By Anthony Diosdi
Foreign investors generally have the same goals of minimizing their income tax liabilities from their business investments, as do their U.S. counterparts, although their objective is complicated by the very fact that they are not U.S. persons. That is, foreign investors must be concerned not only with income taxes in the United States, but also income taxes in their home country. Further, the United States has a special income tax regime that is applicable to foreign persons. Specifically, if the foreign investor derives certain types of passive income, it is typically taxed at a flat 30% rate (without allowance for deductions), unless an applicable U.S. tax treaty reduces this statutory rate. In contrast, if the U.S. activities of the foreign investor rises to the level of constituting a “U.S. trade or business,” then the foreign investor is taxed similarly to a U.S. person (i.e., on the net income from the business at graduated rates).
Since the typical income-producing partnership will constitute a U.S. trade or business, a foreign investor’s investment in a partnership will normally be taxed at the same graduated rates that would apply to a U.S. person. In addition, foreign investors have the benefit of preferential long-term capital gains rates. Although the rules are relatively simple when it comes to determining the U.S. tax consequence of a foreign investor’s partnership distribution, the rules governing the sale of a foreign partner’s U.S. partnership are complicated. This article discusses the U.S. tax and withholding requirements associated with the sale of a foreign partner’s U.S. partnership interest.
The examination of the statutory scheme governing the sale of a partnership interest begins with Internal Revenue Code Section 741, which provides that gain or loss from the sale or exchange of an interest in a partnership shall be considered as gain or loss from the sale of a capital asset. But unqualified capital gain treatment on the sale of a partnership interest historically resulted in abuse if the partnership held assets such as inventory or accounts receivable that gave rise to ordinary income if sold by the partnership. To prevent this potential abuse of conversion of partnership ordinary income into capital gain, Section 741 of the Internal Revenue Code yields to Section 751(a) to the extent that the amount received by a selling partner is attributable to “unrealized receivables” or “inventory items.” Working in tandem, Sections 741 and 751(a) apply whether the selling partner disposes of his entire interest or only some portion of it.
Prior to the 2017 Tax Cuts and Jobs Act, there was no explicit rule in the Internal Revenue Code nor the regulations regarding the treatment of the disposition of a partnership interest by a foreign partner. As such, the source of a foreign partnership interest was primarily governed by Internal Revenue Code Section 865. In general, a partnership interest is considered personal property. Section 865 prescribes the rules for determining the source of gain or loss from the sale of personal property. Section 865 sets forth an apparent rule of general application based upon the residence of the seller, and a special definition of the term “residence.” See IRC Section 865(a) and (g). Source determinations will often depend upon the application of a series of exceptions which reflect a number of variables, including whether the property is inventory and whether the property has been used in connection with a trade or business.
Section 865(a) provided generally that gain from the sale or exchange of personal property was sourced according to the residence of the taxpayer. In the case of a nonresident partner who maintained an office or fixed place of business in the United States, a special rule provided that gain from the sale of personal property that is attributable to such office or fixed place of business is sourced in the United States (to the extent that the exception for inventory property sold for use or consumption outside the United States under Section 865(e)(2)(A). Under these rules, it would appear that if a foreign partner in a partnership that does not have an office or fixed place of business within the United States, the foreign partner would generally not be taxed on gain on the sale of his or her partnership interest, since the gain would be sourced outside the United States. In the event the partnership does have a U.S. office or fixed place of business that is imputed to the partner, the foreign partner’s gain on the partnership interest may be taxable, depending on whether the gain was determined to be “attributable” to the partnership’s office or fixed place of business within the meaning of Section 865.
Revenue Ruling 91-32
Before Grecian Magnesite Mining Indus. & Shipping Co., 149 T.C. 63 (2017) was decided, IRS Revenue Ruling 91-32 reflected the Internal Revenue Service or “IRS” position that a nonresident alien investor selling an interest in an entity classified as a partnership for U.S. federal income tax purposes would be treated as realizing income that is effectively connected with a U.S. trade or business or “ECI” to the extent the gain on the sale of the interest was attributable to a U.S. trade or business of the partnership operating through a fixed place of business.
In that situation, rather than characterizing gain from that sale of the partnership interest as non-U.S. source capital gain from the sale of property (which is generally not subject to U.S. federal income tax to non-U.S. resident sellers), the Revenue Ruling treated the non resident’s gain on a sale of the partnership interest as ECI to the extent attributable to the partner’s assets that would generate ECI if sold by the partnership.
Grecian Magnesite
In 2017, the United States Tax Court, in Grecian Magnesite Mining v. Commissioner, 149 T.C. No.3 (July 13, 2017) ruled that, generally, a foreign person’s gain or loss on its sale or exchange of an interest in a partnership that is engaged in a U.S. trade or business is foreign-source. The Tax Court rejected Revenue Ruling 91-32 which had required that if there is unrealized gain or loss in partnership assets that would be treated as effectively connected with the conduct of a U.S. trade or business if the partnership sold those assets, then some or all of the foreign person’s gain or loss from the sale or exchange of a partnership interest could be taxed as ECI.
