In this three-minute video on effectively connected income, James McCredie, a partner at Macfarlanes who leads the secondary transactions practice for the law firm’s tax group, explains what it is, why sales involving UK and European institutional investors and funds of funds face bigger challenges and how it could stop deals.
Speed and deliverability have become increasingly important elements of secondaries transactions, but both could be affected by new rules around effectively connected income.
ECI means non-US sellers of stakes in limited partnerships that have exposure to a US trade or business – even as little as $1 – can be subject to a 10 percent tax on their realisation. What’s more, the onus to withhold the tax rests with the buyer.
In other words, if you are buying a stake in a fund, you need to seek assurance from the seller or the GP in the form of a certificate that no assets are exposed to the US, or if they are, be prepared to withhold 10 percent of the purchase price for the Internal Revenue Service.
“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,” McCredie says.
You may want to call your tax lawyer now.
What is ECI?
ECI stands for effectively connected income which is income effectively connected with a US place of business so it’s just like trading income in any other jurisdiction. It’s where you you’re making widgets in Wisconsin and if you are treated as directly making those widgets that’s effectively connected income.
How does ECI affect secondaries deals?
If you’re buying a limited partnership and that limited partnership ends an interest in another entity that makes widgets in Wisconsin and that entity is transparent then even though you’re way up the top of the structure in a fund you’re treated as actually trading in the US, as having effectively connected income in the US.
How do the new rules affect secondaries deals?
So the sale of LP interests. If that LP has gone through however many layers of structure, if there is some effectively connected income, the first change that’s been made by these rules which come in this year is that to the extent that the partnership itself would have realized the gain on the sale of its underlying assets and that gain would have been effectively connected income the sale of the partnership itself is also effectively connected income to that extent.
Who is most affected by the new rules?
So the challenge the IRS has is that because by definition the people it’s trying to charge tax are people who are not US residents they don’t have any way of collecting it. So what they’ve done is similarly to their rules for real estate transfers which is called FIRPTA which people might be familiar with, they’ve introduced a withholding regime. In fact they’ve just added it to the end of the existing regime that says if you transfer, if you buy an interest in an limited partnership from a non-US person and there’s any ECI it then you have to withhold 10 percent of the purchase price. Where you have a problem with secondaries on the side of the pond is you’re quite frequently dealing with institutional sellers or funds of funds so it might be but people who are not really engaged with the IRS and certainly have no interest in giving certificates under pain of perjury that none of these things apply. And if you can’t get certificates then you’re back into the position where you might have to withhold.
Has the new ECI rule affected pricing in deals?
I don’t think it’s affected pricing as far as I’ve seen. This is a pain in the neck. It’s something that should be fundamentally solvable. It is a situation that you can get to a position where if you can’t find a solution certainly before the certificates were available since April and in a situation where people just weren’t engaged then, it could be a problem. It could stop sales happening between particular buyers and sellers but it shouldn’t impact price.