The recently enacted Tax Cuts and Jobs Act (TCJA) includes a new withholding tax imposed on buyers of partnership interests (including interests in private funds) from non-U.S. sellers where gain on the sale would be taxed to the seller under a separate provision of the TCJA.
Under new Section 864(c)(8) of the Internal Revenue Code (the Code), a non-U.S. seller of an interest in a partnership has taxable gain to the extent any of the assets of the partnership are used in a U.S. trade or business and would trigger gain if such assets were sold for their fair market value at the time the partnership interest is sold. This new rule codifies long-standing IRS practice which a recent tax court case called into question. This rule would apply, for example, to a non-U.S. seller of an interest in a fund which has direct investments in partnerships or LLCs conducting a business in the United States (not an uncommon fact pattern). The amount of the taxable gain (referred to as “ECI” or “effectively connected income”) is determined by reference to the portion of the underlying assets of the fund that are used in a U.S. trade or business. The non-U.S. seller is taxed at regular U.S. tax rates on any such gain.
To backstop this new tax, new Section 1446(f) of the Code generally imposes a 10% withholding tax on the buyer of a partnership interest where the seller would have taxable gain under the rule described above. The buyer may avoid the withholding tax obligation if it obtains from the seller a certificate stating that the seller is not a foreign person. Absent such a certification, however, the purchaser must withhold 10% on the amount realized by the seller in the sale and remit the tax to the IRS, even if the parties are otherwise comfortable as a diligence matter that the fund is not engaged in a U.S. business and has no ECI. If the buyer does not withhold and is otherwise required to do so, the partnership whose interest is being transferred is required to withhold an equivalent amount from distributions to the buyer.
In practical terms, the new withholding tax poses a significant challenge to buyers and sellers of fund interests. Until regulations are issued providing additional exceptions from the withholding tax, it would appear that a buyer would have no choice but to withhold on a purchase of a fund interest from a non-U.S. seller. A certification from the general partner of a fund that the fund is not engaged in a U.S. business will not relieve the buyer of its obligation. Fund managers should ensure that they have the ability to withhold distributions otherwise to be made to a buyer of a fund interest where the buyer does not withhold as required. They should also ensure that they are indemnified against any such tax liability. Buyers and sellers may consider escrow or holdback arrangements where the tax to be withheld is deposited or held back until further guidance on the new rules is available. Sellers may be able to claim a refund in the event of overwithholding; however, the rules are still unclear.
We will provide an update to this new law as the IRS issues regulations or other guidance.