IRS Clarifies Tax Treatment Resulting from the Sales of Foreign Partners’ Interests
The IRS and Treasury Department recently published final regulations on the tax treatment of the sale of partnership interests held by foreign partners. The changes to Internal Revenue Code Section 864(c)(8) will affect private equity (PE) and venture capital (VC) partnerships that have foreign partners, either directly or indirectly via tiered partnerships.
The final regulations seek to clarify issues surrounding income effectively connected with a U.S. trade or businesses (ECI) and the gains or losses from a sale or exchange of a partnership interest. Below is a recap of what PE/VC firms should know.
ECI and the Gain on Sale of Partnership Interest for Foreign Partners
Section 864(c)(8) provides that all or a portion of the gain or loss derived by a foreign person from the sale or exchange of an interest in a partnership engaged in a trade or business within the U.S. (other than certain publicly-traded partnerships) is treated as gain or loss effectively connected with the conduct of a U.S. trade or business (ECI).
As mentioned above, this rule applies to foreign partners who own a direct investment in the partnership, but also those who hold an indirect ownership interest through a domestic tiered partnership.
The 3-Step Process for Determining Deemed Sale ECI
The amount of gain or loss taken into account for Section 864(c)(8) purposes is limited to the “aggregate deemed sale effectively connected” (ADSEC) amount. The ADSEC amount is determined through the below three-step process:
- Determine the amount of gain or loss from each partnership asset as if the partnership conducted a sale of all of its assets on the date of transfer.
- Determine the amount of the deemed sale gain or loss that would have been treated as effectively connected gain or loss with respect to each asset.
- Determine the foreign transferor’s distributive share of the deemed sale effectively connected gain or loss determined in the previous step.
Once the ADSEC amount is determined, that amount is compared to the foreign transferor's outside gain or loss in each category (i.e., capital gain and loss, and ordinary gain and loss) to determine the amount of effectively-connected gain or effectively-connected loss under Section 864(c)(8). Put another way, the outside gain or loss that is treated as ECI is limited by the inside gain or loss that is considered ECI. Section 864(c)(8)(B) limits the amount of effectively connected gain or loss to the portion of the foreign transferor’s distributive share of gain or loss that would have been effectively connected if the partnership had sold all of its assets at fair market value (the deemed sale limitation).
The deemed sale limitation requires foreign partners to notify the partnership of the transfer of interest in order to obtain the detailed information from the partnership that is necessary to determine how much of their outside gain may be treated as ECI. Partnerships with foreign partners will have a deadline for their response to the foreign partner making such a request: information needs to be provided to the transferor by the due date of the Schedule K-1 for the tax year of the partnership in which the transfer occurred.
Analyzing the ECI Issue for Tiered Partnerships
Tiered partnerships will also be subject to the three-step process for determining ECI. Section 864(c)(8) is applied starting with the lowest tier partnership. The lowest tier and subsequent affected tiers are treated as having a deemed sale of interest and each follows the three-step ECI process to determine the foreign partner’s ADSEC. The same would apply to partnerships in an upper tier transferring interests to a partnership in a lower tier.
Under the 10-year exception, the deemed sale of an asset is not treated as giving rise to ADSEC gain or ADSEC loss if the asset satisfies two conditions. First, the asset must not have produced ECI for the partnership or the foreign transferor (or predecessor to either person) during the prior 10-year period. If the prior period is less than 10 years, the period during which the partnership or foreign transferor (or predecessor to either person) held the asset. Second, the asset must not have been used, or held for use, in the conduct of a U.S. trade or business by the partnership or foreign transferor (or either’s predecessor) during the same period.
Withholding on the Transfer of a Non-Publicly Traded Partnership Interest
The transferee partner should also note they may have withholding requirements on the ECI. The tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) established the withholding rules for transfers of interests for non-publicly traded partnerships under Section 1446(f).
Section 1446(f)(1) states that if any portion of the gain on any disposition of an interest in a partnership would be treated under Section 864(c)(8) as ECI, the transferee shall be required to deduct and withhold a tax equal to 10% of the amount realized on the disposition.
Transferee partners may qualify for an exception to Section 1446(f) withholding if they obtain either:
- A valid Form W-9 signifying the transferor is not a foreign person; or
- Certification from the transferor that there is no realized gain on the transfer of interest.
If the transferee fails to withhold any amount required to be withheld, the partnership shall be required to deduct and withhold from distributions to the transferee a tax in an amount equal to the amount the transferee failed to withhold (plus interest on such amount). From a practical perspective, this may prove to be another administratively burdensome task for the partnership. The partnership will need to monitor any transfers on an ongoing basis to confirm the withholding is being done by the transferee. If not, the partnership would need to provide the cash necessary for the withholding payment and then reduce the transferee’s future distribution by this amount.
Another avenue for reducing any withholding tax owed on the ADSEC gain or loss would be to consider treaties that exist between the foreign partner’s country of residence and the U.S. In order for foreign partners to be eligible for any treaty benefits, they must satisfy the requirements of the limitation on benefits article, if any, in that treaty. This certification to the transferee must include a valid Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for U.S. Tax Withholding and Reporting (Individuals) or W-8BEN-E, Certificate of Status of Beneficial Owner for U.S. Tax Withholding and Reporting (Entities) (as applicable) which contain the information necessary to support the claim for treaty benefits, and the transferee must mail a copy of the certification to the IRS by the 30th day after the date of the transfer in order to rely upon it.
Transferees required to withhold under Section 1446(f) must report and pay any tax withheld by the 20th day after the date of the transfer using IRS 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. Included in those forms are certification that the transferee satisfied its obligation to the partnership to withhold no later than 10 days after the transfer.
What’s Next for PE/VC Firms with Foreign Partners
The final regulations are effective November 6, 2020, but are applicable to transfers occurring on or after December 26, 2018. If your partnerships have foreign partners who may be affected by the final regulations, it is recommended that you work with a tax provider to verify obligations under Section 864(c)(8) and Section 1446(f) are met. For more information, please contact a member of our team. Published on January 11, 2021