A new post tax reform rule: Non-U.S. investor’s capital gain from the sale of an interest in a U.S. partnership is now subject to U.S. federal income tax.
The U.S. tax reform entered into force as of January 1, 2018 contains, among many other complex rules related to non-U.S. taxpayers, a provision applicable (and important) to persons acquiring or disposing an interest in a partnership (or in any other entity that is treated as a partnership for U.S federal income tax purposes, such as LLC). The Code makes it clear now that when a foreign person disposes of an interest in a U.S. or non-U.S. partnership that is engaged in a U.S. trade or business, any gain that is attributable to the partnership’s U.S. trade or business is treated as effectively connected to a U.S. trade or business and subject to U.S. federal income tax. This rule is generally similar to the provision contained in the U.S. model tax convention (and also in the OECD and UN models), pursuant to which “Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise), may be taxed in that other State.” The reference to “permanent establishment” in the U.S. treaty, sometimes aligns with the definition of “trade or business,” but sometimes it does not. The question of whether the new rule overrides a tax treaty is a long-discussed question. The U.S. Constitution provides that, new domestic laws override the provisions of existing treaties (by giving the treaties a status of a domestic law – i.e., “Law of the Land”).
This new rule, comes in a response to a court decision from July 13, 2017 (Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3) confirming that a non-U.S. investor’s capital gain from the sale of an interest in a partnership that is engaged in a U.S. trade or business generally is not subject to U.S. federal income tax. In this decision, the Tax Court rejected a longstanding IRS ruling providing that such non-U.S. seller is subject to tax in the U.S. upon the sale of an interest in a partnership. Therefore, the new rule under the Code makes it clear that the IRS ruling is the appropriate treatment.
Also, as of January 1, 2018, a purchaser of interest in a partnership is required to withhold at a 10% rate of the total consideration paid by it (i.e., the purchase price) and pay such amount to the IRS, whether the interest in the partnership is of a U.S. or a foreign partnership, to the extent such partnership is engaged in a US trade or business.
The code provides for exceptions to the withholding requirements, if (i) the purchaser receives an affidavit from the seller affirming the seller’s U.S. residency (normally in a W-9 form), (ii) no portion of the gain is attributable to a U.S. trade or business, (iii) the IRS agrees to a lower withholding amount, or (iv) the interest sold is an interest in a publicly traded partnership. Failure to withhold by the purchaser results in the partnership to be required to withhold from any distributions made to the purchaser (plus applicable interest). This requirement is not subject to any minimum threshold of the partnership income that is effectively connected with a U.S. trade or business, and applies irrespective of the amount of income that is effectively connected to a U.S. trade or business.
When examining whether a partnership is engaged in a U.S. trade or business or not, one should consider not only obtaining the W-9 forms from sellers, but also to obtain appropriate assurances and indemnifications from the seller that the partnership is not engaged in a U.S. trade or business. Given the effect that a failure to withhold can have on the partnership (why after seller is out of the picture), it is crucial for partnerships to ensure, prior to the acquisition, that they are aware of all transfers of interests in the partnership and they are also able to comply with these new rules.
General partners, sponsors, and managers should run their proper due-diligence with the right amount of investigation regarding any consent to transfer that is provided in the partnership agreement given this new provision.
Although the Code does not currently provide for a certification process for the partnership (or the transferor) that no portion of the gain is attributable to a U.S. trade or business, the IRS has specific authority to implement the withholding provision. The IRS will provide, in the near future guidance that should provide some comfort to transferees. It is also ambiguous how tax treaties may impact the withholding requirements, but as stated above, seems like the treaties already contain a provision that can support this new rule of withholding, for computing the tax credits.
Please consider the above when representing a buyer or seller in a purchase or sale of an interest in a partnership. It is also a good idea to consider the appropriate language in any operating agreement (U.S. or non-US partnership, if it is expected for the partnership to have activities in the US).
We are happy to answer any question you may have on this issue. Please contact Oz Halabi