By Anthony Diosdi
The passage of the Tax Cuts and Jobs Act brought about major changes to the Internal Revenue Code and international tax policy. Among one of many changes the Tax Cuts and Jobs Act made to tax law relates to the handling of the sale of partnership interests by foreign persons. The Tax Cuts and Jobs Act added two new sections to the Internal Revenue Code, Section 864(c)(8) and Section 1446(f).
Prior to the enactment of the Tax Cuts and Jobs Act, withholding had not been required for the sale of a partnership interest by a foreign person. That all changed with the Tax Cuts and Jobs Act. Now, a purchaser of a partnership interest that is being sold by a foreign person is generally required to withhold 10 percent of the sales price of the partnership interest. The withholding must be remitted to the Internal Revenue Service (“IRS”) no later than 20 days after closing of the sale. These new withholding rules
apply to nonresident alien individuals, foreign corporations, foreign partnerships, foreign trusts or foreign estates.
Background of Tax Law and Case Law Governing Partnership Interest Sales
Prior to the enactment of the Tax Cuts and Jobs Act, there was a split of authority regarding the withholding on the sales of foreign persons selling partnership interests. The IRS took the position in Rev. Rul. 91-32 that gain or loss of a foreign partner that disposes of its interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States will be U.S. Effectively Connected Income (“ECI’) or will be ECI loss that is allocable to United States source ECI gain, to the extent that the partner’s distributive share of unrealized gain or loss of the partnership would be attributable to ECI (U.S. source) property of the partnership.
In the Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3 (2017), the United States Tax Court took a contrary position. In Grecian Magnesite Mining, the Tax Court determined that the gain realized on the sale of its interest in a Pennsylvania based company was not U.S.-source income and that gains or losses on sales of partnership interests should be treated as gains or losses on the sales of capital assets.
The Tax Cuts and Jobs Act put an end to this controversy by enacting two new Internal Revenue Code Sections. Internal Revenue Code Section 864(c)(8) now requires foreign persons selling U.S. partnership interests to be subject to U.S. federal income tax on the sale of a partnership interest. Withholding obligations are now also required in most cases under Section 1446(f).
An Overview of the Withholding Tax and Tax Obligations Governing the Sale of Foreign Persons Selling Partnership Interests
The withholding tax under Section 1446(f) requires a 10 percent withholding on the sales price of a partnership interest by foreign persons unless certain exceptions are met. These exceptions include:
1. The seller is not a foreign person;
2. There was no realized gain;
3. The transferred receives a certificate that the transfor had less than 25 percent ECI in the three prior years;
4. The transferee receives a certificate from the partnership of less than 25 percent ECI under Section 864(c)(8);
5. It is a nonrecognition transaction;
6. A determination is made of the amount of partnership liabilities included in the amount realized;
7. Withholding limitations relating to the transferor’s share of partnership liabilities apply;
8. Withholding limitations relating to the transferor’s share of partnership liabilities apply;
9. Determination of the applicability of Section 1446(F)(1) to distribution by partnerships apply;
10. There is a coordination with Section 1445 withholdings;
11. Tiered partnership rules apply.
The 10 percent withholding is similar to the 15 percent FIRPTA withholding on sales of US real property interests by foreign persons. It is computed on the sales price of the partnership interest rather than the amount of any underlying gain of the partnership interest. The withholding is not a tax. The withholding on a partnership interest is a retention of funds to be sent to the IRS for a potential tax liability.
The federal income tax on a gain or exchange of a partnership interest is calculated on a tax return. The amount of withheld and sent to the IRS is used to offset the tax on the actual tax on the sale of the partnership interest. If the tax is less than the withholding, the difference should be refunded to the seller. If the tax is greater than the withholding sent to the IRS, the seller must pay the difference to the IRS. Compliance reporting of the withholding is handled in a similar fashion to FIRPTA withholding on the sale of U.S. real property interests by foreign persons.
Sometimes when a partnership interest is sold, the sales price may include a reduction in liabilities as part of the transaction. This may result in the buyer having to withhold additional amounts in excess of the buyer pays the seller. As a general rule, in these cases, the total withholding is limited to the total amount of cash and/or property transferred. Additional withholdings may also be required if the seller of a partnership takes a distribution of money or property from the partnership in excess of its basis.
The substantive federal tax under Section 864(c)(8) is assessed on the portion of the partner’s distributive share of the amount of gain which would have been effectively connected with the conduct of a trade or business within the United States as if the partnership had sold all of its assets at their fair market value as of the date of the sale or exchange of such interest. However, this provision excludes real property gain already classified as effectively connected under FIRPTA. Under Section 741, the sale of a partnership interest is treated as the sale of a capital asset.
Finally, the Tax Cuts and Jobs Act changed the tax rules governing a foreign partner’s taking distributions from a partnership that exceed its basis. If a foreign partner takes distributions of money or property from a partnership, even without selling his interest in the partnership, and the distributions exceed his basis in the partnership, the foreign partner may be subject to federal tax on this distribution. These rules go into effect for partnership distributions after November 27, 2017.
Compliance Requirements
Just as with FIRPTA, the transferee is responsible for having the withholding tax collected and remitted to the IRS from the proceeds of the sale. In other words, the purchaser of the partnership interest must do the withholding. In the case of a partner’s distribution in excess of its basis, the withholding agent is the partner. In either case, the 10 percent withholding must be remitted to the IRS no later than 20 days after closing or the distribution in excess of basis. The calculation and payment of the substantive tax is done with the filing of the tax return for the partner. In certain cases, income tax treaties may be available to reduce or eliminate the U.S. federal tax associated with the sale of a partnership interest or a distribution that is in excess of a partner’s basis.
These new rules discussed in this article substantially increase the compliance requirements for foreign partners in a U.S. partnership. Any foreign person or entity investing in a U.S. based partnership is well advised to seek competent counsel.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.