IRS final regulations clarify foreign partners’ calculation of taxable gain
Prior to the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), Revenue Ruling 91-32 provided how the IRS would tax transfers of partnership interests by non-U.S. partners. However, in July 2017, the Tax Court in Grecian Magnesite Mining Industrial & Shipping Co. SA v. Commissioner rejected the IRS’s position and held that foreign partners could only be taxed on the portion of the sale attributed to the non-U.S. partner’s indirect interest in U.S. real property.
As a response to this decision, in order to allow the taxation of transfers of partnership interests by non-U.S. persons, Congress introduced Section 864(c)(8) as a part of the TCJA. This subjects the “effectively connected” gain on transfers of partnership interests by foreign individuals and foreign corporations to U.S. tax and provides a statutory framework to calculate the taxable amount. The effectively connected gain is the portion of the foreign partner’s gain on disposal of the partnership interest connected with the conduct of a U.S. trade or business. In conjunction with the enactment of Sec. 864(c)(8) allowing taxation in these cases, a withholding tax requirement was introduced under Sec. 1446(f), which imposes a 10% withholding tax on the transfer of a partnership interest by a non-resident partner.
The IRS recently released final regulations supporting Sec. 864(c)(8) and Sec. 1446, which further clarify how foreign partners should calculate their taxable gain on sales of partnership interests.
The IRS recently released final regulations supporting Sec. 864(c)(8) and Sec. 1446, which further clarify how foreign partners should calculate their taxable gain on sales of partnership interests. The final regulations adopt many of the provisions of the proposed regulations, while providing some additional exceptions and guidance not contained in the proposed regulations.
IRC Sec. 864(c)(8) calculation
To calculate the gain or loss, a foreign taxpayer calculates two amounts. First, the outside gain on their interest in the partnership, and second, their share of effectively connected gain computed as if the partnership sold all its assets for fair market value. The outside gain is calculated using the sales price compared to the foreign partner’s basis in the partnership. The second amount starts with calculating the hypothetical gain on a sale at fair market value of each of the assets inside the partnership. Gain or loss is calculated on each of the assets and the gains and losses are sourced between noneffectively connected sources (generally foreign) and effectively connected sources (generally domestic). The effectively connected gain is then allocated to the foreign partner pursuant to the partnership agreement. Once both figures are calculated, the foreign partner is taxed on the lesser of the outside gain or their share of the effectively connected hypothetical “inside” gain.
Exceptions to 864(c)(8)
For purposes of calculating the amount of gain or loss treated as effectively connected income, the final regulations include a 10-year lookback rule, which excludes assets that didn’t produce effectively connected income in the last 10 years. The regulations also contain additional exceptions when sourcing assets and their deemed sale gains between noneffectively connected and effectively connected sources. The new exceptions include some asset-specific rules and a material change in circumstances rule. These new rules, combined with the 10-year lookback rule retained by the final regulations, are designed to provide a result that reflects the economics of the business.
Interaction with FIRPTA rules
Additionally, the final regulations provide some clarity and coordination between the rules under Sec. 864(c)(8) and the FIRPTA rules of Sec. 897(g). When a foreign partner sells its interest in a U.S. partnership that owns U.S. real property, the amount that’s attributed to real property is generally subject to the FIRPTA rules under Sec. 897(g). The final regulations specify that if a taxpayer is subject to both rules, generally only the rules under Sec. 864(c)(8) will apply. If there is no gain to recognize under Sec. 864(c)(8), the FIRPTA rules may still apply on the portion of the sale attributed to U.S. real property.
With regard to tiered partnership structures, upper tier partnerships are required to calculate the Sec. 864(c)(8) gain for each lower tier partnership if the upper tier partnership interest is exchanged. For example, assume F1, a foreign investor, exchanges an interest in USP 1, a U.S. partnership, which owns an interest in USP 2, a lower tier U.S. partnership. The exchange of F1’s interest in USP 1, could be subject to U.S. tax under Sec. 864(c)(8) to the extent USP 1 or USP 2 are engaged in a U.S. trade or business. As a result, detailed information will be required from both USP 1 and USP 2 to determine the effectively connected gain pursuant to Sec. 864(c)(8).
Notification requirements under Section 864(c)(8)
Sec. 864(c)(8) and the corresponding regulations require detailed notifications by the foreign transferor and the U.S. partnership.
