US tax reform brought in sweeping changes to the tax system, which included a somewhat surprising change for secondaries buyers. By now, many secondaries investors will be aware that a 10 percent withholding tax liability is levied on buyers of partnership interests from non-US persons in some circumstances where the partnership has an exposure to a US trade or business.
The new provision essentially reverses a decision taken by the US courts which concluded that a non-US person was not subject to US tax on a gain from the sale of an interest in a partnership with an American connection.
The measure has the potential to significantly change the way in which buyers and sellers approach the sale of a partnership interest in a fund that conducts business in the US. Secondaries investors will not only need to take into account the risk of a tax liability arising on the purchase of a partnership interest but also consider the additional level of comfort they may wish to seek from the sellers that the withholding does not apply. Buyers will need to be aware that they may encounter reticence from some sellers to furnish exemption certificates if the seller is not used to dealing with the Internal Revenue Service.
As a matter of practice, most funds aimed at non-US investors are carefully structured to ensure no effectively connected income, i.e. income related to a US trade or business, arises. This is standard practice for funds in the European secondaries market and means that the provisions should not ordinarily bite. However, uncertainty arises in connection with funds which ought not to have ECI, but the risk cannot be ruled out and the lack of any de minimis exception in these provisions puts too much risk onto the buyer without contractual protection. So much so, that if any portion of the gain on the sale of a partnership interest is ECI – even if that gain was $1 – a withholding liability of 10 percent of the amount realised by the seller must be withheld by the buyer.
On 2 April 2018 the IRS issued Notice 2018-29 which provides some interim guidance and exceptions to these rules. Before the guidance was published, concern was caused by: the lack of any mechanism to report the withholding or pay it to the IRS; the fact the amount realised by a seller could include not only the purchase price but also its share of any underlying partnership liabilities which were transferred (meaning it could be very difficult to ascertain the correct amount to withhold); and the requirement, where a buyer fails to withhold, for the partnership itself to collect the withholding amount by deducting it from payments to the buyer (as the new limited partner).
The guidance published in April provides some clarification on these points and details the exceptions to the rules. Contrary to the IRS’s earlier informal statements, and disappointingly, the notice does not suspend the withholding requirement wholesale (other than withholding by partnerships themselves), but it does provide useful exceptions for those problem cases. For example, withholding tax will not be levied in circumstances where:
- as contained in the legislation itself, a certificate is given by the seller that it is a US person; this can include a form W-9.
- a certificate is given by the seller that no gain is realised.
- a certificate is given by the seller that in each of the preceding three relevant tax periods, the seller was a partner and ECI income from the partnership for each such year has been less than 25 percent of total income (but see below).
- a certificate is given by the partnership itself that ECI gains would be less than 25 percent of the total gain on a deemed disposal of all its assets at fair market value.
- the transaction is one which is a non-recognition transaction for US tax purposes (for example certain tax-neutral reorganisations).
All certifications have to comply with certain formalities, including a statement that they are provided upon penalty of perjury and in the case of certificates from the seller, must include a US taxpayer identification number. In practice, therefore, while it might appear straightforward for a seller or a GP to provide the documentation, this may still put off European sellers and GPs who are otherwise unexposed or unfamiliar with the IRS. There is also uncertainty over the ability to rely on the certificate in the third bullet where certain US forms are not available in relation to the partnership being transferred.
Secondaries investors and sellers will want to review portfolios in advance of transactions to assess the risk of this withholding applying and ensure that, where it could apply, the contracts allocate the risk appropriately.
James McCredie is a London-based partner at Macfarlanes who leads the limited partner practice for the tax group. He advises on a wide range of tax matters, including the establishment of private equity, property and other investment funds. His expertise includes advising on the tax treatment of secondaries transactions in fund investments, including stapled deals.