Among its many changes, the new tax law clarifies a withholding tax question that had been plaguing foreign investors in U.S. partnerships since this summer. The law introduced as the Tax Cuts and Jobs Act (TCJA) moves the U.S. from a worldwide to a territorial-like tax system and in doing so, enacts changes to limit profit shifting overseas.
Sourcing the gain from the sale of partnership interest numbered among the many provisions affected by the TCJA. Under the new law, gain from a sale of a partnership interest by a non U.S. investor constitutes effectively connected income (ECI) to the extent the seller would have had ECI had the partnership sold all of its assets at fair market value on the date of sale. This treatment is consistent with earlier IRS guidance with respect to the disposition of a partnership interest, but it reverses the 2017 Grecian decision where the Tax Court held that a foreign partner’s gain on the redemption of an interest in a partnership engaged in a U.S. trade or business was not subject to tax. In addition, the new law also imposes a withholding tax on the disposition of such partnership interest.
‘Grecian’ Rule Muddies the Waters of Withholding Tax
In general, if a foreign person is engaged in a U.S trade or business, such person's income constitutes ECI. Furthermore, the IRS has long held the position that if a foreign partner’s gain on the sale of its partnership interest was attributable to a U.S. trade or business, that gain is also treated as ECI.
Foreign individuals or corporations with investments in U.S. businesses generally are subject to one of four types of withholding:
- Withholding under Section 1446 applies to income that is effectively connected with the partnership’s U.S. trade or business. The withholding rate under this regime is the highest rate of tax applicable, 39.6 percent for individual foreign partners and 35 percent for corporate nonresident partners in 2017. Beginning in 2018, these withholding rates are 37 percent and 21 percent, respectively.
- Withholding under Section 1441, 1442, and 1443 applies to U.S.-source income that is fixed, determinable, annual or periodic (FDAP) income. The withholding rate under this regime is 30 percent. A reduced rate, including exemption, may apply if an Internal Revenue Code Section provides for a lower rate, or there is a tax treaty between the foreign person’s country of residence and the U.S.
- Withholding under Section 1445 applies to income on the disposition of a U.S. Real Property Interest (USRPI) and is subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). Generally, if no exclusions or special rules apply, the withholding rate is 15 percent of the amount realized by the foreign transferor. There are special rules for distributions of USRPI’s by entities. A partnership interest will be considered a USRPI in certain circumstances. A partnership that sells a USRPI is not subject to both FIRPTA withholding under section 1445 and withholding under Section 1446. Section 1446 will trump the FIRPTA withholding under section 1445.
- Withholding under sections 1471-1474 is subject to the Foreign Account Tax Compliance Act (FATCA). If applicable, FATCA imposes a 30 percent withholding tax on specified “withholdable payments” made to a non-financial foreign entity (NFFE) or to a foreign financial institution (FFI).
Foreign partners in U.S. partnerships seemingly caught a break with the Tax Court’s holding in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner of Internal Revenue. The court rejected a position long held by the IRS in Rev. Rul. 91-32, which ruled that a redemption of a foreign partner’s interest should be treated as if the taxpayer sold a proportionate share of each of the partnership’s assets. Where the partnership is engaged in a U.S. trade or business, the proportionate share approach would treat the redemption gain as ECI to the extent the partnership’s assets would give rise to ECI if sold by the partnership.
In the Grecian decision, the Tax Court sided with the foreign partner, and concluded that the gain on the sale was not attributable to the partnership’s U.S. office because the activities of that office were not a material factor in the foreign partner’s gain on the sale of his partnership interest. The court also determined that the gain was not realized in the ordinary course of the partnership’s business and thus was not attributable to the partnership’s U.S. office. As a result, gain on the sale of the partnership interest was held not to be U.S.-source income.
How the New Tax Law Negates ‘Grecian’
Effective Jan. 1, 2018, the TCJA clarifies that the sale of a foreign partner’s interest is ECI to the extent that the seller would have ECI had the partnership sold all its assets at fair market value on the date of the sale. Furthermore, this sale is now subject to U.S. withholding. Specifically, a purchaser of an interest in a partnership with ECI assets must withhold 10 percent of the seller’s amount realized on the sale unless the seller can verify it is a U.S. person. If the purchaser does not satisfy this withholding requirement, the consequences will be significant. The partnership is then required to withhold from future distributions to the purchaser the amount, including interest that the purchaser failed to withhold. Exchanges will also be affected by the TCJA’s withholding rules.
How Partnerships Can Navigate the Withholding Requirements
U.S. partnerships should carefully review these new requirements when deciding how to treat sales or exchanges of partnership interests. Withholding is a focal point for regulators, and compliance is essential. An international tax professional may be able to help evaluate whether withholding requirements are being met, or whether exceptions or treaties may apply that would reduce withholding tax costs.
For more information about withholding and foreign partner sales of interest, please contact your local CBIZ MHM tax professional.
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