partnership that engaged in a U.S. trade or business was not US source income and wasn’t effectively connected with a US trade or business, except to the extent the gain was attributable to unrealized appreciation in assets of the partnership that are US real property interests under section 897(g). The Tax Court rejected the long-standing position of the Service set forth in Rev. Rul. 91-32, 1991-1 CB 107 which held that gain or loss of a foreign partner from the taxable disposition of a partnership interest where the partnership is engaged in carrying on a trade or business within the US or has a permanent establishment in the US to the extent that such gain is effectively connected with such trade or business or attributable to such permanent establishment. The Tax Court reasoned that such result was the proper interpretation to be given to Treas. Reg. §1.864-4. The Court rejected the IRS argument, based on its long-standing revenue ruling, that the application of the aggregate theory of partnership taxation required that the enterprise value of the entire trade or business conducted within the US by the partnership was to be treated as effectively connected income. See discussion in August, “Tax Court Rejects Rev. Rul. 91-32, Holds Foreign Partner’s Gain from Redemption Not ECI”, Corporate Taxation (WG&L) (Nov/Dec 2017).
A non-resident individual, person or corporation that is engaged in a trade or business in the US either in carrying on such trade or business under section 864(c) or by application of maintaining a permanent establishment in the US under pertinent tax treaty is subject to US income tax on taxable income that is effectively connected with such trade or business (ECB). Non-resident partners in a partnership are treated as engaged in the conduct of a trade or business within the US if the partnership is so engaged under section 875(1). Section 1446 imposes withholding on a non-resident partner’s distributive share of ECB partnership income based on maximum applicable rates based on each non-resident’s tax profile, subject to the application of a relevant tax treaty based on a particular partner’s jurisdiction of tax residence. In comparison, non-business income (fixed or determinable periodic income or FDAP) from US sources received by a non-resident alien are generally subject to income tax on a gross basis at a rate of 30% percent and 30% flat withholding by the deemed withholding agent under sections 1441 or 1442, without reduction for related expenses, again subject to application of a relevant tax treaty.
Tax Cuts and Jobs Act of 2017 (TCJA)
In reversing the Tax Court’s decision in Grecian Magnesite, supra, Congress amended section 864(c)(8)(A), per TCJA §13501(a), in providing that: (i) gain from the taxable disposition of a partnership interest by a non-resident is taxable as ECI to the extent of the portion of the partner’s distributive share of the amount of gain that would have been effectively connected with the conduct of a US trade or business had the partnership sold all of its assets at their fair market value on such date; and (ii) loss from the taxable disposition of a partnership interest to the extent the partner’s distributive share of the loss on the sale that would have been treated as gain that is effectively connected with the conduct of a U.S. trade or business if gain, rather than loss, had been realized. Where the partnership holds real property subject section 897(c)(FIRPTA) at the time of the sale or exchange of the non-resident partner’s taxable disposition, gain or loss is still treated as ECI and takes priority over section 864(c)(8) to such extent. The new rule applies to sales, exchanges and dispositions after November 26, 2017 although the withholding requirements apply for taxable dispositions and exchanges after 2017. See TCJA §§13501(c)(1), 13501(c)(2).
The Operative Withholding Provision to New Section 864(c)(8): Meet New Section 1446(f)
Section 1446(f)1), sets for the general rule, that unless otherwise provided, where a portion of the gain (if any) on any disposition of an interest in a partnership is characterized under section 864(c)(8) as effectively connected with the conduct of a trade or business within the US, the transferee is required to deduct and withhold a tax equal to 10% of the amount realized on the disposition.
Section 1446(f)(2)(A) sets forth an exception to the required 10% withholding in section 1446(f)(1) where the transferor furnishes an affidavit to the transferee stating, under penalties of perjury, the transferor’s US taxpayer identification number and that the transferor is not a foreign person. Section 1446(f)(2)(B)(i) provides that the exception to withholding provision will not apply where the transferee has actual knowledge that the affidavit furnished is false, or if the transferee receives a notice from a transferor’s agent or transferee’s agent that the affidavit is false.
At the request of either the transferor or the transferee, section 1446(f)(3) provides that regulations may provide a reduced amount to be withheld in instances where the collection of tax on gain under section 864(c)(8) will not be jeopardized. Where the transferee fails to withhold the required amount under section 1446(f)(1), then, under section 1446(f)(4), the partnership must deduct and withhold from distributions to the transferee a tax in an amount equal to the amount the transferee failed to withhold, plus interest. The regulations issued under section 1446(f)(6) are legislative regulations. The provision is effective for sales, exchanges, and other dispositions after December 31, 2017.
