Withholding Tax on Sale of Partnership Interests

Transcription

1 Withholding Tax on Sale of Partnership Interests Steven D. Bortnick Partner Morgan L. Klinzing Associate March 2, 2018

2 Key = Partnership or limited liability company = Corporation = Division or unincorporated branch = Partnership treated as a corporation for US federal tax purposes 2

3 General Rules on Taxation of Foreign Corporations Investment Income 30% gross tax collected through withholding - No deductions in calculating - Rate may be reduced by a treaty Only applies to US source income No tax on portfolio interest - Generally interest (other than certain contingent interest) so long as foreign investor does not own 10% or more of the borrower (taking into account certain stock ownership attribution rules) No tax on capital gains - Exception for US real property, partnerships that hold US real property and US real property holding corporations ( USRPHCs ) - Exception for sale of partnership interests if gain on the sale of assets by the partnership would generate ECI - Exception for gains attributable to US office of foreign corporation Reductions under Treaty No US tax return if tax adequately withheld ECI 21% of net income - Deductions allowed only if tax return filed - No treaty rate reductions 30% branch profits tax on dividend equivalent amount - Can be reduced by treaty - Can be avoided when foreign corporation completely disposes of its US business May apply to foreign source income No exemption for portfolio interest No exemption for capital gains that are ECI Detailed rules apply to determine whether investment income, including foreign source investment income may be ECI If foreign investor invests in a partnership or limited liability company that derives ECI, Foreign investor will be treated as engaged in a US trade or business in the US, and subject to the net income tax on ECI - Partnership required to withhold tax 21% tax on gain on sale of US real property, partnerships that hold US real property and USRPHCs - Buyer withholds 15% tax on gross proceeds 21% tax on gain on sale of partnership interests if gain on the sale of assets by the partnership would generate ECI - Buyer or partnershop withholds 10% on gross proceeds Must file US tax return (and possibly state and local) 3

4 The (Hypothetical) Facts FP1 25% 75% USP AB = $100,000 PS PS is engaged in a trade a business in the US ( ETB ), using the following assets: FMV Basis US Real Property $ 200,000 $ 50,000 US Personal Property $ 300,000 $ 50,000 Self created goodwill $ 500, $ 1,000,000 FP1 is ETB because PS is ETB

5 What If PS Sold Assets Character of gain Full Gain Source USRPI 150,000 US ,000 US 865(c)(1) Cap Gain 500,000 US 865(d)(3) Source generally based on resident of partner. Partner is non-us, so should be foreign source 865(c)(2). Exception for 1231 property. 865(c)(1) to extent of US depreciation; remainder sourced as inventory. Exception for goodwill created in US. 865(d). ECI Analysis for 25% allocable share USRPI: always ECI 1231 gain: ECI (either under 864(c)(2) (asset test) or (c)(3) (all other USS income) Capital gain: ECI under 864(c)(2) (activity test) Impact of ECI - 1 or 11, subject to tax like US person 5

6 What If FP1 Sold Its Interest in PS? Rev. Rul Per ruling, FP1 would be subject to tax on the full $225,000 of gain ($900,000 total gain x 25% FP1 interest) as effectively connected income ( ECI ), because FP1 held only ECI assets - General rule: Income from sale of personal property by a nonresident is foreign source, unless non-resident maintains an office or fixed place of business to which the sale is attributable. Not expressly stated in ruling. - Per ruling, gain was US source income because the US office of PS is attributed to and treated as office of FP1. - Alternatively, the interest in PS was itself arguably an ECI asset, A partner in a partnership is itself engaged in the business of the partnership Gain is arguably ECI under assets use test 6

7 Private Equity Overlay ECI in PE context: - Investment in flow through operating companies - Lending business General disagreement with IRS position (i.e., only $37,500 would be taxable) Direct investor in partnership could disregard IRS position - No reporting if substantial authority for position Outside of FIRPTA, no obligation of buyer or partnership to withhold on gain on sale of partnership interest If fund sells: - If IRS is correct, gain on sale constitutes ECI - Partnership must withhold tax on ECI - Partnership, GP and responsible persons within GP have primary liability for failure to withhold (i.e., fully liable for unpaid tax and penalties) 7

8 Grecian Magnesite Mining ( GMM ) GMM, a Greek corporation, which operated in Greece, acquired a 15% interest in Premier Chemicals LLC, a tax partnership Premier s assets included USRPI and other assets used in a US trade or business of extracting, producing and distributing magnesite which it mines or extracts in the US Premier redeemed GMM s interest at a gain, made payments in 2008 and 2009 GMM did not include any redemption gain as income in its 2008 US tax return and did not file for 2009; IRS audited and asserted gain was US source ECI and is taxable Parties agreed that gain attributable to the real estate was taxable. IRS said all gain was taxable. The court agreed with the GMM. 8

9 2017 Tax Reform Grecian Magnesite case overturned by statute effective November 27, 2017 Gain from the sale of a partnership interest (US or foreign) treated as ECI - Limited to the gain that would have been ECI if partnership sold all of its assets at FMV Transferee required to withhold - If any gain would be ECI, then must withhold 10% of gross proceeds - IRS given authority to prescribe reduced withholding if it would not jeopardize collection If transferee does not withhold, partnership must withhold Withholding effective beginning January 1, 2018 IRS authorized to issue regulations or guidance to deal with tax free transfers to/from corporations 9

10 Example 1 Flow Through Struture Topco is UK, but everything flow through to US sub Topco Withholding would be required unless either - Seller provides non-foreign affidavit Midco - Topco certifies that no gain on sale of assets of US sub would constitute ECI US LLC Bidco UK Sub Presumably, not possible - Certifications presumably under penalties of perjury (similar to FIRPTA) Treaty interplay? Withholding on entire purchase price - Expect IRS regulations to provide mechanism to reduce to actual ECI - Similar to current FIRPTA rules. UK Entity US Entity Not simple task Seller required to file US tax return - Pay additional tax or claim refund 10

11 Example 2 Partnership Topco with Midco Blocker US Sub Topco Midco Bidco UK Sub Topco is a partnership, but Midco is a blocker Clearly no ECI if Topco is a mere holding company To avoid withholding either - Seller must provide nonforeign transferor affidavit or - Topco provides no ECI affidavit Presumably, easy to give UK Entity US Entity 11

12 Example 3 Topco Blocker Management Topco Midco Bidco Topco corporation for US tax purposes - Anti-Grecian statute does not apply to sale of Topco Would apply to Topco sale of Midco Sale of Topco UK - FIRPTA can not apply US LLC UK Sub UK Entity US Entity 12