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Broker Withholding on PTP Sales: New Section 1446(f) Regulations
On October 7, 2020, the IRS released final regulations governing withholding rules for transfers of partnership interests by non-U.S. transferors. Under Internal Revenue Code section 864(c)(8) enacted as part of the Tax Cuts and Jobs Act in 2017, gain or loss on the sale, exchange or disposition by a non-U.S. partner of an interest in a partnership that engaged in a U.S. trade or business could be taxed as U.S. trade or business income. Such sales or dispositions are also subject to withholding under section 1446(f).
The newly issued final regulations implement the section 1446(f) withholding rules. Different rules apply to non-publicly traded partnerships versus publicly traded partnerships (PTPs) under the regulations. For non-publicly traded partnerships, withholding generally is imposed on the transferee, though the partnership itself may have to withhold under certain situations. For transfers of PTPs, where the transferee will generally not know the transferor, the obligation to withhold is imposed on the broker.
For financial accounts, brokers, custodians, and other financial institutions have been focused on PTP withholding. Pursuant Notice 2018-8, the IRS had suspended section 1446(f) withholding on transfers of PTPs pending further guidance. These new rules on PTP withholding, which will be effective for transfers and distributions made on or after January 1, 2022, will render Notice 2018-8 obsolete as of that effective date.
Overall, the section 1446(f) withholding regulations follow the framework of the proposed regulations issued last year. And while the IRS has provided some flexibility with respect to qualified intermediaries that receive payment on PTP transfers, a number of industry requests for modifications to the proposed rules was not incorporated into the final regulations. A key item is that there is no exemption for DVP trades.
Moreover, nonqualified intermediaries still will not be allowed to reduce section 1446(f) withholding by providing documentation of their underlying beneficial owners (even if some are U.S. persons). The exceptions to section 1446(f) withholding remain roughly the same as in the proposed regulations (with a few tweaks), and PTP distributions remain subject to both existing section 1446(a) withholding and new withholding under section 1446(f). Thus, a number of the operational challenges noted by industry at the time of the proposed regulations remain in the final regulations.
Given the complexity of these final regulations and only a year or so before the January 1, 2022 effective date, it will be a significant challenge over the next year to design, build and test upgrades to systems and processes that can accommodate section 1446(f) withholding and reporting on PTP transfers. Thus, initial assessments of potential section 1446(f) impact on business operations and required upgrades need to be a priority for tax operations functions that handle PTP trades.
Highlights of Withholding Rules on PTP
There is much still to digest on the new section 1446(f) regulations, but here are the highlights of the regulations as applied to PTP transfers:
1. Broker Withholding. A broker is generally required to withhold tax at a 10% rate on the amount realized on a sale, exchange or disposition of a PTP interest if it pays the amount realized to either (1) a non-U.S. customer or (2) another broker that it is required to treat as a "foreign broker."
2. PTP Distributions. Distributions to the extent they exceed cumulative net income of the PTP can also be treated as transfers subject to the 10% withholding tax. This may include, for example, return of capital distributions.
3. Effective Date. The regulations apply to transfers that occur on or after January 1, 2022.
4. Withholding on Settlement. For sales or exchanges, withholding occurs on the payment (settlement) date.
5. Clearing Organizations. The definition of brokers (as in the proposed regulations) includes clearing organizations, but clearing organizations clearing or settling a sale of a PTP interest is not required to withhold under 1446(f). However, clearing organizations acting in the role of a central counterparty are required to report on Form 1042-S sales of PTP interests that it clears or settles on a net basis as required by form instructions.
6. No DVP Exception. There is no exception for delivery versus payment (DVP) transactions. This differs from Form 1099 reporting and backup withholding rules which exempt such transactions. This raises the issue of potential increase in failed trades.
7. Qualified Intermediaries. Payments to qualified intermediaries (QIs) that assume withholding responsibility on 1446(f) transfers and U.S. branches treated as U.S. persons for this purpose are not subject to withholding. A QI can also provide withholding rate pools to the U.S. withholding agent for purposes of 1446(f) withholding or payee specific documentation. QI obligations would be governed under a rider to the QI Agreement for 2022 and a new QI Agreement beginning in 2023. QIs that assume responsibility for withholding may have obligations under PTP nominee rules. They would generally be allowed to conduct pool reporting.
8. Exceptions from Withholding. Exceptions to section 1446(f) withholding on PTP transfers have been modified slightly and now include the following:
(a) broker or customer is a U.S. person (as documented by a Form W-9)
(b) claim for exemption under a U.S. tax treaty supported by a Form W-8BEN or Form W-8BEN-E
(c) foreign dealers operating through a U.S. branch that provide a Form W-8ECI
(d) PTP provides in a qualified notice that the less than 10% effectively connected gain exception applies, which could be the case where a deemed sale of partnership assets results in less than 10% effectively connected gain or no effectively connected income or the PTP is not engaged in a U.S. trade or business
(e) No withholding if the amount is subject to backup withholding under section 3406
9. Exception on PTP Distributions. Note the prior exception relating to distributions out of current net income has been modified and incorporated as part of definition of amount realized. With respect to a distribution, amount realized is the amount of distribution decreased by the portion of the distribution attributable to cumulative net income of the PTP. This is to be provided by a qualified notice issued by the PTP.
10. Qualified Notice for less-than-10% ECG. Qualified notices relating to the less than 10% effectively connected gain exception may be relied upon for a 92-day period ending on date of transfer. Brokers can rely on the qualified notice, and PTP no longer has secondary withholding responsibilities. However, a PTP that does not make a "reasonable estimate" could be held liable for any underwithholding resulting from the notice.
11. Qualified Notice for Distributions. Qualified notices are to be posted on the PTP's websites and also delivered to registered holders that are nominees. For distributions, absent a qualified notice that specifies the amounts to be withheld for FDAP and section 1446 purposes, the broker is generally required to withhold on the distribution at the highest ordinary income tax rate applicable to the individual or corporation or the higher of the two rates where the corporate or individual status cannot be determined.
12. Foreign Partnerships and NQIs. Special rules apply to foreign partnerships and nonqualified intermediaries. Foreign partnerships can provide certification for a modified amount realized based on their partners' foreign and U.S. status. Nonqualified intermediaries though obtain no conduit treatment in this respect. Providing underlying payee documentation, whether the underlying beneficial owners are U.S. or foreign, does not appear to reduce withholding for an NQI.
13. Impact on other IRS Documents. Due to these final regulations, changes are expected in the form of a 2022 rider to the QI agreement, an updated QI agreement for 2023, updated forms - in particular Form W-8IMY for QI roles and U.S. branch responsibilities, updated instructions for Form W-8BEN/BEN-E section 1446(f) treaty claims and perhaps for Form W-8ECI foreign dealer U.S. branch operations and Form 1042-S and instructions to facilitate new section 1446(f) reporting.
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