2017 Tax Cuts and Jobs Act
The 2017 Tax Cuts and Jobs Act affected the Grecian decision by introducing a new set of statutory rules codified in Sections 864(c)(8) and 1446(f) of the Internal Revenue Code. These new rules are designed to cause a foreign partner’s gain on its disposition of its partnership interest to be treated as ECI for U.S. income tax purposes. In addition, the sale of a partnership interest is subject to a 10 percent withholding tax.
To the extent that the sale of a partnership exceeds a foreign partner’s basis in the partnership, the distribution will be taxed as ECI. The effectively connected gain or loss on the partnership’s U.S. trade or business (i.e., arising from the “deemed sale” of those assets) is allocated in the same manner as a partner’s distributive share of “non-separately” stated items of income or loss. Prop. Reg. Section 1.864(c)(8)-1(b) and (c) describes computational process/steps:
Step 1: Determine Outside Gain/Loss
Determine gain or loss on the transfer of a partnership interest under generally applicable tax principles, e.g., Section 741 and 751 of the Internal Revenue Code. Gain or loss on a sale or exchange of a partnership interest can comprise capital gain, capital loss, ordinary income, or ordinary loss (or a combination thereof).
Under Prop. Reg. Section 1.864(c)(8)-1(b)(2), the character of the gain or loss is applied separately for purposes of the deemed sale transaction utilized in the subsequent computational steps. For example, a foreign transferor may recognize capital gain or loss (outside capital gain/outside capital loss) and ordinary gain or loss (outside ordinary gain/loss) on the transfer of its partnership interest, and that foreign transferor must separately apply Section 864(c)(8) with respect to its capital gain or loss and its ordinary gain or loss.
Step 2: Determine Deemed Sale Gain and Loss
Determine the amount of gain or loss that the partnership would recognize with respect to each of its assets (other than interests in other partnerships) upon a deemed sale of all of the partnership’s assets on the date of the transfer of the partnership interest (“deemed Sale”). For this purpose, a deemed sale is a hypothetical sale by the partnership to an unrelated person of each of its assets (tangible and intangible) in a fully taxable transaction for cash in an amount equal to the fair market value of each asset immediately before the partner’s transfer of the interest in the partnership.
Step 3: Determine Deemed Sale Effectively Connected Gain and Loss
With respect to each asset deemed sold, determine the amount of gain or loss from the deemed sale that would be treated as effectively connected gain or effectively connected loss. Gain is referred to as “deemed sale EC loss.” Section 864 and the regulations thereunder apply for the purpose of determining whether gain or loss that would arise in a deemed asset sale would be treated as effectively connected gain or loss. Gain or loss from the deemed sale of an asset is treated as attributable to an office or other fixed place of business maintained by the partnership in the United States, and is not treated as sold for use, disposition, or consumption outside the United States in a sale in which an office or other place of business maintained by the partnership in a foreign country materially participated in the sale. Gain or loss from the deemed sale of an asset (other than a United States real property interest) is not treated as deemed sale EC gain or deemed sale EC loss if-
(1) No income or gain produced by the asset was taxable as income that was effectively connected within the United States by the partnership during the ten-year period ending on the date of the transfer; and
(2) The asset has not been used, or held for use, in the conduct of a trade or business within the United States by the partnership during the ten-year period ending on the date of the transfer.
Step 4: Determine the foreign transferor’s distributive share of deemed sale EC gain or deemed sale EC loss.
A foreign transferor’s distributive share of deemed sale EC gain or deemed sale EC loss with respect to each asset is the amount of the deemed sale EC gain and deemed sale EC loss that would have been allocated to the foreign transferor by the partnership under all applicable Code section (including Section 704) upon the deemed sale taking into account allocations of tax items applying the principles of Section 704(c), including any remedial allocations under Section 1.704-3(d), and any Section 743 basis adjustment pursuant to Section 1.743-1(j)(3)).
A foreign transfer’s aggregate deemed sale EC ordinary gain (if the aggregate results in a gain) or aggregate deemed sale EC ordinary loss (if the aggregate results in a loss) is the sum of-
(1) The portion of the foreign transferor’s distributive share of deemed sale EC gain and deemed sale EC loss that is attributable to the deemed sale of the partnerships assets that are Section 751(a) property; and
(2) Deemed sale EC gain and deemed sale EC loss from the sale of assets that are Section 751(a) property that would be allocated to the foreign transferor with respect to interests in partnerships that are engaged in the conduct of a trade or business within the United States.
If a foreign transferor transfers less than all of its interest in a partnerships, then the foreign transferor’s distributive share of deemed sale EC gain and deemed sale EC loss is determined by reference to the amount of deemed sale EC gain or deemed sale EC loss that is attributable to the portion of the foreign transferor’s partnership interest that was transferred.
