Transfers of PTP interests: Options for foreign intermediaries

Editor: Mary Van Leuven, J.D., LL.M.

The introduction of withholding requirements for publicly traded partnership (PTP) interests under Sec. 1446(f) and related updates to the qualified intermediary (QI) agreement created a substantially new regulatory landscape for withholding agents and foreign intermediaries. Historically, the responsibilities of both sets of parties have often been determined in substantial part by the obligations the foreign intermediary chooses to either assume or pass to its upstream withholding agent. New rules specific to the PTP context, however, have created additional issues for foreign intermediaries to consider when determining the roles they want to fill. This item summarizes the options available to foreign intermediaries for transfers of PTP interests under current guidance and comments on some practical benefits and burdens of each.

Background

Codified in December 2017 through the law known as the Tax Cuts and Jobs Act, P.L. 115-97, Sec. 1446(f), along with Regs. Sec. 1.1446(f)-4(a)(2), requires brokers to withhold 10% from the amount realized on the transfer of a PTP interest occurring on or after Jan. 1, 2023, (as deferred by Notice 2021-51) unless the broker can establish that an exception to withholding applies. A transfer for this purpose includes a sale or exchange of an interest in a PTP, including certain distributions made by a PTP. A broker may establish that no withholding is required based on a valid qualified notice (QN) posted by the PTP or transactional information available to the broker that identifies the transaction as falling within the scope of the offshore or short-sale exceptions (see Rev. Proc. 2022-43 and Notice 2023-8). In addition, the broker will determine whether Sec. 1446(f) withholding is required based on a withholding certificate provided by the transferor of the PTP interest or the intermediary acting on its behalf. These certifications affect the broker’s information-reporting obligations as well.

A QI agreement is an agreement between a foreign intermediary and the IRS under which the intermediary takes on additional compliance obligations, including stepping into the shoes of a U.S. withholding agent for certain withholding and reporting purposes. QIs have historically been classified as either “withholding QIs” or “nonwithholding QIs”; however, the updated QI agreement that went into effect Jan. 1, 2023, includes a new category of “disclosing QI” for Sec. 1446(f) purposes (see Notice 2022-23 and Rev. Proc. 2022-43). A foreign intermediary that does not act as a QI is classified as a nonqualified intermediary (NQI).

The discussions that follow assume that the PTP transfer at issue is not exempt from withholding based on a QN or other exemption and, accordingly, the withholding obligations of the parties (i.e., the upstream broker or the intermediary counterparty) are being determined based on the status of, and documentation provided by, the intermediary.

Types of intermediaries

Each intermediary role has its own obligations, benefits, and burdens. These roles are addressed in further detail below.

Withholding QIs: A withholding QI receives amounts from upstream brokers free of Sec. 1446(f) withholding but must generally assume withholding and reporting obligations with respect to any transferors for which it acts. Because withholding QIs assume these obligations, the only documentation they need to provide to an upstream broker is a Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding and Reporting.

One of the primary benefits of this arrangement is the privacy it affords to withholding QIs’ account holders. When intermediaries pass up documentation, that documentation discloses not only the identities of the parties but also sensitive tax information. Further, the information that gets passed up is not necessarily limited to the intermediary’s direct counterparties but instead may need to be passed up through multiple tiers of intermediaries or flowthrough entities. In addition to disclosures to upstream counterparties, each additional party in possession of this information increases the risk of inadvertent disclosure, whether by accident, leak, or hack. Certain customer populations highly value the ability to limit such disclosures and will pay accordingly.

Keeping the identity of its account holders private can also directly benefit the intermediary. When an account holder’s information is passed up, upstream parties not only know the identity of the customer but also obtain some insight into their investment profile (e.g., types of investments, dollar value, etc.). Because competitors with access to that information may end up using it for their own marketing purposes, withholding the information may protect these QIs from having their customers poached.

Weighing against these privacy benefits are the additional compliance obligations that come with being a withholding QI, including reporting, withholding, and periodic reviews. Withholding QIs need to establish and maintain sufficient, and often costly, procedures to satisfy their withholding and reporting obligations. These costs generally increase as the volume of account holders for which they act increases, because each additional account holder, at a minimum, requires additional documentation reviews, along with the associated reporting and withholding analysis.

Withholding QIs also have additional Sec. 6031 nominee reporting obligations (for Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., information) with respect to their account holders, assuming they elect not to pass up a nominee statement to protect the privacy interests discussed above. Compliance costs for withholding QIs are further increased by the obligation to complete a periodic review every three-year cycle, which can easily take hundreds of hours of work, typically paid for through a combination of employment hours and consulting fees.

In addition to these general compliance costs, taking on reporting and withholding obligations also exposes withholding QIs to penalties for failing to comply with those obligations. Information-reporting penalties are imposed on a per-form basis, and, therefore, larger customer volumes will generally increase a withholding QI’s total costs (including risks as a cost).

