IRS Proposes New Rules For Withholding On Interest Transfers In Certain Partnerships

The landmark U.S. tax reform legislation that was enacted at the end of 2017 contained a new federal income tax on gain realized by a foreign seller on the transfer of an interest in a partnership that is engaged in a U.S. trade or business. This measure reversed a court decision that had exempted such gains from federal income tax. In order to enforce that new tax, the legislation also included a new withholding provision under section 1446(f) of the Code, which requires a purchaser of such an interest to withhold tax from the sale proceeds at a rate of 10%. On May 7, 2019, the IRS released proposed regulations with guidance on how to apply the section 1446(f) withholding tax. The proposed regulations are potentially relevant to any foreign investor in a partnership (including a limited liability company classified as a partnership for U.S. federal tax purposes) that carries on a trade or business in the United States or otherwise realizes income effectively connected with such a trade or business (ECI).

Background

The proposed regulations follow two notices (the Notices) issued in 2018, which provided interim guidance on the application of section 1446(f) withholding.1 In addition, the Notices delayed the implementation of section 1446(f) withholding with respect to the transfer of interests in a publicly traded partnership (PTP) and with respect to distributions from a partnership to a transferee partner that failed to withhold in accordance with section 1446(f). Once the proposed regulations are finalized, they will end these delays.

The proposed regulations relate only to section 1446(f) withholding, which is essentially an advance payment of the selling partner's underlying tax on ECI resulting from the sale. The IRS issued proposed regulations on the underlying tax in December 2018.

The Proposed Regulations

The proposed regulations make important, and some surprising, changes to the interim guidance. Significant changes include the following:

The Notices provided several exceptions from section 1446(f) withholding, including (i) an exception when the partnership certifies that the amount of effectively connected gain on a hypothetical sale of a partnership's assets would be below a threshold percentage, and (ii) an exception when a transferor certifies that less than a threshold percentage of its share of the partnership's income was ECI. The proposed regulations would reduce the applicable threshold (to 10%, from 25%). The proposed...