In early October, the US Treasury and the IRS released regulations in relation to the withholding tax imposed on the transfer of a partnership interest by a non-US person in respect of income effectively connected with a US trade or business (“ECI”).
The ECI withholding tax on transfer of partnership interests imposed under section 1446(f) of the IRS code was first introduced in 2017. In April 2018, the Treasury and IRS released a notice providing temporary guidance on the application of section 1446(f), pending publication of official regulations. Proposed regulations were published in May 2019, and following a consultation period these have now been finalised, including some of the amendments proposed in the consultation.
Since it was introduced, concerns around the application of ECI withholding tax under section 1446(f) have caused complications on secondaries deals. The issue is that the section applies very broadly to impose a 10 percent withholding tax on the consideration paid on the transfer by a non-US partner of an interest in any partnership – and potentially even those where there was no ECI (under the proposed regulations).
The 2018 Notice and the Proposed Regulations provided that no withholding was required in situations where:
- (i) the transferor certifies that the transfer of its partnership interest will not result in a gain;
- (ii) the transferor certifies that it has received less than 25 percent ECI (10 percent under the Proposed Regulations) from the partnership in the previous three taxable years, although in order to do this, the transferor must have received a Schedule K-1 (US tax reporting form), and a Form 8805 (a form only received when a partnership has reported some ECI) for each of those pervious taxable years; or
- (iii) the GP of the transferring partnership certifies that if the partnership disposed of all its assets, less than 25 percent (10 percent under the Proposed Regulations) of the resulting gain would be ECI.
Typically, a transferee on a secondaries deal would take the position that ECI withholding would apply to the purchaser price, unless one of the certificates described above could be provided.
In reality, it was virtually impossible for an investor in a non-US fund to provide such a certificate, as that investor would usually realise a gain on transfer (so the certificate as described at (i) would be impossible to provide), the partnership would not have generated ECI and therefore no Forms 8805 would have been issued (meaning the certificate described at (ii) would be impossible to provide), and GPs of non-US funds would be extremely reluctant to agree to give the certificate mentioned at (iii).
In the absence of a valid certificate, a common solution was to come to the view that no ECI withholding should apply in a fund that had generated no ECI, as section 1446(f) in the Code is specifically stated to apply only to the transfer of partnership interests where a portion of the gain on disposal would be ECI.
However, the Proposed Regulations didn’t include such an exemption and in fact were drafted such that a withholding obligation would apply even on a transfer of a partnership with no connection to the US if no certificate was provided, which had the potential to gum up the global secondaries market.
In the Final Regulations, this point has been addressed in two ways. First, a new exemption has been added for if the partnership itself certifies that it has had no ECI/was not engaged in a US trade or business in the year in question (so funds should be able to give this more easily where they have no US connection) and second, even if the fund does not want to provide that certificate, the rules have been changed to make clear that the transferee will not be liable for any withholding (or penalties, interest, etc) where it can evidence that there was no ECI gain realised by the transferor. Thus, parties to a contract will now be able to allocate risk between them and through audit trails rather than requiring a certificate in every circumstance.
The Final Regulations also make it easier for a transferor of an interest in a partnership to certify that no ECI withholding is necessary by virtue of the fact that the transferor has received less than 10 percent ECI in the previous three taxable years, as it allows a transferor to make such a certification even if it has not received a Form 8805 (ie, even if the partnership as received no ECI).
The Final Regulations should therefore now mean that the issue of ECI withholding on non-US secondaries deals becomes less difficult to manage, as it is more likely that a transferor or a GP is in a position to give comfort to a transferee by providing a certificate in line with IRS guidance or the parties can deal with the point through contract and diligence.
James McCredie is a London-based partner who advises on a wide range of tax matters. Florence Barnes is also London-based and is a solicitor who advises on UK and cross-border corporate tax issues, among others.