IRS Relaxes Withholding Rules on Transfers of Partnership Interests

(Parker Tax Publishing October 2020)

The IRS issued final regulations under (1) Code Sec. 864(c)(8), which provide rules for determining the amount of gain or loss treated as effectively connected with the conduct of a trade or business within the United States, including rules coordinating Code Sec. 864(c)(8) with Code Sec. 741 and Code Sec. 751 (relating to the character of gain or loss realized in connection with the sale or exchange of an interest in a partnership), and (2) under Code Sec. 1446(f), which provide guidance on the tax withholding and information reporting with respect to dispositions of interests in partnerships engaged in a trade or business within the United States. In a taxpayer-favorable move, the IRS modified the scope of the withholding obligation under Code Sec. 1446(f) in response to practitioners' concerns. T.D. 9919, T.D. 9926.

Background

The Tax Cuts and Jobs Act of 2017 (TCJA) enacted Code Sec. 1446(f) and Code Sec. 864(c)(8). Code Sec. 1446(f) provides rules for withholding on the transfer of a partnership interest described in Code Sec. 864(c)(8). Code Sec. 864(c)(8)(A) provides that gain or loss of a nonresident alien individual or foreign corporation (i.e., a foreign transferor) from the sale, exchange, or other disposition of an interest in a partnership that is engaged in any trade or business within the United States is treated as effectively connected gain or loss to the extent such gain or loss does not exceed the amount determined under Code Sec. 864(c)(8)(B). In general, Code Sec. 864(c)(8)(B) limits the amount of effectively connected gain or loss to the portion of the foreign transferor's distributive share of gain or loss that would have been effectively connected if the partnership had sold all of its assets at fair market value (the deemed sale limitation).

Compliance Tip: Code Sec. 1446(f) is effective for sales, exchanges, and dispositions after December 31, 2017. Code Sec. 864(c)(8) is effective for sales, exchanges, and dispositions on or after November 27, 2017.

Generally, under Code Sec. 1446(f), if a portion of the gain (if any) on any disposition of an interest in a partnership would be treated under Code Sec. 864(c)(8) as effectively connected with the conduct of a trade or business within the United States, the transferee is required to deduct and withhold a tax equal to 10 percent of the amount realized on the disposition. There is an exception to this general withholding requirement if the transferor furnishes an affidavit to the transferee stating, under penalties of perjury, the transferor's U.S. taxpayer identification number (TIN) and that the transferor is not a foreign person. The IRS may prescribe a reduced amount to be withheld if it determines that reducing the amount to be withheld will not jeopardize the collection of tax on gain treated under Code Sec. 864(c)(8) as effectively connected with the conduct of a trade or business within the United States. If a transferee fails to withhold any amount required to be withheld under Code Sec. 1446(f) then 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. Reg. Sec. 1.1446-3(b) provides that, in the case of a partnership's underpayment of Code Sec. 1446 tax, the penalty provisions of Code Sec. 6655 apply.

In Notice 2018-29, the IRS issued temporary guidance under Code Sec. 1446(f) and announced its intention to issue proposed regulations under Code Sec. 1446(f) with respect to the sale, exchange, or disposition of certain interests in non-publicly traded partnerships.

In December of 2018, the IRS issued proposed regulations (REG-113604-18) on the withholding of tax and information reporting with respect to certain dispositions of interests in partnerships engaged in the conduct of a trade or business within the United States described in Code Sec. 864(c)(8), including rules coordinating Code Sec. 864(c)(8) with Code Sec. 741 and Code Sec. 751 (relating to the character of gain or loss realized in connection with the sale or exchange of an interest in a partnership). The regulations also provided rules for the coordination of Code Sec. 864(c)(8) with Code Sec. 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.

In 2019, the IRS issued proposed regulations (REG-105476-18) that provided rules for withholding, reporting, and paying tax under Code Sec. 1446(f) upon the sale, exchange, or other disposition of an interest in a partnership. The proposed regulations would, when finalized, adopt many of the rules that were described in Notice 2018-29. In addition, the proposed regulations provided reporting rules relating to Code Sec. 864(c)(8) and rules implementing withholding under Code Sec. 1446(f). They also contained rules clarifying the reporting rules applicable to transfers of partnership interests subject to Code Sec. 6050K (i.e., returns relating to exchanges of certain partnership interests). Finally, the proposed regulations provided rules coordinating withholding under Code Sec. 1446(f) with other withholding regimes to prevent over-withholding of tax.

