The Internal Revenue Service (IRS) has now finalised rules regarding the sale of certain Partnership interests by foreign (non-US) persons. The regulations affect foreign individuals and corporations investing in Partnerships, whether domestic or foreign, that are engaged in a trade or business in the US.
Prior to 2018, neither the Internal Revenue Code (IRC) or regulations contained rules dealing with the sale of a Partnership interest by a foreign Partner. Instead, alternative approaches could be adopted, including:
- The Entity approach: This was the favoured approach for taxpayers and took the position that the sale of a Partnership interest was the sale of an interest in an entity – an investment asset as defined in the code. Apart from some specific rules dealing with underlying Partnership ‘hot assets’ and real property, the gain was generally sourced based upon where the taxpayer was resident and so, unless the taxpayer was physically present in the United States for 183 days or more, the gain could be sourced foreign and fall outside of the US tax net for the foreign Partner.
- The Aggregate approach: The IRS of course favoured a different approach, arguing that the flow-through nature of a Partnership meant that the foreign Partner had an interest in the underlying assets of the Partnership, which could result in a US-sourced effectively connected gain, subject to US tax. Their position was laid out in a revenue ruling from 1991.
- The US Office approach: A third approach argued by the IRS related to the existence of a US office and that any gain is attached to such office and so sourced to the US.
In the case of Gracian Magnesite Mining v. Commissioner (2017), the Tax court rejected the IRS’s position and concluded that the Greek company should not be subject to US tax following the disposal of a US Partnership interest. The ruling was later affirmed in June 2019 by the US court of appeals.
The IRS’ response to the Tax Court’s ruling was to enact new rules effective for sales and dispositions after November 27, 2017. Proposed regulations were published on December 27, 2018.
While there are a number of tweaks to the final and temporary regulations, particularly regarding how these rules work with other parts of the IRC and sourcing of assets, they retain the same approach and structure as the proposed regulations.
Under the IRC and regulations, sales and exchanges of Partnership interests made by non-resident aliens or a foreign corporation would now be taxable. Included within this are Partnership distributions in excess of tax basis which, under section 731, would result in a capital gain.
US tax applies to the extent the gain from a hypothetical sale of the underlying Partnership assets would be treated as effectively connected with a US trade or business and allocated to the selling Partner. This impacts both direct and indirect holdings in Partnerships. The rules apply to both US Partnerships and foreign Partnerships that have US business operations associated with a US office or permanent establishment.
The rules on how to calculate the gain associated with an effective sale of the Partnership’s assets are complex. They require a Partner to determine the amount of ‘outside’ gain or loss and then follow a three-step process to determine their share of effectively connected income on a hypothetical sale. Understanding if an asset is to be sourced to the US and generate effectively connected income is not straight forward.
Separate regulations, that have not yet been finalised, require Partnerships to withhold tax at a rate of 10% on the proceeds. It is acknowledged that non-controlling Partners will have difficulty in obtaining the information to determine the final taxable gain, particularly in determining the fair market value of assets on a hypothetical sale. However, the Treasury has stated that the withholding regulations will ‘facilitate and encourage’ the transfer of information between the Partnership and the Partner, so that the Partner may fully comply.
The final and temporary regulations look to address many of the unanswered questions in what are a complex set of rules. For Partnerships with a number of foreign Partners, the compliance burden could become overwhelming and taxpayers will struggle to obtain data that will allow them to properly calculate their taxable effectively connected gain.
If you would like advice on how these complex new rules impact your business, please get in touch with your usual Blick Rothenberg contact or one of the Partners to the right.