Asset Managers Face New Potential Withholding Obligation on Sales of Interest in Their Funds
There is a new “secondary withholding obligation,” effective January 1, 2023, that may apply to a partnership whose interest has been sold or transferred to the extent that the primary withholding obligation was not satisfied. Investment fund managers and professionals need to be aware of their potential obligations that could arise under these new rules.
Congress enacted a set of income tax and withholding tax rules as part of the Tax Cuts and Jobs Act of 2017 (TCJA). Those rules, which have been further clarified by regulations, impose new income or withholding tax obligations on buyers and sellers of interests in partnerships that have U.S. activity in cases where a seller may be a non-U.S. person. Generally, in these cases the buyer will have the primary withholding obligation to withhold some portion of the proceeds due in the purchase transaction. This obligation can also arise if there is a “deemed” purchase under the U.S. tax rules.
The application of the secondary withholding obligation under Section 1446(f), enacted as part of the TCJA, was deferred until this year under IRS guidance.
How Does the New Secondary Withholding Obligation Affect Asset Managers?
The Section 1446(f) withholding tax may apply to any partnerships that have non-U.S. partners and generate income that is effectively connected with a U.S. trade or business (ECI). With the secondary withholding obligation effective as of January 1, 2023, for investment partnerships whose interest are sold, fund managers must take active steps to understand the applicable rules and procedures. These include the timing requirement to comply, getting documentation and data ready to claim exceptions, providing information to transferors and transferees, and making the withholding payments if necessary.
Discussion and consultations with fund administrators and tax advisors prior to executing the transfer of partnership interests is highly recommended to ensure the parties understand their withholding obligations and make timely disclosures as appropriate. With the rise of secondary transactions in private equity funds, this issue is likely to be increasingly common.
Changes Enacted by the Tax Cuts and Jobs Act
Non-U.S. persons are subject to tax on ECI, including ECI that is earned through a partnership interest. Historically, many taxpayers took the position that a non-U.S. person’s gain from the sale of a partnership interest could be treated as capital gain sourced to the residence of the non-U.S. partner (non-U.S. sourced) and thus not taxable in the U.S. However, this position was in contrast to the public IRS position on the issue.
The TCJA enacted Section 864(c)(8), which codified the IRS’s position and affirmed the characterization and source of a foreign partner’s (transferor’s) gain or loss from the sale or exchange of a partnership interest as ECI to the extent that the transferor would have had effectively connected gain or loss if the partnership had sold all of its assets at fair market value as of the date of the sale or exchange (deemed sale).
Section 1446(f)(1) serves as an enforcement mechanism for Section 864(c)(8) by imposing a 10% withholding tax on the amount realized from the disposition. The withholding obligation falls primarily on the transferee (i.e., the buyer). If the transferee fails to withhold, Section 1446(f)(4) imposes a secondary withholding obligation on the partnership to withhold from future distributions to the transferee an amount equal to the amount the transferee failed to withhold (plus interest on that amount).
On November 30, 2020, Treasury issued T.D. 9926 (Final Regulations) and provided details clarifying the operating mechanism of the primary and secondary withholding obligations. The primary withholding obligation took effect upon the issuance of the Final Regulations, but the applicability date of the secondary withholding obligation was deferred by Notice 2021-51 to January 1, 2023.
Secondary Withholding Obligations and Its Interaction with Primary Withholding Obligations
If an interest in an investment partnership has been sold, the partnership may be obliged to withhold upon distribution when the primary withholding obligation has not been or was not satisfied. In the following four situations, the partnership may be able to rely on either exceptions or certifications that support the satisfaction of primary withholding obligations.
First, the partnerships can rely on a certification from the transferee stating that an exception to withholding applies or that the transferee has satisfied its primary obligation to withhold to the partnership. Procedurally, the transferee is required to provide this certification within 10 days after the transfer. The certification typically is made either by including a copy of Form 8288-A that the transferee files with respect to the transfer, or by stating the amount realized and the amount withhold on the transfer. Second, the partnerships are also allowed to rely on non-foreign status certification of the transferor (including a Form W-9) to determine that it has no withholding obligation due to the transferee being a U.S. person. However, the partnership may not rely on any certification if it knows or has reason to know that the certification is incorrect or unreliable. The third and fourth scenarios that exempt partnerships from their secondary withholding obligation of the partnership are when the partnership is a publicly traded partnership or when the partnership is the transferee because it makes a distribution.
If none of the above exceptions is applicable, a partnership is required to withhold the full amount of each distribution made with respect to the transferred interest until it has withheld 10% of the amount realized on the transfer. The partnership may begin withholding on the distributions made with respect to the transferred interest on the later of (1) the date that is 30 days after the date of transfer or (2) the date that is 15 days after the date on which the partnership acquires actual knowledge that the transfer has occurred. The partnership must file Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, and transmit the tax withheld to the IRS by the 20th day after the date of the distribution to the transferee. The partnership should also attach copy A of Form(s) 8288-C, Statement of Withholding Under Section 1446(f)(4) for Withholding on Dispositions by Foreign Persons of Partnership Interests, to Form 8288.
Any amount that is withheld by the transferee at any time, even if it’s withheld after when it was required to be withheld, reduces the amount that the partnership is required to withhold. Once the requirement amount is fully paid by either the partnership or the transferee, the partnership may stop withholding on distributions. Further, as soon as the partnership receives and is able to rely on a certification of exemption from the transferee, even after the prescribed time (10 days), the partnership may stop withholding on distributions.
If the total amount withheld by the transferee and partnership exceeds the withholding tax liability under Treas. Reg. §1.1446(f)-2, the transferee may claim a refund for the excess amounts. However, the partnership is not permitted to claim a refund on behalf of the transferee for the excess amount withheld.