All of the changes regarding ECI and withholding tax established by the TCJA create significant uncertainty related to calculating and complying with the withholding requirement. The IRS and the Department of the Treasury have released two notices since the enactment of the TCJA that separately addressed issues related to withholding on dispositions of publicly traded partnership (PTP) and non-PTP interests. This discussion gives a historical perspective of the treatment of the sale of a partnership interest and the changes enacted as part of the TCJA.
Rev. Rul. 91-32
Prior to the TCJA, taxpayers looked to Rev. Rul. 91-32 for relevant guidance. Rev. Rul. 91-32 treats the partnership as an aggregation of its assets for the purpose of calculating ECI upon sale or exchange of a partnership interest. The position in the ruling is that a partner is deemed to own a proportionate share of the partnership assets, and that, upon sale of a partnership interest, a foreign partner should be subject to tax on his or her share of gain relating to assets that generate ECI as if the assets in the partnership were sold directly. Accordingly, under Rev. Rul. 91-32, a foreign person's gain on the sale of a U.S. partnership that conducts business in the United States would be treated as ECI to the extent that the foreign person's share of unrealized gain is made up of ECI property.
The position of Rev. Rul. 91-32 has been controversial since its issuance. While the IRS stance in the ruling is clear, prior to the TCJA, there had been uncertainty around whether existing law supports the conclusion that gain on the sale of a partnership interest by a non-U.S. person is ECI based on the partnership's being engaged in a U.S. trade or business. An opposing viewpoint uses Sec. 741 (the relevant Code section that governs the recognition of gain or loss on the sale of a partnership interest) and is based on the entity theory of a partnership. Under the entity approach, the partnership is treated as an entity on its own as opposed to each partner being treated as a co-owner of the partnership's assets.
Most of Subchapter K applies the entity approach to partnership transactions. However, some sections use the aggregate approach, such as the treatment of unrealized receivables or inventory under Sec. 751. Rev. Rul. 91-32 states that while the IRS recognizes that Subchapter K is a blend of aggregate and entity treatment for partnerships and agrees that, in some cases, it is appropriate to treat the partnership as an entity distinct from its partners, in this case the entity approach could provide unintended results and be inconsistent with other areas of tax law.
Grecian Magnesite Mining
In its July 13, 2017, decision in Grecian Magnesite Mining, Industrial & Shipping Co., SA,149 T.C. No. 3 (2017), the Tax Court addressed the position of Rev. Rul. 91-32 and determined 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 exceptions. By rejecting Rev. Rul. 91-32, the Tax Court went against the IRS's long-standing position of treating a sale of such a partnership interest as ECI.
Looking at the statutory provisions, including Sec. 864, the Tax Court agreed with Grecian that the gain from a sale of a partnership interest is a sale of an indivisible capital asset; therefore, the gain from Grecian's sale of the partnership interest in this case was not ECI. As a side note, the gain subject to litigation in the case was separate from the capital gain from the sale attributable to the real property assets owned by the partnership that were subject to the Foreign Investment in Real Property Tax Act of 1980, P.L. 96-499. Grecian and the IRS agreed that the gain on the portion of the sale of its partnership interest that related to the U.S. partnership's investment in U.S. real property was ECI.
With respect to its rejection of the IRS's position in Rev. Rul. 91-32, the court explained that while an agency's interpretation of its own ambiguous regulation should be accorded deference, where a revenue ruling interprets statutory text, the ruling will only be followed to the extent it has the "power to persuade." The Tax Court found that the IRS was not merely interpreting ambiguous IRS regulations in Rev. Rul. 91-32, and the revenue ruling had no power to persuade because of its inadequate analysis of the issues involved. Thus, instead of following Rev. Rul. 91-32, the court chose to "follow the Code and the regulations to determine whether the disputed gain is effectively connected income." While the IRS has appealed the decision, the ruling in the Grecian case was very favorable to foreign investors, creating many planning opportunities.
The TCJA effectively reversed the application of the Grecian ruling to future transfers of U.S. partnership interests only a few months after the case was decided. New Sec. 864(c)(8) provides that gain or loss to a nonresident alien individual or foreign corporation from the sale, exchange, or other disposition of a partnership interest is ECI to the extent that all or a portion of the gain would have been treated as ECI if the partnership had sold all of its assets at fair market value. The new law is effective for a sale of a U.S. partnership interest by a foreign person on or after Nov. 27, 2017, interestingly applying the application of the law retroactive to the date of the TCJA's passage.
New Sec 1446(f)(1), enacted under the TCJA, requires a transferee (i.e., a purchaser) of a partnership interest to deduct and withhold a 10% tax on the amount realized on the sale or exchange by the transferor of a U.S. partnership interest that would be treated as ECI under Sec. 864(c)(8), unless the transferor certifies that it is not a foreign person. The new withholding requirement applies to any sales, exchanges, and dispositions made after Dec. 31, 2017. A secondary rule under Sec. 1446(f)(4) requires the partnership to deduct and withhold from distributions to the transferee partner an amount that would satisfy the withholding requirement plus interest on that amount if the transferee fails to withhold upon the transfer. The TCJA authorized the IRS and Treasury to issue further guidance necessary to carry out the withholding requirement.
