With the fund-of-funds filing season well underway and the extended filing deadlines looming, now is a good time to look back at one of the more overlooked changes made by the Tax Cuts and Jobs Act (TCJA): Internal Revenue Code Section 1446(f). Under Section 1446(f), all foreign persons or entities that realize a gain on the sale or exchange of their partnership holdings to which Section 864(c)(8) applies are liable for a 10% withholding tax unless they qualify for a specific exemption.
This article will explain the Section 1446(f) guidelines, how they apply to non-publicly and publicly traded partnerships, and the general U.S. tax filing requirements for foreign individuals with U.S. business interests.
Section 1446(f): Purpose and Scope
Until the TCJA was passed in 2017, little guidance was available concerning U.S. taxation on the sale of partnership interests held by foreign individuals and entities. A single ruling, Rev. Rul. 91-32, concluded that foreign partners owned a proportionate share of all partnership assets and were liable for any gains on the sale of their interests, provided the assets they owned generated effectively connected income (ECI).
The TCJA clarified rules concerning taxation on gains of partnership interests and imposed a mandatory 10% withholding tax on a foreign person’s sale, exchange, or disposition of their partnership interests unless an exception applies. Section 1446(f) closes potential loopholes and provides clear instructions to partnerships and foreign persons concerning their taxation responsibilities relating to sales, exchanges, and other dispositions of partnership interests.
Withholding on Non-Publicly Traded Partnership (Non-PTP) Interests
Under Section 1446(f), any transferee is responsible for paying a 10% withholding tax on the amount realized from the sale, exchange, or other disposition of their non-publicly traded partnership (non-PTP) interest if any portion of the gain on any such sale, exchange, or other disposition would be treated as effectively connected with the conduct of a trade or business within the U.S. under Section 864(c)(8) unless they qualify for an exemption under Section 1.1446(f)-2(b)(2)-(7).
Foreign partners and partnership entities may determine whether an exception applies in one of three ways:
- Self-certification by the transferor
- Certification by the partnership
- Reliance on existing books and records of the partnership
The six exceptions to the withholding tax as it applies to non-publicly traded partnerships include the following:
1. Non-Foreign Status
A foreign partner may qualify for an exception if they provide certification of non-foreign status, including via a valid Form W-9. Form W-9 requires a U.S. taxpayer identification number (TIN).
2. No Realized Gain
The No Realized Gain exception states that the transferor may provide certification that the sale or disposition of the partnership interest doesn’t result in any realized gain. Such certification should also state there is no ordinary income from Section 751 inventory or unrealized receivables.
3. 10% Effectively Connected (EC) Gain Exception
This exception requires the partnership to demonstrate a sale of all assets at fair market value (FMV) would result in one of the following:
- The transferor would have no EC gain, or if it realized a gain, the amount of the EC gain would be less than 10% of the net total gain.
- The transferor doesn’t have a distributed share of any partnership EC gain, or if it did, the transferor’s distributive share of the net EC gain is less than 10% of the transferor’s distributive share of the total net gain from the partnership.
- The partnership was not engaged in any trade or business activities within the U.S. during the tax year through the transfer date.
4. 10% Effectively Connected Income (ECI) Exception
The 10% ECI exception applies to minor foreign partners with minimal ECI related to the partnership over the previous three taxable years (the “look-back period”). To qualify, the transferor must prove all of the following:
- It was a partner during the previous three taxable years before the sale, exchange, or other disposition of the partnership interest.
- For each of the previous three tax years, the partner’s share of gross ECI was less than $1 million.
- The partner’s distributive share of gross ECI was less than 10% of the partner’s total distributive share of gross income from the partnership for each of the previous three tax years, as reported on a Schedule K-1 or other required statement.
- The partner filed a federal tax return for each of the prior three tax years, reported their share of ECI, and paid all taxes due in a timely manner.
5. Certification of Nonrecognition by Transferor
Transferees may rely on a transferor’s certification that the transferor isn’t required to recognize a gain or loss from the transfer due to a nonrecognition provision in the Internal Revenue Code. If the transferor claims this exception, they must provide documentation of the law and supporting facts to substantiate the exception.
6. Tax Treaty Benefits
If the foreign partner qualifies for tax treaty benefits, it may claim an exception to the 10% withholding tax using Form W-8BEN or Form W-8BEN-E. The partner must submit documentation to support their claim for tax treaty benefits along with the appropriate form.
Transferee Responsibilities and Liability
Section 1.1446(f)-3 imposes transferee liability on partnerships and requires them to take greater responsibility concerning the sale or other disposition of foreign partnership interests. If the transferee fails to withhold the necessary amounts from the gain on a sale of their interest, the partnership must withhold from any distributions to the partner. Under the new regulations, partnerships must review their foreign partner’s certificate of withholding and any exceptions claimed to determine its accuracy and reliability.
