On October 7, 2020, Treasury and the IRS issued final regulations under sections 864(c)(8) and 1446(f) of the tax code. Under section 864(c)(8), foreign partners are taxed on certain gains realized from a sale or redemption of an interest in a partnership that is engaged in a U.S. trade or business. This tax is enforced through the withholding provisions of section 1446(f), which generally require a purchaser of the interest to withhold from the gross sale proceeds at a rate of 10%.
Foreign partners in a partnership that is engaged in a U.S. trade or business generally are subject to U.S. net income tax on their distributive share of the partnership's net income that is "effectively connected" with that U.S. trade or business. This effectively connected income is often referred to as ECI. The tax under section 864(c)(8) generally is intended to ensure that foreign partners do not avoid being taxed on built-in ECI by selling their partnership interests before the partnership recognizes the ECI.
The final regulations largely follow the proposed regulations issued in May 2019, which we discussed here. Below is a brief summary of some of the changes made in the final regulations.
Expanded 10% Safe Harbor. Under the proposed regulations, a transferee of a partnership interest was not required to withhold tax on a foreign transferor if the partnership certified that the amount of effectively connected gain on a hypothetical sale of its assets would be less than 10% of the partnership's total net gain. The final rules expand this safe harbor by referring to the transferor's distributive share of net effectively connected gain, instead of the partnership's gain. So if, for example, a partnership has assets with significant built-in ECI but, on a hypothetical sale of its assets, all of that gain would be allocated away from the foreign partner, then the foreign partner likely can rely on the safe harbor in the final regulations.
Failure to Withhold. The final regulations provide that a transferee is not liable for failing to withhold on a foreign transferor if it establishes that the transferor had no gain under section 864(c)(8).
Exception for Non-ETB Partnerships. The final regulations contain an exception from withholding if a partnership certifies that it is not engaged in a U.S. trade or business. The regulations do not specify the form that this certification must take.
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