New Regulations Clarify the Application of U.S. Withholding Regime to Secondary Transfers of Partnership Interests by Non-U.S. Partners

Under Sections 864(c)(6) and 1446(f) of the Code, when a non-U.S. person transfers an interest in a partnership (or other entity taxed as a partnership) that is engaged in a U.S. trade or business (a “USTB”), the non-U.S. person may be subject to U.S. federal income tax on all or a portion of the gain recognized on the transfer, and the transferee may be required to withhold 10% of the amount realized in the transfer.¹ On October 7, 2020, the IRS released final regulations that implement the foregoing rules (the “Final Regulations”).  Investment funds and other entities and arrangements treated as partnerships for U.S. federal income tax purposes, as well as their partners, should be aware of these rules as they will impact most, if not all, secondary transfers.

The Tax Cuts and Jobs Act of 2017 (i) codified in Section 864(c)(6) that a non-U.S. person’s gain from the sale of an interest in an entity classified as a partnership for U.S. tax purposes is subject to U.S. federal income tax to the extent that gain is attributable to built-in gains in partnership assets effectively connected with the partnership’s USTB (“ECI”), and (ii) enacted Section 1446(f), which enforces this tax liability by requiring the transferee to withhold 10% of the “amount realized” unless the transferor demonstrates that an exception applies.

If the transferee fails to withhold as required by Section 1446(f), the partnership would be obligated to withhold the amount that should have been withheld, plus interest, from subsequent distributions to the transferee.

Withholding is not required, however, where the transferor of a partnership interest provides a certificate of non-foreign status or otherwise satisfies requirements set forth in regulations to establish an exemption from withholding tax.  The statute also authorized the Treasury to issue regulations addressing transfers of interests in publicly traded partnerships (“PTPs”) given the particular challenges raised by withholding in that context.

As noted above, a transferee must withhold 10% of the “amount realized” by the transferor on the sale, unless an exception applies.  The amount realized by the transferor of a partnership interest generally equals the sum of the consideration received and any reduction of the transferor’s share of partnership liabilities resulting from the transfer.  The Final Regulations provide that for the purposes of determining the transferor’s share of partnership liabilities, a transferee may rely on a certificate from the transferor providing (i) the transferor’s share of liabilities as shown on the most recent Schedule K-1 issued to it by the partnership, and (ii) that the transferor does not have any actual knowledge that the transferor’s share of liabilities differs from the amount shown on the Schedule K-1 by more than 25%.  The transferee may also rely on a similar certificate provided by the partnership. 

However, if a transferee has no actual knowledge of the amount of the transferor’s share of the partnership’s liabilities and cannot rely on any of the aforementioned certificates, or if the amount required to be withheld would exceed the amount realized without regard to any reduction in partnership liabilities, the amount realized may be calculated without regard to the partnership’s liabilities.  The transferor may not simply ignore the partnership’s liabilities by simply failing to do any diligence because the Final Regulations suggest the partner would need to provide the certificate regarding its share of liabilities on its most recent Schedule K-1. 

If a transferee is required to withhold amounts pursuant to both Section 1445 of the Code (i.e., with respect to certain partnerships that hold U.S. real property interests) and to Section 1446(f), the transferee must withhold the greater of the two amounts.

The Final Regulations provide that a transfer of a partnership interest is presumed to be subject to withholding under Section 1446(f) unless the transferor establishes an exemption.  To that end, the Final Regulations implement both the statutory exemption for transferors that are not non-U.S. persons as well as additional exemptions in certain circumstances.²

Non-Foreign Status.  As described above, a transferee is not required to withhold under Section 1446(f) if the transferor provides a certificate of non-foreign status.  Helpfully, the Final Regulations permit a transferor to provide an IRS Form W-9 to satisfy this requirement, which reduces the compliance burden for transferors that must otherwise also provide an IRS Form W-9, as is often the case.³

No Realized Gain.  A transferee is not required to withhold any amounts if the transferor certifies that it will not realize gain on the transfer.  The Final Regulations confirm that this certificate may not be provided, however, if the transferor realizes an overall loss but is required to recognize ordinary income pursuant to Section 751 of the Code.⁴  To determine whether any gain would be subject to tax pursuant to Section 751, the Final Regulations require the transferor to provide a certificate from the partnership that no such gain will be realized on the sale.

Less Than 10% EC Gain.  A transferee is not required to withhold if the transferor provides a certificate from the partnership stating that if the partnership were to sell its assets for fair market value, the net “effectively connected gain” (i.e., gain that would be ECI) allocable to the transferor would be less than 10% of the total net gain allocable to the transferor on the deemed sale.

No U.S. Trade or Business.  The Final Regulations helpfully permit a new exemption for a transferor that provides the transferee with a certificate from the partnership stating that the partnership has not been engaged in a USTB at any time during the taxable year in which the transfer occurs.