The TCJA withholding rules apply both to PTPs and private partnerships. This puts PTPs and their investors in a peculiar administrative and compliance position. While the withholding rule provides a process to ensure that tax due from a foreign person on the disposition of a U.S. partnership interest is collected, the tax status of that seller is not easy to determine for a PTP, as the sale is typically facilitated through an exchange. A buyer of a PTP interest on an exchange will generally not know the tax status of the seller of the interest. Additionally, the new provisions do not provide guidance on how PTPs are to comply with their obligation to withhold tax when the buyer of the PTP units does not withhold the necessary amount.
On Dec. 29, 2017, the IRS and Treasury released Notice 2018-08, which grants a temporary suspension of the 10% withholding obligation on the sale of PTPs that meet the definition of a PTP in Sec. 7704(b). The notice did not suspend the treatment of gains or losses as ECI to a foreign partner under new Sec. 864(c)(8), but provided relief to transferees on the 10% withholding tax for PTP sales until regulations or other guidance is issued. The IRS acknowledged that the transferee of a PTP interest may not be able to determine if the transferor is foreign or domestic or whether any portion of the transferor's gain should be treated as ECI. PTP units are generally held by a broker and transferred through a clearing agent. While brokers could potentially withhold on behalf of the transferee, brokers did not have time to develop systems and controls to implement the withholding process given the short timeline between the Dec. 22, 2017, enactment of the TCJA and the Dec. 31, 2017, effective date of this rule. Furthermore, the TCJA does not require brokers to facilitate this withholding on their clients' behalf. Once guidance is issued, the IRS states that withholding will be prospective from the date of the new guidance and include transition rules.
Notice 2018-08 also referred taxpayers to its position in Rev. Rul. 91-32 for any sales occurring prior to Nov. 27, 2017. This is consistent with the IRS appeal of the Grecian case.
While the PTP notice did not extend to non-PTPs, Treasury and the IRS did request comments on whether there is a need to have a temporary suspension of the withholding requirements for partnerships that are not publicly traded. The notice also solicited comments on the application of the withholding requirement, the possible role of brokers, and procedures for requesting a reduced amount to be withheld, including how to determine the appropriate reduced amount and whether those procedures should be automatic or require IRS approval.
On April 2, 2018, the IRS and Treasury issued Notice 2018-29, addressing a non-U.S. person's disposition of a partnership interest that is not publicly traded. While the notice did not suspend or provide enough detail to calculate the withholding requirement under Sec. 1446(f) in all circumstances, it provided interim guidance on the withholding requirements on transfers of nonpublicly traded partnerships that taxpayers may rely upon pending the issuance of further regulations. Similar to Notice 2018-08, Notice 2018-29 referenced Rev. Rul. 91-32 as it relates to any sales prior to Nov. 27, 2017, further solidifying the IRS's stance that it will apply the aggregate approach to any sales in the period prior to the TCJA, pending the results of the appeal of the Grecian decision. In general, Notice 2018-29 provided guidance on how a transferee can comply with the withholding requirements under Sec. 1446(f)(1) and temporarily suspends the partnership withholding requirements under Sec. 1446(f)(4).
Under Notice 2018-29, a transferee that is required to withhold must follow the forms and procedures used to comply with withholding on the disposition of U.S. real property by a foreign person under Sec. 1445 and related regulations, including the requirement to report and remit withholding within 20 days of a transfer. A transferee of a relevant partnership must also include the statement "Section 1446(f)(1) withholding" at the top of relevant forms. Penalties and interest for relevant transactions will not be asserted if withholding is properly reported and paid to the IRS on or before May 31, 2018.
Notice 2018-29 provides clarification on several exceptions that would exempt the transferee from the withholding requirement:
- Certification of nonforeign status: The withholding exception under Sec. 1446(f)(2) related to certifying nonforeign status can be satisfied by obtaining certifications under Regs. 1.1445-2(b) as modified for specifics under Sec. 1446 until regulations under Sec. 1446 are issued. Furthermore, a transferor may submit a Form W-9, Request for Taxpayer Identification Number and Certification, to a transferee that includes certain information to satisfy this requirement, and a transferee may generally rely upon a Form W-9 previously received that includes the required information.
- Certification of no realized gain: A transferee can be exempt from the withholding requirement if the transferee received a certification from the transferor (signed under penalties of perjury and including a U.S. taxpayer identification number) stating that the transfer of its partnership interest will not result in realized gain.
- Certification of less than 25% ECI in three prior tax years or less than 25% effectively connected gain: A transferee can be exempt from withholding if the transferee receives a certification that (1) the transferor was a partner in the partnership for the entirety of the partner's immediately prior tax year and the two tax years that precede it, and the transferor's ECI is less than 25% of the transferor's total distributive share of income from the partnership in each of those years, or (2) if the partnership was deemed to sell its assets at fair market value, the amount of gain that would be ECI would be less than 25% of the total gain on the deemed sale.
- Nonrecognition transaction: No withholding is required if the transferee receives a notice from the transferor that the transfer is a nonrecognition transaction.
Notice 2018-29 also has specific rules about the treatment of liabilities and tiered structures that transferees will need to consider.
Permanent guidance awaited
The two notices issued on Sec. 1446(f) have been a welcome temporary relief to the new 10% withholding rules for PTPs and provide much-needed clarification on the basics of non-PTP withholding. While the partners selling and purchasing PTP units received temporary full relief, the non-PTP sales are still subject to withholding as of Jan. 1, 2018. Although there is still significant uncertainty as to how these withholding rules will apply in practice, the notices provide interim guidance that taxpayers can rely upon until that guidance is issued.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale or email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.