As mentioned previously, Sec. 1446(f) was also introduced by Congress as part of the TCJA. Sec. 1446(f) institutes an income tax-withholding requirement that accompanies the effectively connected gain calculated under Sec. 864(c)(8). Generally, under Sec. 1446(f), a transferee of a partnership interest is required to deduct and withhold 10% of the amount realized on the transfer.
Exceptions to the general rule on withholding
Shortly after the final regulations under Sec. 864(c)(8) were released, the IRS released final regulations under Sec. 1446(f). The final regulations under Sec. 1446(f) contain slight modifications from the proposed regulations but overall keep the same approach and structure.
Like the proposed regulations, the final regulations require that a transferee assumes a transfer is subject to withholding unless a certification is provided to prove an exception or adjustment to the withholding applies. Additionally, the final regulations contain the same six exceptions or adjustments to the required 10% withholding provided in the proposed regulations, but with slight changes. The exceptions include:
- The partner disposing of the partnership interest certifies under penalty of perjury that it’s a U.S. resident at the time of disposition.
- There is no taxable gain realized by the partner during the disposition of the partnership interest.
- The partnership certifies that, if under a hypothetical sale of all its assets at fair market value as of the “determination date,” no part of the hypothetical gain is considered effectively connected income.
- The partner certifies the gain on disposition of partnership interest qualifies for nonrecognition under certain provisions of the Internal Revenue Code.
- The partner certifies the gain on disposition isn’t subject to tax under a relevant tax treaty between the United States and the foreign jurisdiction.
- There’s a three-year effectively connected taxable income (ECTI) exception under the following circumstances: (a) The partner was a partner of the partnership for at least the prior three taxable years; (b) the partner’s share of ECTI allocated from the partnership during the aforementioned tax years didn’t exceed $1 million in any year; (c) the percentage of partnership income that was gross ECTI was less than 10%of total partnership taxable income in each of the prior three taxable years; and (d) that all U.S. tax returns for the past three years were properly filed with IRS and that the partner paid any related income tax.
Determining the amount to withhold: Potential adjustments
In general, the 10% withholding applies to the amount realized on the transfer of the partnership interest. The regulations provide for an adjustment to withholding amount in the following circumstances:
- Certification of treaty benefits: The final regulations allow for a reduction of the amount realized on the transfer if the transferor is a foreign partnership, and the foreign partnership provides a certification of treaty benefits stating any of its partners aren’t subject to tax on any gain from the transfer pursuant to an income tax treaty between the United States and the foreign jurisdiction. In this case, the foreign partnership must provide Form W-8IMY, a withholding statement and a Form W-8BEN or W-BEN-E from each partner certifying treaty benefits.
- Maximum tax liability: The final regulations allow foreign partners, including foreign trusts, to reduce the required withholding to not exceed the maximum tax liability on the transaction.
- A lack of cash, property, or knowledge regarding the reduction in liabilities: The amount realized on a transfer of a partnership interest includes a reduction in the transferor’s liabilities. In such cases, this reduction could result in the amount required to be withheld to exceed the cash or other property transferred. The final regulations provide that the amount required to be withheld is equal to the amount realized determined without regard to the decrease in the transferor’s share of liabilities.
Interaction with FIRPTA withholding rules under Sec. 1445(e)
Generally, to the extent a transferee is subject to the FIRPTA withholding rules under Sec. 1445 (relating to a transfer or distribution of by the partnership of a partnership interest in a partnership that holds U.S. real property) and is also subject to the withholding rules under Sec. 1446(f), the regulations state that the transferee should follow the payment and reporting requirements under Sec. 1445 only.
Partnership’s requirement to withhold: Secondary withholding obligations
Generally, if a transferee fails to withhold under Sec. 1446(f), or fails to provide proper documentation indicating an exception to withholding applies, the partnership is required to deduct and withhold from future distributions to the transferee until the withholding liability — plus interest — is satisfied. If withholding is required, a partnership may rely on a certification from the transferee stating that the withholding obligation was satisfied within 10 days of the transfer. The certification must include a copy of the Form 8288-A or state the amount realized and the amount withheld on the transfer. However, the final regulations do allow for a transferee to obtain a refund of over-withholding as opposed to only allowing the partnership to obtain the refund. This was a welcome change due to the impracticality of expecting the partnership to claim the refund on behalf of the transferee.
Sec. 864(c)(8) and Sec. 1446(f) became effective as of Jan. 1, 2018. For the final regulations under Sec. 1446(f), generally, the provisions in the final regulations apply to transfers that occur on or after Nov. 30, 2020. Certain provisions have later effective dates.
If you have any questions about these final regulations and how they could affect you, please contact your Plante Moran advisor.