Treasury Issues Final Regulations on Withholding with Respect to Interests in Partnerships Engaged in a U.S. Trade or Business
Summary
On October 7, 2020, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) issued an early version of final regulations that provide guidance related to the withholding of tax and information reporting with respect to certain dispositions of interests in partnerships engaged in a trade or business within the United States. The final regulations affect certain foreign persons that recognize gain or loss from the sale or exchange of an interest in a partnership that is engaged in a trade or business within the United States, and persons that acquire those interests. The final regulations also affect partnerships that, directly or indirectly, have foreign persons as partners.
Background
On April 2, 2018, Treasury released Notice 2018-29, which provided temporary guidance and announced an intent to issue proposed regulations under Internal Revenue Code Section 1446(f) with respect to the sale, exchange, or disposition of certain interests in non-publicly traded partnerships (non-PTPs). On May 13, 2019, Treasury published proposed regulations (REG-105476-18) primarily under Section 1446(f) relating to the withholding of tax and information reporting in the Federal Register (84 FR 21198). The proposed regulations implemented Section 1446(f) by providing guidance related to the withholding of tax and information reporting with respect to certain dispositions by a foreign person of an interest in a partnership that is engaged in a trade or business within the United States. In general, the proposed regulations provided rules that apply to transfers of interests in non-PTP interests and transfers of publicly traded partnership (PTP) interests. For a summary discussion of the proposed regulations, see our May 2019 tax alert.
Final Regulations Modify Withholding Exceptions and More
The final regulations retain the basic approach and structure of the proposed regulations with certain revisions.[1] Some of the key revisions are summarized below.[2]
The final regulations retain the general rule in proposed Treasury Regulation §1.1446(f)-2(a) that requires withholding on the transfer of a partnership interest unless an exception or adjustment to withholding applies. However, in response to comments, the final regulations add a rule in §1.1446(f)-5(b) that provides that any person required to withhold under Section 1446(f) is not liable for failure to withhold, or any interest, penalties, or additions to tax, if it establishes to the satisfaction of the Commissioner that the transferor had no gain under Section 864(c)(8) subject to tax on the transfer. Accordingly, while the general scope of the withholding obligation under §1.1446(f)-2(a) is retained in the final regulations, the consequences for failing to comply with the obligation are modified when the transferor had no gain under Section 864(c)(8) subject to tax on the transfer. As this rule applies for all purposes of Section 1446(f), it also modifies the consequences for a partnership that fails to comply with its withholding obligation under §1.1446(f)-3 or a broker that fails to comply with its withholding obligation under §1.1446(f)-4 on the transfer of a PTP interest. The final regulations also add an exception to withholding if the partnership certifies to the transferee that it is not engaged in a trade or business within the United States. The same exception is added for a PTP that is not engaged in a trade or business within the United States.
The final regulations modify the rule in proposed §1.1446(f)-2(b)(3), which provided an exception to withholding if the transferee relies on a certification from the transferor that states that the transfer of the partnership interest would not result in any realized gain, including ordinary income arising from the application of Section 751 and §1.751-1 (No Gain Exception). The final regulations provide that a transferor may rely on a certification from the partnership stating that, as of the determination date (as determined under the rules of §1.1446(f)-1(c)(4)), the transfer of the partnership interest would not result in any ordinary income arising from the application of Section 751 and §1.751-1.[3] This certification, in turn, is attached to, and forms part of, the general certification provided by the transferor to the transferee as part of the No Gain Exception.