Withholding QIs can somewhat limit this exposure by electing to pool report; however, for PTP interests, reporting on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, requires the name of the PTP to be included in the payer field on each form. Consequently, withholding QIs must issue pooled Forms 1042-S, broken down by each specific PTP with respect to which they act as an intermediary. Underwithholding exposure is another major factor to consider, given that withholding QIs, having specifically agreed to take on withholding obligations, are the parties the IRS is most likely to pursue when the appropriate withholding tax is not paid.

Nonwithholding QIs: Nonwith-holding QIs do not assume withholding obligations for non-U.S. account holders and, instead, include with their Forms W-8IMY pooled withholding instructions so that the upstream withholding agents can withhold to the extent required. Nonwithholding QIs can choose whether to assume or pass up Form 1099 and backup withholding obligations with respect to U.S. account holders for proceeds from the sale of PTP interests; however, their Forms 1042-S and Sec. 6031 nominee reporting obligations, and the associated costs, mirror those of withholding QIs. Nonwithholding QIs are also required to complete periodic reviews.

Pooled withholding instructions do not identify any of a nonwithholding QI’s non-U.S. account holders, and, therefore, the privacy benefits available to withholding QIs apply equally. Whether those privacy benefits are afforded to a nonwithholding QI’s U.S. account holders depends on whether the nonwithholding QI chooses to assume Form 1099 reporting and backup withholding obligations.

Although nonwithholding QIs do not directly withhold on non-U.S. account holders, the fact that they are responsible for determining the appropriate amount of Sec. 1446(f) withholding means that they may also be liable for withholding failures similar to withholding QIs, e.g., liable for underwithholding resulting from their failure to provide correct information. They are, however, generally relieved of other associated burdens, such as maintaining deposit procedures and reconciliations.

Disclosing QIs: The disclosing QI is a new category introduced in the 2023 QI agreement. Disclosing QIs do not assume withholding or reporting obligations and instead include with Forms W-8IMY underlying recipient documentation and withholding statements that include recipient-specific gain allocations, so that an upstream broker can withhold and report on a disclosing QI’s account holders to the extent required. This role is very similar to that of an NQI in the standard Chapter 3 and 4 context. A disclosing QI is also required to pass up a Sec. 6031 nominee statement unless the PTP (or its agent) already has the information necessary to report directly to the underlying transferors of the PTP interest.

Because they must pass up recipient-specific documentation, disclosing QIs cannot offer their account holders the same privacy benefits available to other QIs. On the other hand, disclosing QIs are generally relieved of the compliance costs attributable to withholding and reporting, given that those obligations follow the recipient-specific information up the chain. Thus, documentation review and periodic review are the primary compliance costs that disclosing QIs are likely to face.

Notwithstanding the general rules described above, however, the withholding rules for Sec. 1446(f ) purposes are unique in that an upstream broker is only allowed to withhold in accordance with the allocations and documentation passed up by a disclosing QI. If the upstream broker determines that any documentation is invalid, it must treat the disclosing QI as undocumented, withhold 10% from the entire payment (i.e., not just on the allocations attributed to invalid documentation), and issue a Form 1042-S solely to the intermediary, regardless of whether the intermediary thought all the documentation it passed up was valid. In addition, the reporting obligations with respect to underlying account holders, along with the associated costs, will shift to the intermediary. The intermediary may not be ready to fulfill these obligations at the last minute because it had intended to act as a disclosing QI. Because of these risks, it is critical that disclosing QIs ensure that upstream brokers agree that the documentation passed up is valid or be ready to fulfill NQI reporting obligations.

Nonqualified intermediaries: NQIs are subject to 10% withholding under Sec. 1446(f) and, therefore, are not required to withhold further on their own account holders. Because NQIs are withheld upon, they do not need to pass up any account holder documentation with their Forms W-8IMY for Sec. 1446(f) purposes and, instead, generally complete account holder–specific reporting themselves. Thus, NQIs may get the privacy benefits of withholding and nonwithholding QIs without the compliance costs of withholding or periodic reviews — but at the cost of being subjected to maximum Sec. 1446(f) withholding and bearing the burden of recipient-specific reporting.

Alternately, NQIs have an option to pass up recipient-specific documentation and gain allocations, along with the associated reporting obligations, to upstream brokers, provided that the upstream brokers agree to assume the reporting obligations. In this scenario, the NQI role is similar to that of a disclosing QI, without the burden of periodic reviews and without the requirement that all transferor documentation be valid for any documentation to be relied upon. The NQI remains subject to 10% withholding on the entire payment, but an intermediary may prefer this approach, as it eliminates the NQI’s reporting obligations with respect to recipients for whom valid documentation has been passed to the upstream broker.

Adjusting to new roles

While these rules are not a new concept, and the benefits and burdens of different types of intermediaries generally carry over to the Sec. 1446(f) context, affected entities should reevaluate the specific roles they plan to fill in light of the new rules applicable to transfers of PTP interests.

Editor notes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C. Contributors are members of or associated with KPMG LLP. For additional information about these items, contact Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained in these articles is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the authors only, and do not necessarily represent the views or professional advice of KPMG LLP.