Late last year, the Treasury and the IRS issued Notice 2018-08, 2018-7 I.R.B. 352, which temporarily suspends the requirement to withhold on amounts realized in connection with the sale, exchange, or disposition of certain interests in a publicly traded partnership not treated as a corporation under section 7704 and the regulations thereunder. Then, this Spring, on April 2, 2018, Notice 2018-29, 2018-16 I.R.B. 495 was issued in providing temporary guidance prior to the forthcoming proposed regulations. Notice 2018-29, and section 1446(f)(1) essentially adopt a set of principles on withholding contained in the FIRPTA withholding rules under section 1445. Under section 1445, if a foreign person disposes of a United States real property interest (“U.S. real property interest”), as defined in section 897(c), a withholding obligation is imposed on the transferee of the interest.
On December 27, 2018, the Treasury Department and the IRS published in the Federal Register a notice of proposed rulemaking at 83 FR 66647 (REG-113604-18) under section 864(c)(8) (“NOPRM Section 864(c)(8)”) which sets out rules for determining the amount of gain or loss treated as effectively connected with the conduct of a trade or business within the US (“effectively connected gain” or “effectively connected loss”) described in section 864(c)(8), including rules integrating section 864(c)(8) with sections 741 and 751 (relating to the character of gain or loss realized in connection with the sale or exchange of an interest in a partnership). Additional rules integrate section 864(c)(8) with section 897 (relating to amounts treated as effectively connected gain or loss with respect to U.S. real property interests), tiered partnerships, and U.S. income tax treaties.
Issuance of Proposed Regulations under Section 1446(f)
The proposed regulations (NOPRM Section 1446(f)) issued in early May, 2019, set forth, in some detail, the set of withholding and compliance reporting rules under section 1446(f) pertaining to the sale, exchange, or other disposition of an interest in a partnership where the partnership is engaged in a US trade or business under section 864(c)(8). See NOPRM Section 864(c)(8). The section 1446(f) proposed regulations generally adopt the rules set out in Notice 2018-29, supra, with certain modifications. The NOPRM Section 1446(f) also modify the rules on withholding on distributions by publicly traded partnerships, including the rules that apply to qualified notices and nominees. Coverage is also provided for “overwithholdings”.
Summary of Section 1446(f) Through the Lens of NOPRM Section 1446(f)
Section 864(c)(8) requires a deemed sale at the partnership level to determine a foreign partner’s effectively connected gain or loss. This look thru type analysis requires that the foreign person transferring its partnership interest will be unable to compute its income tax liability under section 864(c)(8) unless the partnership provides relevant information to the foreign partner. This issue is addressed in the NOPRM Section 1446(f). Thus, the proposed regs provide rules that facilitate the transfer of information between a foreign partner and the partnership for purposes of section 864(c)(8).
Under section 1446(f)(1), a transferee of a partnership interest must withhold as a tax 10% of the amount realized on any disposition when the disposition results in gain that is treated as effectively connected with the conduct of a trade or business within the US under section 864(c)(8). The transferee partner will be credited with the withholding taken against its US tax obligation for the year of sale. There is, as mentioned, the concept of a withholding to be exempt if the proper information is provided prior to or at the closing. There are six such exceptions.
The section 1446(f)(4) withholding regime also applies to distributions on any amount that the transferee failed to property withhold, plus interest. Rules are also set forth in the NOPRM Section 1446(f) on the transfer of an interest in a publicly traded partnership (PTP) which, when finalized, will override the rules provided in IRS Notice 2018-08. The sale of PTP interests withholding obligation is limited, for the most part, to brokers who receive proceeds from the sale and who act on behalf of the transferor. There are five exceptions to withholding applicable to a transfer of a PTP.
The proposed regulations provide rules coordinating withholding under section 1446(f) with other withholding regimes to prevent overwithholding of tax.
The operative statutory provisions, NOPRMs and related Code sections need to be carefully reviewed and evaluated. The government continues to invite comments in this area.
The information set forth in this post was intended solely for information purposes only and may not be construed by the reader as legal advice issued by Fox Rothschild LLP or the undersigned attorney. Any reader of this post having questions on section 864(c)(8), section 1446(f) and/or related provisions is urged to consult with its tax counsel or tax advisor. You may also call you lead legal advisor at Fox Rothschild LLP or the undersigned attorney at Fox Rothschild.