Proposed §1.1446(f)-2(b)(4) provided an exception to withholding if the transferee relies on a certification from the partnership stating that if the partnership sold all of its assets at fair market value on the determination date, the amount of net effectively connected gain resulting from the deemed sale would be less than 10% of the total net gain from the deemed sale (the EC Gain Exception). The EC Gain Exception also applied to a partnership that is a transferee because it makes a distribution, in which case the partnership can rely on its books and records as of the determination date to determine if the EC Gain Exception applies. The final regulations modify the EC Gain Exception in §1.1446(f)- 2(b)(4)(i)(A)(2), which provides, in relevant part, that a transferee may rely on a certification from the partnership that states that if the partnership sold all of its assets at fair market value on the determination date in the manner described in §1.864(c)(8)-1(c), the transferor’s distributive share of net effectively connected gain from the partnership would be either zero or less than 10% of the transferor’s distributive share of the total net gain from the partnership. Accordingly, this modification applies to situations in which the transferor would not have a distributive share of net effectively connected gain (including by reason of having a distributive share of net effectively connected loss). Additionally, the final regulations retain the rules provided in proposed §1.1446(f)-2(b)(4)(i)(A) and (B) to allow partnerships to make the relevant determination at the partnership level as of the determination date, without regard to the transferor’s distributive share of net effectively connected gain.[4] For this purpose, however, the final regulations simplify the partnership-level exception to withholding by combining proposed §1.1446(f)-2(b)(4)(i)(A) and (B) into a single rule; this simplification is intended to be non-substantive.
In the preamble, Treasury states that a transfer of an interest in a partnership that is not engaged in a trade or business in the United States is not subject to Section 864(c)(8) and, therefore, should be excepted from withholding under Section 1446(f). Accordingly, §1.1446(f)-2(b)(4)(i)(B) provides that the transferee may rely on a certification from the partnership stating that the partnership was not engaged in a trade or business within the United States at any time during the taxable year of the partnership through the date of transfer (that is, the partnership was not a partnership engaged in a trade or business within the United States at any time during the period beginning on the first day of the partnership’s taxable year in which the transfer occurs and ending on the close of the date of transfer). For partnerships engaged in a trade or business in the United States that hold U.S. real property interests, deemed sale gain attributable to U.S. real property interests continues to be treated as effectively connected gain for purposes of the 10% prong of the EC Gain Exception provided in §1.1446(f)-2(b)(4)(i)(A). For partnerships that are described in §1.1445-11T(d)(1), see §1.1446(f)-1(d).
The final regulations also modify the exception to withholding under §1.1446(f)-2(b)(5). Under the exception in the final regulations (the ECI Exception), a transferor may qualify if its distributive share of gross effectively connected income from the partnership for each taxable year within the look-back period was less than $1 million and less than 10% of the transferor’s total distributive share of gross income from the partnership for that year, with both amounts reflected on a Schedule K-1 (Form 1065) (or other statement furnished to the partner) received from the partnership for each year. Because the ECI Exception looks to the transferor’s share of effectively connected income (as reported on a Schedule K-1 or other statement furnished to the partner), rather than its allocable share of ECTI, a transferor that is not allocated any effectively connected income or loss in any relevant year can still use the exception even if it has not received a Form 8805 for that year. The rule provided in proposed §1.1446(f)-2(b)(5)(iv) is modified to state that a transferor cannot provide the certification required for the ECI Exception if the transferor did not have a distributive share of gross income from the partnership in each of the relevant years. §1.1446(f)-2(b)(5)(iii). Therefore, a transferor will generally be able to use the ECI Exception even if it is allocated a distributive share of net loss from the partnership for the relevant taxable year.
Treasury notes in the preamble that it plans to revise the instructions to Forms W-8BEN and W-8BEN-E to describe the information required to be provided for making a treaty claim for purposes of Section 1446(f), including a treaty claim made with respect to a transfer of a PTP interest. To make the rules regarding claims for treaty benefits more administrable, the final regulations allow a transferor to use the applicable withholding certificate as the certification for making a claim for benefits under an income tax treaty.
