Understanding Tax Withholding for Nonresident Partners: A Deep Dive into the Impact of Section 1446(f)

The landmark 2017 Tax Cuts and Jobs Act (TCJA) ushered in a transformative change in the Internal Revenue Code. Notably, it introduced Section 1446(f), an often overlooked yet critical provision that stipulates a 10% withholding tax on the amount garnered from the sale or exchange of a partnership interest by a foreign person, specifically when the transfer results in U.S. effectively connected income (ECI). This article explores the circumstances prompting the legislation’s implementation and delves into the potential tax repercussions of Section 1446(f) for non-public and publicly traded partnership transfers.

Introduction

Before passing of the Tax Cuts and Jobs Act (TCJA) in 2017, taxation on the sale of a partnership interest by a foreign person was not clearly defined. Rev. Rul. 91-32, issued in 1991, held that a partner was deemed to own a proportionate share of the partnership assets (aggregate approach). Under this revenue ruling, a foreign partner was subject to tax, upon the sale of a partnership interest, on their share of gain related to assets that generated ECI as if the assets in the partnership were sold directly. However, on July 13, 2017, the U.S. Tax Court declined to follow Rev. Rul. 91-32 in its opinion in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner. The Tax Court stated that the aggregate approach used in Rev. Rul. 91-32 was inconsistent with the Tax Court’s general view that the capital gain from the sale of an interest in a partnership engaged in a U.S. trade or business generally is not ECI to the foreign partner, subject to exception.

The TCJA settled an ongoing dispute about whether nonresident aliens and foreign corporations not otherwise engaged in a U.S. trade or business were subject to U.S. tax on gains from the sale of interests in partnerships engaged in a U.S. trade or business. Section 1446(f), enacted under the TCJA, imposed a 10 percent withholding tax on the amount realized from a foreign person’s sale, exchange, or other disposition of a partnership interest to the extent the foreign person would have ECI under section 864(c)(8), as if the partnership had sold all of its assets. The new withholding requirement applies to any sales, exchanges, and dispositions unless a specific exception applies. If the transferee fails to withhold under Section 1446(f)(4), the partnership is required to deduct and withhold from distributions to the transferee partner an amount that would satisfy the withholding requirement plus interest to ensure collection of tax.

Withholding on the transfer of a Non-Publicly Traded Partnership (“Non-PTP”) interest

As mentioned above, the transferee of a non-PTP interest must withhold 10 percent of the amount realized on the sale or exchange of partnership interest unless a specific exception applies under Regulation 1.1446(f)-2.

There are six exceptions to withholding:

1. Certification of non-foreign status

This requires the transferor to certify its non-foreign status by providing a valid Form W-9 or equivalent.

2. No realized gain by transferor

This exception requires the transferor to certify that the transfer of the partnership interest would not result in any realized gain, including ordinary income from unrealized receivables and inventory items under section 751 (“Hot assets”).

3. Less than 10 percent effectively connected gain

This requires the partnership to certify that if it were to sell all of its assets at fair market value, either:

1. the partnership would have no effectively connected gain or, if the partnership would have effectively connected gain, the amount of net effectively connected gain resulting from the deemed sale would be less than 10 percent of the total net gain; or
2. the transferor would not have a distributive share of any partnership effectively connected gain or, if the transferor would have a distributive share of the partnership’s effectively connected gain, the transferor’s distributive share of net effectively connected gain would be less than 10 percent of the transferor’s distributive share of the partnership’s total net gain; or
3. the partnership was not engaged in a trade or business within the United States at any time during the tax year of the partnership through the date of transfer.

4. Less than 10 percent effectively connected income

This requires the transferor to certify that:

1. it was a partner in the partnership at all times during the three taxable years (look-back period) immediately prior to the transfer;
2. the transferor’s distributive share of gross ECI, as reported on schedule K-1, was less than $1 million for each look-back period;
3. the transferor’s distributive share of gross effectively connected income, as reported on Schedule K-1, was less than 10 percent of the transferor’s total distributive gross income from the partnership for each look-back period; and
4. the transferor’s distributive share of ECI or effectively connected gain (or deductions or losses allocated and apportioned to that income) in each of the tax years within the look-back period has been timely reported on a federal income tax return, and all amounts due have been timely paid.

5. Certification of nonrecognition by transferor

This requires a certification from the transferor that under the tax code, the transferor is not required to recognize any gain or loss on the transfer.

