ECI and secondaries: How will the proposed regulations affect you?

The US Treasury issued proposed regulations in May to enforce a recently enacted provision regarding withholding tax imposed on buyers who purchase partnership interests from non-US partners where the partnership is engaged in a US trade or business. These proposed regulations are particularly relevant to secondaries market participants. 

What do the IRS’s proposed regulations entail?

Section 1446(f) of the Internal Revenue Code is an enforcement mechanism which imposes tax on a foreign partner that transfers an interest in a partnership engaged in a US trade or business to the extent that gain on a deemed sale of the partnership’s assets would produce income effectively connected with a US trade or business (“ECI”).

The proposed regulations require withholding on a foreign person’s transfer of an interest in a partnership that is engaged in a US trade or business. The regulations require the transferee to deduct and withhold a 10 percent tax from the amount realised by the foreign transferor (ie the amount of cash and fair market value of property received, plus the amount of liabilities the foreign transferor is relieved of).

The proposed regulations define transfer as a sale, exchange or other disposition of, and certain distributions on, a partnership interest and require both non-US persons and domestic partnerships with non-US direct or indirect partners that transfer an interest in a partnership engaged in a US trade or business to notify the partnership within 30 days of the transfer.

The notification must include the date of the transfer and identifying information of the transferor and transferee. If the transferor would have allocable US ECI on a deemed sale of the partnership’s assets, then the partnership must report the information necessary for the transferor to comply with its tax obligations relating to ECI.

What are the timelines for implementing the regulations and what do sellers and buyers need to be aware of regarding these dates?

The implementation of the withholding, reporting and tax payment requirements have not yet come into effect. These withholding rules will become effective on transfers occurring more than 59 days after the publication of final regulations. The notification requirement and the reporting requirement would apply to transfers occurring on or after the date of the publication of the final regulations.

What are the exceptions to withholding being applied?

The proposed regulations provide six exceptions to withholding for transferees of partnership interests, other than with respect to publicly-traded partnerships:

1)        Receipt of documentation of the transferor’s US status. The documentation must include the transferor’s taxpayer identification number. A Form W-9 or certificate of non-foreign status may be used for this purpose.

2)        Bilateral tax treaty exemptions may cover the transferor. The transferor must provide documentation supporting the claim for treaty benefits, and within 30 days the transferee must mail a copy of this documentation to the IRS.

3)        Certification of no realised gain. The transferee is not required to withhold where the transferor provides a certification stating that the transferor would not realise any gain on the transfer.

4)        Certification that 10 percent or less of the partnership’s total gain on a deemed sale of all partnership assets on the transfer date would be gain that is effectively connected to a US business.

5)          Certification that 10 percent or less of the partnership’s ECI is allocable to the transferor over the prior three-year period. This exception requires the transferee to obtain several other certifications from the transferor.

6)        Certification that a non-recognition provision of the Code applies to all of the gain realised on a transfer. 

The proposed regulations provide five exceptions to withholding for transferees of publicly-traded partnership interests that are generally similar.

Are there any changes to the withholding amount that are being proposed?

There are two alternatives to the default 10 percent withholding on the amount realised. A procedure is provided for determining an amount to withhold that more closely aligns with the actual tax liability of the transferor. For this procedure to apply, the transferor must provide the transferee with certifications establishing the transferor’s effectively connected gain.

The transferee may then withhold based on the transferor’s maximum tax liability, which is the amount of the transferor’s effectively connected gain multiplied by the highest tax rate for each type of income or gain.

Alternatively, upon request, the IRS may allow a reduction in the amount withheld if it determines that such a reduction would not jeopardise the collection of tax. 

What are you advising your clients to do regarding these latest ECI proposals?

We advise partnerships and investors in partnerships engaged in a US business to continue requesting documentation (such as certificates of non-foreign status, W-9s, W-8s) establishing the applicability of withholding tax to any partner. We are seeing (1) some partnerships requiring, as a condition of consenting to a transfer, both the transferor and the transferee to indemnify the partnership for any withholding tax liability, and (2) transferee partners requiring the transferor to indemnify them for any withholding tax liability.

Joseph Opich is a partner in Paul Hastings tax practice. Based in New York, he practices in the areas of federal and state tax law, finance, real estate and securities law. Leanne Moezi is a partner in the firm’s private equity practice of Paul Hastings and is based in London. She has advised on a range of secondaries and GP-leds, including the Lyceum, Avenue and Three Hills GP-led processes. Adam Brown is a Washington DC-based partner who advises investors on complex secondaries transactions. Stephen Grace is a tax associate based in New York.