The final regulations modify proposed §1.1446(f)-2(c)(2)(iv) to allow for a reduction of the amount realized when a transferor that is a foreign partnership has a direct or indirect partner that is not subject to tax on gain from a transfer pursuant to an applicable U.S. income tax treaty. Specifically, this modification provides that a treaty-eligible partner is not a presumed foreign taxable person for purposes of determining the modified amount realized under §1.1446(f)-2(c)(2)(iv). A foreign partnership that provides a certification of modified amount realized must include, in addition to the Form W-8IMY and a withholding statement, the certification of treaty benefits (on a Form W-8BEN or Form W-8BEN-E) from each direct or indirect partner that is not a presumed foreign taxable person.[5] Similar changes are made to the modified amount realized procedure for transfers of PTP interests.[6]
The final regulations modify the proposed regulations to allow transferors that are foreign trusts to use the maximum tax liability procedure in §1.1446(f)-2(c)(4) to reduce the amount to withhold. Similar to the approach taken with respect to foreign partnerships, these rules treat the foreign trust as a nonresident alien individual for purposes of computing its maximum tax liability under §1.1446(f)-2(c)(4).
In the preamble, Treasury states that it plans to amend the instructions to Forms 8804, 8805 and 8813 to provide that to obtain a credit against its Section 1446(a) liability, a foreign partnership withheld upon under Section 1446(f) on the sale of its non-PTP interest must attach to its Form 8804, Annual Return for Partnership Withholding Tax (Section 1446), a stamped copy of Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests.
The final regulations provide guidance for foreign trusts or estates that are withheld upon under Section 1446(f). Specifically, §1.1446(f)-2(e)(2)(ii) provides that a foreign trust or estate may claim a credit for an amount withheld under Section 1446(f) in accordance with §1.1462-1. Thus, the trust or estate may claim a credit to the extent it is ultimately liable for tax on the gain under Section 864(c)(8). Similar guidance is provided for foreign trusts or estates claiming credit for amounts withheld on transfers of PTP interests.[7]
Under the final regulations, a foreign grantor trust may provide to the transferee a Form W-8IMY, a withholding statement that provides the percentage of the amount realized allocable to each grantor or owner of the trust, and any applicable certification for each grantor or owner. A domestic grantor trust that has a foreign grantor or other owner may provide a similar statement in lieu of Form W-8IMY. The allowance described in this paragraph may also be applied in the context of a grantor or other owner of a grantor trust transferring a PTP interest.
The final regulations include a rule that allows a partnership to determine that it does not have a withholding obligation under §1.1446(f)-3 if it already possesses a Form W-9, Request for Taxpayer Identification Number and Certification, for the transferor that meets the requirements provided in §1.1446(f)-2(b)(2) to establish non-foreign status, even if the transferee does not provide a certification of withholding to the partnership under §1.1446(f)-2(d)(2).[8] Consistent with the general rules for partnerships that rely on information in their books and records, a partnership may not apply this rule when it knows, or has reason to know, that the Form W-9 that it possesses is incorrect or unreliable.
The final regulations remove the requirement in the proposed regulations that a PTP withhold on a transferee under §1.1446(f)-3 and instead add provisions imposing liability for underwithholding under Section 1461 on the partnership that issued the qualified notice.[9]
The final regulations allow a transferee to directly claim and obtain a refund for the excess amount withheld under §1.1446(f)-3. Specifically, the final regulations modify §1.1446(f)-3, in relevant part, to provide that a transferee may obtain a refund of the excess amount if it has made payments in excess of the tax that is properly due by the transferee for the tax period. Accordingly, under the final regulations, the partnership is not permitted to claim a refund on behalf of the transferee for the excess amount withheld under §1.1446(f)-3.
The final regulations also clarify that the excess amount withheld under §1.1446(f)-3 is the amount of tax and interest withheld under §1.1446(f)-3 that exceeds the transferee’s withholding tax liability under §1.1446(f)-2 and any interest owed by the transferee with respect to such liability.[10] This rule retains the general approach in the proposed regulations that computes the excess amount as the difference between the amount withheld under §1.1446(f)-3 and the transferee’s withholding tax liability under §1.1446(f)-2, but clarifies that both amounts are computed by including interest, and a refund may be claimed only to the extent that the excess amount produces an overpayment. To coordinate a partnership’s obligation to withhold with the transferee’s withholding liability, the final regulations modify §1.1446(f)-2(d)(2) to provide that a transferee’s withholding tax liability under §1.1446(f)-2 is not satisfied if a partnership knows or has reason to know that a certification relied on by the transferee to reduce or eliminate withholding is incorrect or unreliable.