Withholding Requirements Associated with the Sale of a Foreign Investor’s Partnership Interest
Internal Revenue Code Section 1446(f) provides that a 10 percent gross withholding tax applies to the transferred (buyer) of the partnership interest, with the partnership subject to potential additional withholding obligations.
The Treasury and the Internal Revenue Service released Notice 2018-8, 2018-7 I.R.B 352 (Jan 2, 2018) and Notice 2018-29, 2018-16 I.R.M. 495 (Apr. 2, 2018) in relation to these rules. Notice 2018-29 provides a number of different exceptions to the withholding requirements, which include the following:
1) The notices generally adopts the rules in the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) rules. If the transferor does not receive the required affidavit, it must presume that the transferor is foreign for purposes of withholding under Section 1446(f)(1) of the Internal Revenue Code.
2) The notices generally adopts the forms and procedures relating to withholding on dispositions of U.S. real property interests under the FIRPTA rules.
3) The notices provide that if a transferee receives a certification from a transferor that the disposition will not result in gain, then the transferee generally is not required to without under Section 1446(f).
4) If a transferor certifies to a transferee that for each of the past three years the transferor’s ECI from the partnership was less than 25% of the transferor’s total income from the partnership, the transferee is not required to withhold; or
5) No withholding by transferee of its withholding obligation under Section 1446(f)(1) when the transferee receives a certification from the partnership that the partnership’s effectively connected gain under Section 864(c)(8) would be less than 25% of the total gain on the deemed sale of all its assets.
Withholding on Foreign Partner’s Effective Connected Taxable Income
If during a partnership’s tax year the partnership has taxable income effectively connected with the conduct of a trade or business or ECI within the U.S. that is allocable to a foreign partner, the IRS requires the partnership to report and pay a withholding tax under Section 1446 of the Internal Revenue Code to the IRS. The partnership must pay the Section 1446 withholding tax regardless of the amount of the foreign partners’ ultimate U.S. tax liability and regardless of whether the partnership makes any distributions during its tax year. Revenue Procedure 92-66, and Treasury Regulation Section 1.1446-3 set forth the time and manner for paying the withholding tax, as well as the general reporting obligations with respect to the tax. The partnership may reduce the foreign partner’s share of the partnership’s gross effectively connected income by certain partner level deductions and losses if the foreign partner certifies these losses on IRS Form 8804-C.
Section 1446 imposes a withholding obligation on the share of partnership net income that is effectively connected with a U.S. trade or business allocable to a foreign partner. The result is that the partnership must withhold an amount equal to the product of the allocable share of such income attributable to the foreign partner and the maximum marginal tax rates specified in Section 1 (for individuals) and 11 (for corporations). Unlike other situations in which withholding obligations apply when payments are made, the partnership is required to withhold the appropriate amount whether or not the foreign partner’s share of income is actually distributed. The tax so withheld will be treated as a distribution to the foreign partner to whom the withholding applies. See Treas. Reg. Section 1.1446-3(d)(2)(v).
Withholding on Foreign Partner’s Fixed or Determinable Annual or Periodical Income
Most forms of U.S.-source income received by foreign persons that are not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount of the income received. Internal Revenue Code Section 871(a) (for nonresident aliens) and Section 881(a) (for foreign corporations) impose the 30-percent tax on “interest * * * dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodic gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income.” The collection of such taxes is affected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person to withhold the tax and pay it over to the IRS. The tax collected, therefore, is often referred to as a “withholding tax”. In fact, however, the recipient of the income is the foreign investor. The obligation imposed on the payor to withhold tax is intended to assure its collection. A partnership may have to withhold tax on a foreign partner’s distributive share of FDAP not effectively connected with a U.S. trade or business, as well as withhold on any other FDAP income paid to a foreign person regardless of whether he is a partner or not.
Tax treaties generally provide for the reduction or elimination of withholding taxes on specified items of U.S.-sourced FDAP income that is not attributable to a permanent establishment in the United States.
Withholding under the Foreign Investment in Real Property Tax Act or FIRPTA
If a partnership acquires a U.S. real property interest from a foreign person, the partnership may have to withhold tax under Internal Revenue Code Section 1445. U.S. partnerships are required to withhold tax in respect of the share of gain attributable to a foreign partner of any amount realized by the entity upon a disposition of a U.S. real property interest. The withholding rate will generally be 37 percent. However, the withholding rate may be reduced to 15 percent. Every U.S. or foreign partnership is generally required to withhold 15 percent of the fair market value of a U.S. real property interest distributed to a foreign partner of the distribution would be taxable.
Conclusion
When a foreign partner sells its interest in a U.S. partnership, the foreign partner must prepare for the U.S. income tax consequences and withholding associated with the sale of its partnership interest. In certain cases, an income tax treaty may reduce the U.S. income tax and withholding. In order to properly plan for the required income tax and withholding consequences of a partnership sale, it is best to retain international tax counsel well before the actual sale of the partnership interest.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or 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.