Buyer Beware: Foreign Partner Exit Taxes
By Ryan Riddle, for Tax Analysts as published in Tax Notes Federal on August 12, 2019
The Tax Cuts and Jobs Act introduced many new rules for U.S. taxpayers, including some relating to foreign investment in the United States. Although the Tax Court decided in Grecian Magnesite1 to allow a foreign partner to escape U.S. income tax on most gain (other than gain under the 1980 Foreign Investment in Real Property Tax Act) on the complete disposition of its interest in a U.S. partnership engaged in a U.S. trade or business, the TCJA added section 864(c)(8) (effective for sales, exchanges, and dispositions occurring on or after November 27, 2017) so that the amount of gain or loss treated as effectively connected with a U.S. trade or business is reduced to remove any gain or loss attributable to the partnership’s U.S. real property interests, which may be separately subject to tax under sections 897 and 1445.
New section 864(c)(8) treats gain or loss recognized by a nonresident alien individual or foreign corporation from the sale, exchange, or other disposition of a direct or indirect interest in a partnership engaged in a U.S. trade or business as effectively connected with the conduct of a U.S. trade or business to the extent that the gain or loss does not exceed the gain or loss the partner would have recognized had the partnership sold all of its assets (including related goodwill) at fair market value on the date of the exchange. Moreover, the TCJA added section 1446(f), which creates a new 10 percent withholding tax applicable to the amount realized from the sale, to be collected and remitted by the U.S. person acquiring the partnership interest. Note that in some circumstances, the partnership itself can be held liable for remitting the withholding tax if the acquirer fails to do so. Section 1446(f)(4) requires applicable partnerships to withhold tax from future distributions — also known as backstop withholding — to transferees that were previously required to withhold tax on the amount realized by the non-U.S. transferor but failed to do so. Backstop withholding must be collected until the amount not withheld, plus interest, is recovered by the IRS. It should be noted that when the partnership is a transferee because of a distribution (including a redemption of a partnership interest), the proposed regulations would clarify that withholding under section 1446(f)(4) does not apply. However, the partnership is liable for withholding under the general rule of section 1446(f)(1) in this instance because it is treated as the transferee for U.S. federal income tax purposes.
For a partnership that conducts business only in the United States (so that all its assets are connected to U.S. income), the new rule taxes the foreign partner on all gain attributable to the sale of the partnership interest. The TCJA effectively reinstates Rev. Rul. 91-32, 1991-20 IRB 20, which the Tax Court overturned in Grecian Magnesite. The IRS concluded in Rev. Rul. 91-32 that a foreign partner’s capital gain or loss on the sale of a partnership interest is properly treated as effectively connected with a U.S. trade or business if and to the extent that a sale of the underlying assets by the partnership would have resulted in effectively connected income for the foreign partner.
Although section 864(c)(8) provides rules regarding the treatment of gain or loss on the transfer of a partnership interest as effectively connected gain or loss, it does not address the computation of the actual amount of gain or loss to a partner upon the transfer. Rather, applicable tax law under subchapter K determines the amount and character of outside gain or loss on the transfer of a partnership interest. For example, the reduction in a transferor’s share of partnership liabilities is treated as an amount realized on the transfer of the partnership interest under section 1001 and the corresponding regulations. Section 741 provides that on a sale or exchange of an interest in a partnership, gain or loss is recognized by the transferor, and is considered capital gain or loss except as otherwise provided in section 751. Section 751 provides that an amount received by a transferor of a partnership interest that is attributable to unrealized receivables or inventory items of the partnership is considered ordinary income or loss. As a result of sections 741 and 751, and the associated regulations, gain or loss on a sale or exchange of a partnership interest can comprise capital gain, capital loss, ordinary income, ordinary loss, or a combination of these.
Prop. reg. section 1.864(c)(8)-1(b) provides that a foreign transferor must determine the portion of its capital gain or loss, and the portion of its ordinary income or loss from section 751 property, that must be characterized as effectively connected gain or loss under section 864(c)(8).
The IRS and Treasury later issued Notice 2018-29, 2018-16 IRB 495, which provides guidance for transferees to comply with the withholding requirements under section 1446(f)(1). Notice 2018-29 requires an applicable transferee (the buyer) to withhold in the same manner as provided under section 1445 and the related regulations for the disposition of U.S. real property by a foreign person. A transferee required to withhold must report and pay any tax withheld by the 20th day after the date of the transfer using Form 8288, “U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests,” and Form 8288-A, “Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests.” Both forms 8288 and 8288-A must include the taxpayer identification number of both the transferor and the transferee. Unlike a payee’s copy of Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding,” which is sent directly to the payee, the transferor’s copy of Form 8288-A is sent to the IRS. The agency will stamp a valid Form 8288-A to show receipt and mail a copy to the transferor so that the transferor can use it to claim a credit for amounts withheld. The transferee is generally also required to provide the Form 8288-A or equivalent information to the partnership. The partnership must conduct its own review of the certification provided by the transferee, including any certifications for exception to withholding. A transferee of an affected partnership interest must include the statement “Section 1446(f)(1) Withholding” at the top of any relevant forms. Notice 2018-29 also includes specific rules about the treatment of assumed liabilities and tiered structures that transferees will need to consider.
On December 27, 2018, and again on May 13, 2019, Treasury issued proposed regulations (REG-113604-18, REG-105476-18) providing additional information on determining effectively connected gain or loss and its character, reporting of applicable dispositions of partnership interests, the treatment of tiered partnerships, and the potential for reduced withholding under a U.S. income tax treaty. These proposed regs largely comport with Notice 2018-29, with a few minor exceptions mostly related to withholding and reporting issues for publicly traded partnerships.
The proposed regulations provide six exceptions to withholding and allow the transferee to rely on specified certifications that it receives from the transferor or partnership, unless it has actual knowledge that the certifications are incorrect or unreliable. When a partnership is a transferee because it makes a distribution, it may instead rely on its books and records, unless it knows or has reason to know that the information is incorrect or unreliable. Most of the exceptions carry over from Notice 2018-29 but with stricter thresholds in some instances:
- documentation of non-foreign status (including Form W-9);
- documentation of treaty exemption;
- certification of no realized gain (including section 751 income);
- certification of de minimis effectively connected gain on a deemed sale;
- certification of de minimis ECI over a three-year period; and
- certification of a nonrecognition transaction.
A transferor (as opposed to an owner of an interest in the transferor, including a partner in a partnership that is a transferor) may certify that gain from the transfer is not subject to tax under an income tax treaty in effect between the United States and a foreign country. The transferor cannot make this certification, however, if treaty benefits apply to only a portion of the gain from the transfer. Moreover, the transferor must include with the certification a Form W-8BEN, “Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals),” or W-8BEN-E, “Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities)” (or a substitute form), containing the information necessary to support the claim for treaty benefits. The transferee must mail a copy of the certification (including the withholding certificate) to the IRS by the 30th day after the date of the transfer.
Buyers should beware of the enhanced withholding requirements on purchases of partnership interests (including limited liability company interests treated as partnership interests for income tax purposes) and deal with those requirements aggressively in their due diligence and documentation of acquisition agreements.