The final regulations clarify that a related person is treated as liable for tax under Section 1461 to the same extent to which the transferee is liable under §1.1446(f)-2.
The final regulations also include additional guidance for withholding on the transfer of a PTP interest by a foreign person. In terms of the scope of the withholding obligation, the final regulations include rules related to (1) the qualified intermediary (QI) agreement, (2) transfers of PTP interests that are cleared and settled at a clearing organization, (3) documentation of non-foreign status of broker, (4) QIs assuming Section 1446(f) withholding responsibility, (5) QIs not assuming Section 1446(f) withholding responsibility, (6) withholding under Section 1446(f) on payments to non-qualified intermediaries, (7) brokers determination of prior broker withholding under Section 1446(f), and (8) the withholding date for sales of PTP Interests.
In addition, the final regulations make certain modifications to the exceptions to the withholding requirement that applies to a broker paying an amount realized from the transfer of a PTP interest, including exceptions that apply to distributions by PTPs and exceptions dependent on certifications obtained from transferors. Certain modifications were made to the ECI exception, which provides relief from withholding for transferors that certify on a Form W-8ECI that the transferor is a dealer in securities (as defined in Section 475(c)(1)) and that any gain from the transfer of a PTP interest is effectively connected with the conduct of a trade or business within the United States without regard to Section 864(c)(8),[11] and to the 10% exception, which provides that a broker may rely on a qualified notice stating that if the PTP sold all of its assets at fair market value in the manner described in §1.864(c)(8)-1(c), the amount of net gain that would have been effectively connected with the conduct of a trade or business within the United States would be less than 10% of the total net gain, or no gain would have been effectively connected with the conduct of a trade or business in the United States, or the partnership was not engaged in a trade or business within the United States at any time during the taxable year of the partnership through the PTP designated date.[12]
The final regulations include guidance with respect to determining the amount to withhold on a transfer of a PTP interest by a foreign person with additional guidance on the modified amount realized for transfers by foreign partnerships along with rules on determining the amount realized with respect to distributions. The final regulations also include additional guidance for reporting with respect to transfers of PTP interest on Form 1042-S.
The final regulations also include additional guidance with respect to the Section 1446 regulations relating to distributions by PTPs. The final regulations include a requirement for a PTP to provide a qualified notice to any registered holder that is a nominee for a distribution.
The proposed regulations added a default withholding rule (the default withholding rule) for cases in which a qualified notice fails to provide sufficient detail for a nominee to determine the amounts subject to withholding on a PTP distribution (a deficient qualified notice). Under this rule, to the extent that a deficient qualified notice fails to specify the type of income from which a distribution is made, the nominee must withhold at the highest rate specified in Section 11(b) or 881 for a partner that is a foreign corporation, or the highest rate specified in Section 1 or 871 for a foreign partner that is not a corporation.[13] The final regulations clarify that a lower treaty rate is not considered for purposes of determining the amount to withhold under the default withholding rule. In addition, the final regulations add language to clarify that a nominee must apply the default withholding rule when a PTP fails to issue a qualified notice for a distribution under §1.1446-4(b)(4) of the final regulations. Also, the final regulations add that if a nominee cannot determine the status of a partner as a corporation, for purposes of the default withholding rule the nominee is required to use the higher of the following rates: (1) the rate of withholding applicable to a foreign person that is a corporation, and (2) the rate of withholding applicable to a foreign person that is not a corporation.
To address cases in which a distribution by a PTP is paid through multiple nominees that might each be required to withhold under proposed §1.1446-4(d), the final regulations add an exception to withholding for a nominee paying the distribution to a QI or U.S. branch that is also a nominee for the distribution.
For additional details and guidance not discussed in this summary along with applicability dates to the final regulations, see the final regulations.
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