Reporting and Payment Procedures
A transferee is responsible for providing a certification of withholding to the partnership within 10 days of the transfer of their interest. Payment of withholding tax must be made within 20 days following the sale or disposition of their interest. If the partnership doesn’t receive or cannot rely on a certification of withholding, it must withhold tax equal to the full amount of each distribution until the foreign partner complies with Section 1446 requirements.
Withholding on Publicly Traded Partnership (PTP) Interests
Under Section 1446, the transfer of a foreign individual or entity’s interest in a publicly traded partnership (PTP) places the 10% withholding tax requirements in the hands of the broker managing the transfer rather than the transferee. The broker’s withholding responsibilities arise if the broker pays a realized gain to another broker who is considered a foreign person or to a foreign transferor who is a customer.
Like with non-PTP sales, some exceptions may limit withholding tax obligations. They include the following.
1. Non-Foreign Status
If the transferor qualifies as a non-foreign person or entity, they may provide certification of non-foreign status using Form W-9 or a valid substitute form and forego the withholding tax.
2. ECI Exception
An ECI exception is available for transferors who certify they are a dealer in securities and that their gain from transferring a PTP interest is connected to a U.S. trade or business but falls outside the scope of Section 864(c)(8). The transferor must certify their exception using Form W-8ECI.
3. 10% Effectively Connected (EC) Gain Exception
Under the 10% exception rule, brokers may rely on a transferor’s qualified notice stating that if the PTP were to sell all its assets at FMV, either one of these situations would apply:
- The EC net gain would be less than 10% of the total net gain.
- No gain would be considered to be effectively connected with the conduct of a U.S. trade or business.
4. Income Tax Treaties
Brokers may rely on a transferor’s certification stating they’re not subject to withholding taxes because of an existing tax treaty between the U.S. and a foreign country. The transferor must make the certification using Form W-8BEN or Form W-8BEN-E and provide appropriate supporting documentation to qualify for treaty benefits.
5. Subject to Other Withholding Requirements
Brokers are not required to withhold tax on PTP interests if the gain from the transfer is subject to withholding under Section 31.3406(b)(3)-2.
Broker Responsibilities
In general, brokers are responsible for withholding 10% of the realized gain on any PTP interests unless the transferor supplies reliable certification that they qualify for an exception to the withholding tax. Examples of reliable certification include the tax forms listed in the exceptions, including Forms W-9, W-8ECI, W-8BEN, and W-8BEN-E. If the broker withholds the tax despite the transferor being eligible for an exception, the transferor may claim a credit on their U.S. tax return.
Tax Return Filing Requirements for Foreign Persons
Foreign individuals or entities are subject to withholding tax on the sale of non-publicly traded or publicly traded partnership interests, should Section 864(c)(8) apply, and must fulfill their U.S. tax obligations, including filing a U.S. tax return. Their tax return responsibilities apply regardless of whether they withhold the appropriate tax.
If the tax is withheld by a broker, nonresident aliens or foreign corporations must still comply with U.S. tax return rules and report the withholding. If the broker withheld the incorrect amount, the foreign individual or entity is responsible for either paying the remaining liability arising from the underwithholding or claiming a refund resulting from any overwithholding.
Keep in mind that a foreign person may qualify for a credit on their U.S. tax return for taxes withheld on the sale, exchange, or other disposition of a partnership interest, which may reduce any U.S. tax liability or allow a refund claim for any amount over withheld.
Penalties and Liabilities
Failure to pay withholding tax impacts all persons required to withhold and pay tax under Section 1446(f), including a partnership that may be treated as a transferee. Every person required to withhold and pay tax under Section 1446(f) but fails to do so is subject to the full amount of the tax due, plus interest and penalties determined by the IRS.
Partnerships that don’t withhold or pay applicable tax on the gain of a sale, transfer, or other disposition of a partnership interest held by a foreign person are liable for the uncollected tax amount, plus interest, penalties, and other additions to the tax.
Understand Your Obligations Under Section 1446(f)
Section 1446(f) clarifies the tax obligations and partnership liability concerning gains on the sale, exchange, or other disposition of non-publicly traded and publicly traded partnership interests to which Section 864(c)(8) applies. In most cases, foreign individuals or entities that realize a gain when transferring partnership interests owe a 10% withholding tax on such a gain unless they qualify for an exception. Partnerships and brokers also have responsibilities to withhold under the act, should certain circumstances apply.
If you need guidance concerning tax compliance as a foreign partner, transferee, or partnership under Section 1446(f), Jared Mahar at Prager Metis can help. Contact us today to schedule a consultation.