6. Income tax treaties

This requires the transferor to certify that it is not subject to tax by reason of an income tax treaty between the U.S. and a foreign country on any gain from the transfer. Form W-8BEN or W-8BEN-E, as applicable, may be used to make such a claim for benefits under an income tax treaty.

A transferee of a partnership interest is not required to withhold if it properly relies on its books and records or various certifications described above that establish an exception applies. However, the transferee’s withholding liability is not satisfied if the transferor or partnership has reason to know that a certification the transferee relies on to reduce or eliminate withholding is inaccurate or incorrect.

A transferee who is required to withhold should report and pay any tax withheld by the 20th day after the date of the transfer. Form 8288, U.S. Withholding Tax Return for Certain Disposition by Foreign Persons, and Form 8288-A, Statement of Withholding on Certain Disposition by Foreign Person, should be filed by the transferees to report and pay tax withholding. In addition, the transferee must certify to the partnership the extent to which it has satisfied its obligation to withhold no later than 10 days after the transfer.

Withholding on the transfer of a Publicly Traded Partnership (“PTP”) interest

In general, a transferee of a PTP interest is not required to withhold under Section 1446(f) when the transfer is between one or more brokers. Instead, the broker effecting such a transfer is required to withhold tax equal to 10 percent of the amount realized under Section 1446(f), unless an exception applies. A broker must withhold if the broker pays an amount realized to another broker that is required to be treated as a foreign person or pays an amount realized to a foreign transferor that is its customer. A withholding exception applies to payments made to another broker if documentation is obtained establishing the payee broker is either a qualified intermediary (“QI”) that assumes the primary withholding responsibility for the withholding payment, or it is a U.S. branch of a foreign person agreeing to be treated as a U.S. person with respect to the payment.

Similar to exceptions for the transfer of a non-PTP interest, the transfer of a PTP interest also has a list of exceptions to the withholding requirement mentioned in Regulation 1.1446(f)-4.

1. Certification of non-foreign status

This requires the transferor to certify its non-foreign status by providing a valid Form W-9 or equivalent.

2. Less than 10 percent effectively connected gain by partnership

Permits a broker to rely on a “qualified notice” posted by the PTP certifying that if the PTP sold all its assets at fair market value, either:

1. The amount of effectively connected net gain would be less than 10 percent of the total net gain; or
2. No gain would have been effectively connected to the conduct of U.S. trade or business.

3. Amount subject to withholding under section 3406

A broker is not required to withhold if the amount realized on the transfer of the PTP interest is subject to withholding under Reg. §31.3406(b)(3)-2 backup withholding.

4. Income tax treaties

A broker may rely on a certification from the transferor that it is not subject to tax on any gain from the transfer under an income tax treaty in effect between the U.S. and a foreign country. This exception does not apply if treaty benefits apply to only a portion of the gain from the transfer.

5. Foreign dealers that provide Form W-8ECI

A broker may rely on a certification provided by a transferor that certifies that it is a dealer in securities and that any gain from the transfer of the PTP interest is effectively connected with the conduct of a trade or business within the U.S. without regard to provisions of section 864(c)(8). Form W-8ECI may be used to make this certification.

The withholding tax under Section 1446(f) does not relieve a foreign person from filing a U.S. tax return with respect to the transfer. The foreign person may claim a credit for the amount withheld under Section 1446(f) on the U.S. tax return.

Every person who fails to withhold and pay tax under Section 1446(f) is liable for tax, plus any applicable interest, penalties, or additions to tax. A partnership that failed to withhold and pay tax under Reg. §1.1446(f)-3 is liable for the amount of tax that it failed to collect (but not any interest the partnership failed to withhold on that amount), plus any interest, penalties, or additions to tax with regards to the partnership’s failure to withhold.

Conclusion

Section 1446(f) withholding will require substantial time and attention in connection with all partnership interest transfers. For example, Treasury did not provide any exception for a disguised sale of non-PTP interest, which means that investors that purchase a partnership interest directly from an existing partnership fund would be required to obtain a certification from the fund to establish an exception from withholding. Fund managers will be responsible (and funds liable) for withholding if the investor does not satisfy its withholding requirement. Both the transferee and the partnership need to be aware of the section 1446(f) withholding requirement to ensure withholding liability is satisfied. Consider consulting your Marcum tax professional to discuss tax planning opportunities and filing requirements that may be of issue for you.