IRS Issues Interim Partial Relief From the Withholding Tax Obligations on Transfers of Partnership Interests

Background:

Section 1446(f) of the Code, along with Section 864(c)(8), was introduced on December 22, 2017 by legislation referred to as the Tax Cuts and Jobs Act (TCJA). These new sections overturn the decision in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Comm’r, 149 T.C. No. 3 (Jul. 13, 2017), and codify the IRS’s longstanding position in Revenue Ruling 91-32 that gain of a foreign partner from the disposition of an interest in a partnership that is engaged in a trade or business in the United States is effectively connected to a U.S. trade or business and therefore subject to tax in the U.S. The TCJA further requires the transferee to withhold 10 percent of any amount realized on the sale or disposition of a partnership interest if any portion of the gain would be treated as effectively connected income, unless the transferor furnishes to the transferee an affidavit, under penalties of perjury, stating that the transferor is not a foreign person. If a transferee fails to withhold and no exception applies, the partnership is required to withhold that amount, plus interest, from distributions to the transferee.

Notice 2018-08, issued on December 29, 2017, suspended the withholding requirement with respect to dispositions of publicly traded partnership interests and that suspension remains in effect.

Summary of Notice:

Suspension of Secondary Withholding Obligation

Under the TCJA, if the transferee fails to properly withhold tax on payments made to the transferor of a partnership interest, the partnership is required to withhold such tax, plus interest, from distributions to the transferee. Until further guidance is issued, the Notice suspends the withholding obligation imposed on the partnership.

Partnership Distributions

The Notice clarifies that a partnership making a distribution to a partner is subject to the withholding tax rules as a transferee to the extent that the distribution exceeds the partner’s basis in the partnership interest. However, no withholding is required on a distribution if, based on the partnership’s books and records or on a certification from the distributee partner, the distribution does not exceed the partner’s basis in its partnership interest.

Certification of Non-Foreign Status and W-9 Forms

The Notice permits partnerships and transferees to rely on new or previously collected IRS Forms W-9 in lieu of an affidavit of non-foreign status as long as the form includes the name and U.S. TIN of the transferor, is signed and dated by the transferor, and the penalties of perjury statement has not been deleted. The Notice also provides that taxpayers may use non-foreign status certificates similar to the ones used for purposes of Sections 897 and 1445 of the Code (otherwise known as FIRPTA) as long as they are modified to reflect the affidavit requirements of Section 1446(f).

Observation. The ability to rely on previously collected IRS Forms W-9 is a relief for partnerships that redeem partners on a regular basis and that—absent this relief—would have been required to collect new non-foreign certifications from their U.S. partners.

Certification That No Gain Is Realized

Withholding is required only if the transferor realizes gain on the transfer of the partnership interest. The Notice permits a transferee to rely on a certificate from the transferor that the transfer will not result in realized gain to avoid the withholding tax obligation.

Nonrecognition Transactions

No withholding is required if the transferee receives a certificate from the transferor (meeting the requirements of similar certifications applicable for FIRPTA purposes) that by reason of the nonrecognition provisions of the Code or an applicable tax treaty the transferor is not required to recognize any gain or loss with respect to the transfer. Unlike FIRPTA, there is no requirement to file this certification with the IRS. The Notice provides, however, that the Treasury Department and the IRS are studying the appropriate treatment of nonrecognition transactions.

De Minimis Exceptions

The Notice sets forth two de minimis exceptions from withholding tax based on the amount of the effectively connected income or gain:

1. A transferee is not required to withhold if it receives a certification from the transferor stating that, for each of the past three taxable years, the transferor’s share of the partnership’s effectively connected income was less than 25 percent of the transferor’s total distributive share of the partnership’s income. This exception includes a few important restrictions: (i) this certification is not available for transferors that were not partners in the partnership for the entire three-year period, (ii) this certification is not available for transferors that did not have a distributive share of income in any of the three years during which the partnership had effectively connected income, and (iii) transferees may not rely on such certification prior to the receipt by the transferor of the Form 8805 (that includes the foreign partner’s share of effectively connected income) and Schedule K-1 for each of the relevant three years;
2. A transferee is not required to withhold if it receives a certificate from the partnership stating that if the partnership had sold all of its assets at their fair market value, the amount of effectively connected gain would be less than 25 percent of the total gain.

The Notice further states that the IRS intends to provide future guidance reducing the threshold for withholding below 25 percent.

Observation. The requirement to look back three years applies only to transferor certifications and does not apply to partnership certifications. Therefore, non-U.S. partners may want to include a provision in either the partnership agreement or a side letter requiring the partnership to provide such certification where they are permitted to transfer their partnership interests if the partnership is able to make the certification. In cases where the partnership is unable to certify that the effectively connected gain is less than 25 percent, the transferee may still request a transferor certificate that the effective connected income over the prior three years was less than 25 percent.

Partnership Liabilities

Withholding under Section 1446(f) is determined by reference to the “amount realized” from the transfer of a partnership interest, which includes the partner’s share of partnership liabilities. Therefore, the amount of the withholding tax potentially could be greater than the actual cash and property paid by the transferee for the partnership interests. To address these and similar issues, the Notice provides the following guidance:

1. The Notice permits the transferee to rely on a certification from the transferor or partnership as to the amount of the transferor’s share of partnership liabilities in reliance on the last Schedule K-1 received by the transferor, provided that the transferor or partnership certifies that it does not have actual knowledge of events after the close of the taxable year that would cause that amount to change by more than 25 percent. A certification by the transferor (as opposed to the partnership) is limited to transfers within ten months after the close of the partnership tax year. Transferors that were “controlling partners” (e.g., owned a 50 percent or greater interest in capital, profits, deductions or losses) in the 12 months prior to the transfer are not entitled to provide this certification.
2. To avoid situations in which the transferee is required to withhold an amount that is greater than the actual cash and property transferred to the transferor, the Notice caps the amount of the withholding by the amount of the cash and property. However, if the transferee does not receive a certification from either the transferor or the partnership, and is unable to determine the transferor’s share of partnership liabilities, the transferee is required to withhold the entire amount of the cash and other property paid to the transferor. These rules apply only if the transferee is not related to the transferor and do not apply in case of partnership redemptions. The obligation to withhold on property means that the transferee may be required to fund the cash required to be paid to the IRS from other sources.

Tiered Partnerships

The Notice provides that the Treasury Department and the IRS intend to issue regulations clarifying that a sale of an upper tier partnership that owns an interest (directly or indirectly) in a lower tier partnership would be subject to these rules if the lower tier partnership would have effectively connected gain upon a sale of its assets.

Extension to File and Pay Tax

The Notice provides that no penalties or interest will be assessed for any late forms or withholding tax payments required under Section 1446(f), as long as they are filed and paid on or before May 31, 2018. For these purposes, the Notice requires taxpayers to use the withholding forms used for FIRPTA purposes.

Coordination with FIRPTA Withholding

The Notice provides that where a transfer of a partnership interest is subject to withholding under both FIRPTA and 1446(f), the taxpayer must withhold under FIRPTA unless the transferor obtains a withholding certificate reducing the amount of the withholding under FIRPTA. In such a case, the transferee must withhold the greater of the FIRPTA and 1446(f) withholding tax.

We will continue to monitor these developments closely.