Uncertainties Exist for Withholding on Dispositions of Partnership Interests with U.S. Effectively Connected Income
The Tax Cuts and Jobs Act has created significant uncertainty regarding withholding on the disposition of interests in partnerships that have U.S. effectively connected income (“ECI”).
Background: Application of IRC Sec. 864(c)(8) and Sec. 1446(f)
IRC Sec. 864(c)(8) effectively codifies the position set forth by the IRS in Rev. Rul. 91-32 and overturns the Tax Court’s ruling in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3 (2017) (on appeal). IRC Sec. 864(c)(8) provides that a foreign individual or corporation which directly or indirectly owns an interest in a partnership that is engaged in a U.S. trade or business must treat gain or loss on the sale or exchange of that interest as ECI. If the foreign person disposes of a partnership interest at a gain or loss, then that seller must treat as ECI the amount of gain or loss that would have been allocated to that partner if the partnership had sold all its assets for fair market value. IRC Sec. 864(c)(8) applies to dispositions of partnership interests on or after November 27, 2017.
IRC Sec. 1446(f) imposes a 10% withholding requirement on the buyer of a partnership interest on the “amount realized” on the sale or transfer of a partnership interest after December 31, 2017, if the gain is U.S. ECI and the seller does not provide certification of its non-foreign status. In Notice 2018-08, the IRS announced a delay in withholding under IRC Sec. 1446(f) with respect to dispositions of certain publicly traded partnerships until regulations or other guidance have been issued.
There are many uncertainties in the application of the withholding obligation under Section 1446(f).
- In the case of tiered partnerships and foreign partnerships that own interests in U.S. partnerships, it is not clear how the withholding obligation will be implemented. For example, if a non-resident partner sells its interest in a foreign partnership, how will the transferee know to withhold? If it does not withhold, how will the U.S. partnership know that it has a withholding obligation?
- The amount realized under IRC Sec. 1446(f) includes both the value of the consideration received as well as any deemed relief from partnership liabilities allocated to the transferred interests. This will raise a number of issues.
- The amount withheld could exceed the actual tax liability and, although refunds are possible, this will cause cash flow issues.
- The withholding obligation will in essence require valuation of assets every time an interest in a partnership is sold or transferred. Who pays for this?
- It is not clear how IRC Sec. 1446(f) will interact with the non-recognition rules. For example, if a partner exchanges its interests in an IRC Sec. 351 or Sec. 721 transaction, will this be exempt from withholding?
- Coordination of withholding under IRC Sec. 1446(f) and Sec. 1445 (Withholding of Tax on Dispositions of United States Real Property Interests) will also be required.
It has been recommended by bar associations and trade groups that there also be a delay in withholding under IRC Sec. 1446(f) for non-publicly traded partnerships until more guidance can be issued. However, as of now there has been no such announcement.