Private equity limited partner investors based outside the United States are now subject to tax on gains from the sale of partnership interests, the result of a provision in the tax reform package passed in December.
The move reversed a tax court decision from six months earlier that held that foreign taxpayers were not responsible for paying taxes on gains from such sales. To prevent foreign partners from trying to avoid the new tax by selling in 2017, the law is effective for transactions on or after Nov. 27, 2017.
IRS Decision Adopted
The Tax Cuts and Jobs Act of 2017 passed in December included a provision that codified an IRS position established in the early ’90s. It effectively overturned a more recent decision in a case involving a Greek mining company.
The Internal Revenue Service in 1991 ruled that a foreign LP would be subject to tax in the United States on the capital gain it recognizes from the sale of an interest in a partnership that is engaged in a U.S. trade or business.
That IRS ruling was effectively overturned by a Tax Court decision made on July 13, 2017 in a case involving Grecian Magnesite Mining, Industrial & Shipping Co. The company, a Greek mining and industrial concern, in 2008 became a founding member of Premier Magnesia LLC, which extracts magnesite from a mine in Nevada, manages its business through headquarters in Pennsylvania, and conducts all of its operations through offices and facilities within the United States.
The Tax Cuts and Jobs Act settles a 25-year debate over the taxation of foreign partners on the sale of partnership interests in the IRS’s favor.
After redeeming its membership interest, Grecian did not report any gain on its 2008 U.S. income tax return, nor did it file a tax return in 2009.
The Tax Court heard a case against Grecian and ruled that its capital gain was not U.S.-source income and not effectively connected with a U.S. trade or business. The court ultimately declined to follow the IRS’s 1991 ruling.
The provision included in the December tax reform package reversed the decision in the Grecian case, adopting the treatment in the IRS ruling (though not overturning the application of Grecian Magnesite with respect to transfers prior to the effective date). The provision in the tax law mandates that gain or loss on the sale or exchange of a partnership interest constitutes effectively connected income—income that is directly connected with a U.S. trade or business. ECI recognized by a partnership flows through to the foreign partners, who are required to pay tax on that income.
Under the new tax law, the purchaser of a partnership interest is required to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the seller certifies that the seller is not a foreign person or that none of the gain would constitute ECI. As drafted, if even $1 of the gain would constitute ECI, the transferee must withhold 10 percent of the gross proceeds from the sale. Similarly, even if the gross proceeds exceed the gain on the transfer, the transferee must withhold 10 percent of the gross proceeds. If the transferee fails to withhold, then the partnership itself must do so.
This is an extreme departure from rules related to withholding on the transfer of a partnership interest where the partnership owns U.S. real estate. In that case, withholding is not even required unless at least 50 percent of the gross assets of the partnership are composed of U.S. real property interests.
The Tax Cuts and Jobs Act settles a 25-year debate over the taxation of foreign partners on the sale of partnership interests in the IRS’s favor. In doing so, it likely increases the U.S. tax burden on foreign partners that sell partnership or LLC interests (or have such interests redeemed).
Blockers and alternative investment vehicles can move the tax and reporting obligations to corporate vehicles, away from the foreign partners, but this will not mitigate the ultimate tax liability, as most practitioners believed before the act was passed.
Moreover, withholding is required on gross proceeds from the gain if even the slightest amount of gain would be ECI. The IRS has authority to reduce this burden to, for example, reduce withholding based on the actual amount of gain, though it is questionable whether the IRS will adopt a significant threshold of ECI gain before withholding is required. The IRS also will undoubtedly adopt procedures for the remission of withheld tax to the IRS, as the current procedures—which would apply to withholding by partnerships on ECI allocable to foreign partners—do not apply to withholding by transferees of partnership interests, other than those holding U.S. real property.
Steven Bortnick is a partner in the tax practice group at Pepper Hamilton LLP. He also is a member of the firm’s investment fund industry group, which includes more than 40 attorneys with diverse backgrounds and experience devoted to the investment funds industry.