T.D. 9919

In September 2020, the IRS published final regulations under Code Sec. 864(c)(8) (the Code Sec. 864(c)(8) regulations) in T.D. 9919. The final regulations largely adopt the framework in the proposed regulations. In the final regulations, the IRS illustrates how to determine the deemed sale limitation described in Code Sec. 864(c)(8)(B), which the regulations refer to as the aggregate deemed sale effectively connected (ADSEC) amount. Once the ADSEC amount has been determined for each applicable category of gain or loss, the foreign transferor's outside gain or loss in each category is compared to the relevant ADSEC gain or ADSEC loss amount for that category to determine the amount of effectively connected (EC) gain or effectively connected loss under Code Sec. 864(c)(8).

In general, the ADSEC amount is determined through a three-step process. Step one determines the amount of gain or loss from each partnership asset as if the partnership conducted a deemed sale of all of its assets on the date of transfer (these amounts are referred to as deemed sale gain or deemed sale loss). Step two determines the amount of the deemed sale gain or loss that would be treated as EC gain or loss with respect to each asset (i.e., deemed sale EC gain or deemed sale EC loss). Finally, step three determines the foreign transferor's distributive share of the deemed sale EC gain or deemed sale EC loss amounts determined in step two.

In the preamble to the final regulations, the IRS noted that, because the sourcing rules in the Code and regulations are generally fact-specific, the application of the proposed rules in the context of the deemed sale required by Code Sec. 864(c)(8)(B) was unclear. As a result, while the final regulations retain the basic framework of the proposed regulations, the IRS adjusted their effects by adding rules for sourcing gain or loss from specific assets that may be particularly difficult to source in a deemed sale.

T.D. 9926

In T.D. 9926, the IRS the finalized the proposed regulations under Code Sec. 1446(f). The general approach in the proposed regulations required withholding on the transfer of a partnership interest unless an exception or adjustment to withholding applied. Under Prop. Reg. Sec. 1.1446(f)-2(a), a withholding obligation would be imposed on any transfer of a partnership interest, regardless of whether the partnership in question had any assets in, or any other connection to, the United States, or whether a transfer of an interest in the partnership would result in tax on gain under Code Sec. 864(c)(8). Practitioners complained that this rule was overly broad since it required a transferee to withhold in a number of circumstances where the language of Code Sec. 1446(f)(1) did not.

The IRS noted that, while the statutory language of Code Sec. 1446(f)(1) imposes a withholding requirement when a portion of the gain from a transfer would be treated under Code Sec. 864(c)(8) as effectively connected gain, a transferee will not know whether a transfer results in tax on gain under Code Sec. 864(c)(8) without information from either the transferor or the partnership. Therefore, the IRS said, the proposed rules would require that the transferee presume that a transfer is subject to withholding unless it obtains a certification from the transferor establishing otherwise (or, if the partnership is the transferee because it makes a distribution, by relying on information in its books and records to make such determination). A transferee that obtains and properly relies on this certification (or, when the partnership is the transferee, its books and records), the IRS observed, would generally not be subject to any withholding tax liability, even if the transfer results in tax on gain under Code Sec. 864(c)(8).

In response to practitioners' concerns, the IRS retained the proposed rule in the final regulations but added a rule in Reg. Sec. 1.1446(f)-5(b) that provides that any person required to withhold under Code Sec. 1446(f) is not liable for failure to withhold, or any interest, penalties, or additions to tax, if it establishes to the satisfaction of the IRS that the transferor had no gain under Code Sec. 864(c)(8) subject to tax on the transfer. Accordingly, while the general scope of the withholding obligation under Prop. Reg. Sec. 1.1446(f)-2(a) is retained in the final regulations, the consequences for failing to comply with the obligation are modified when the transferor has no gain under Code Sec. 864(c)(8) subject to tax on the transfer.

Observation: Thus, because this rule applies for all purposes of Code Sec. 1446(f), it also modifies the consequences for a partnership that fails to comply with its withholding obligation under Reg. Sec. 1.1446(f)-3 or a broker that fails to comply with its withholding obligation under Reg. Sec. 1.1446(f)-4 on the transfer of a PTP interest.

The final regulations also added an exception to withholding if the partnership certifies to the transferee that it is not engaged in a trade or business within the United States. The same exception is added for a publicly traded partnership that is not engaged in a trade or business within the United States.

For a discussion of (1) the withholding tax on dispositions of interests in partnerships engaged in a U.S. trade or business, and (2) the calculation of a gain or loss of foreign persons from the sale or exchange of certain partnership interests, see Parker Tax ¶202,145.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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