10% ECI.  A transferee is not required to withhold if the transferor certifies that (a) the transferor has been a partner in the partnership for the prior three taxable years, and (b) the transferor’s allocable share of any ECI earned by the partnership was (i) less than 10% of its allocable share of the partnership’s aggregate gross income, and (ii) less than US$1 million in each of the prior three taxable years.

Treaty Benefits.  Certain non-U.S. persons may be eligible for the benefits of a tax treaty between their home jurisdiction and the United States with respect to ECI.  In those cases, the transferee may rely on an IRS Form W-8 provided by the transferor demonstrating the transferor’s eligibility for that treaty in order to determine whether that withholding is not required, or that the transferor is entitled to a reduced rate of withholding.

Non-Recognition Transfer.  If a partnership interest is transferred in a transaction that is a “non-recognition” transaction (e.g., a tax free contribution to a corporation pursuant to Section 351), the transferee is not required to withhold if the transferor certifies that the transaction so qualifies.

Maximum Tax Liability.  A transferee may also rely on the transferor’s certification of its “maximum tax liability” on the sale in order to limit its withholding to such amount.  A transferor’s maximum tax liability is the amount of the transferor’s share of the effectively connected capital gain and effectively connected ordinary income that would be realized in a deemed sale of the partnership’s assets, multiplied by the highest rate applicable to U.S. corporations or individuals, as applicable, taking into account the type of the relevant income.  However, a transferor’s certification of this amount may only be relied upon if the partnership has provided the transferor with a certificate as to the amounts described in the previous sentence.

Transfers of PTP interests are particularly challenging because a transferee will not always know the identity of the transferor.  To address this issue, the Final Regulations provide that a U.S. broker effecting a transfer by a non-U.S. transferor will be required to perform the withholding required under Section 1446(f) upon payment to either the non-US transferor or a foreign broker, as applicable, rather than the transferee.  Although it is outside the scope of this alert, the Final Regulations provide a number of certificates similar to the ones described above that a broker may rely on in order to determine that withholding does not apply or applies at a reduced rate. 

Non-U.S. investors in partnerships should give careful consideration to the rules mentioned above and may wish to request confirmation from those partnerships that they will provide one of the certificates described above in the event of a transfer (if possible).  Fund managers and general partners of other partnerships should expect that their non-U.S. investors may make those requests.  In many cases, it may be easy for partnerships to assist their investors with these requests; for example, venture capital and private equity partnerships often operate so as to avoid engaging in a USTB, making a certificate to that effect relatively simple to provide.  Secondary purchasers should also exercise care to obtain the appropriate withholding tax certifications prior to effecting a transfer and preserve the right to withhold in the purchase agreement in case no such certifications will be forthcoming.

In addition, given that a partnership will be required to withhold from future distributions if the appropriate withholding under Section 1446(f) is not made at the time of transfer, partnerships may wish to include specific provisions in their governing documents requiring notice of transfers, provision of any information required to satisfy their withholding obligation if it becomes necessary, and indemnification for any taxes imposed under Section 1446(f) and related expenses. 

Section 1446(f) may cause particular challenges for non-U.S. investors in the initial stages of fund formation, with closings occurring on different dates, potentially resulting in disguised sales of partnership interests when distributions are made as part of that process.  Practitioners hoped that the Final Regulations would provide relief in these circumstances given that it is unlikely a transfer at the formation stage of a fund will result in ECI, but the Treasury explicitly declined to do so.

O’Melveny will be closely monitoring further developments in this area and can assist clients with analyzing and complying with the Final Regulations and any future guidance related to Section 1446(f).  Please contact the attorneys listed on this Client Alert or your O’Melveny counsel for questions regarding the information discussed herein.

¹ All section references are to the Internal Revenue Code of 1986, as amended from time to time (the “Code”), and to the Treasury Regulations promulgated thereunder.

² All certificates described below are sufficient to demonstrate that a transfer is exempt from withholding pursuant to Section 1446(f).  However, these certificates do not mean that a transferor is exempt from withholding under any other Code provision or that the gain realized on the transfer is not nevertheless subject to tax as ECI.

³ In addition to permitting transferors to provide an IRS Form W-9 to demonstrate an exemption from withholding for purposes of Section 1446(f), the Final Regulations also permit a transferor to use the same form to demonstrate an exemption from FIRPTA withholding pursuant to Section 1445.

⁴ While a transferor of a partnership interest will generally realize capital gain or loss, Section 751 provides that transferor will realize ordinary income with respect to certain so-called “hot assets” of the partnership, including inventory, accounts receivable and depreciation recapture, even if the transferor has an overall loss in its partnership interest.