The 600-plus-page GOP tax bill was signed by President Trump on December 22, 2017, becoming Public Law no. 115-97, commonly known as the Tax Cuts and Jobs Act or US tax reform. This tax reform essentially codifies, inter alia, IRS Rev. rul. 91-32 (1991-1 CB 107), which was briefly overturned by the 2017 decision of Grecian Magnesite Mining, Industrial & Shipping Co., SA (149 TC no. 3). The new rule sources to the United States the gain on an asset sale of a US partnership interest, and a 10 percent withholding is imposed on that gain. In other words, it is on the gross
amount realized, similar to FIRPTA withholding.
Rev. rul. 91-32 says that the rules in section 865(e)(2) apply to a foreign partner that has a fixed place of business in the United States:
Section 865(e)(2) provides, inter alia, that income from the sale of personal property by a nonresident will be sourced in the United States if the nonresident has a fixed place of business in the United States and if the income is attributable to such fixed place of business. A foreign partner of a partnership that is engaged in a trade or business through a fixed place of business in the United States itself has a fixed place of business in the United States, since the foreign partner is considered to be engaged in such trade or business pursuant to section 875(l). Income from the disposition of a partnership interest by the foreign partner will be attributable to the foreign partner's fixed place of business in the United States.The IRS cited section 865(e)(3) and Unger (TC Memo 1990-15, 58 TCM 1157, at 1159) to support its position that the proceeds or loss received on a disposition of an interest in a US partnership by a non-resident is sourced to the United States. The IRS thus applied an aggregate approach to a partnership, as the Code does for the sale of a FIRPTA interest. Section 897(g) says that on the sale of a partnership interest, the proceeds received that are attributable to a US real property interest are considered to be amounts received in the United States. In Grecian, the US Tax Court distinguished the aggregate and entity approaches: "The aggregate approach arises from the observation that a partnership is an aggregation of individuals, while the entity approach applies where the Code focuses on the distinct legal rights that a partner has in its interest in the partnership entity, distinct from the assets the partnership itself owns. See William S. McKee, et al., Federal Taxation of Partnerships and Partners. . . . Subchapter K adopts the entity or the aggregate approach depending on the context, and '[t]he entity approach . . . predominates in the treatment of transfers of partnership interests as transfers of interests in a separate entity rather than in the assets of the partnership."
The court also recognized that "the enactment of section 897(g) actually reinforces our conclusion that the entity theory is the general rule for the sale or exchange of an interest in a partnership. Without such a general rule, there would be no need to carve out an exception to prevent U.S. real property interests from being swept into the indivisible capital asset treatment that section 741 otherwise prescribes."
Section 741 provides that income realized on the sale of a partnership interest shall be considered a gain or loss from the sale or exchange of a capital asset. The court noted that Congress used the singular of "asset" rather than the plural. The court also cited section 731(a) in support of the entity theory that when an interest in a partnership is sold, "[a]ny gain or loss recognized under this subsection shall be considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner."
The court emphasized that the sourcing rules in sections 861-863 do not specify the source of a foreign partner's income from the sale or liquidation of its partnership interest.
The Tax Cuts and Jobs Act added to the sourcing rules in section 864(c), effective November 27, 2017. Section 864(c)(8)(A) deems a gain or loss from the sale or exchange, by a non-resident alien or foreign corporation, of an interest in a partnership engaged in a trade or business in the United States to be effectively connected with the conduct of a trade or business in the United States. The Act has also amended the Code's withholding rules: section 1446(f) is effective for sales, exchanges, and dispositions after 2017. Section 1446(f)(1) provides that if any portion of any gain on a disposition of a partnership interest was treated under section 864(c)(8) as effectively connected with the conduct of a trade or business within the United States, the transferee must deduct and withhold a 10 percent tax on the amount realized on the disposition. Two exceptions to the withholding are provided. Under the first, the seller must provide a non-foreign affidavit (section 1446(f)(2)(B)) that (1) includes the transferor's US taxpayer identification number and (2) attests that the transferor is not a foreign person. Under the second exception, similar to FIRPTA, either the seller or the buyer of the partnership interest can apply to the IRS for authority to withhold a reduced amount. Otherwise, if the buyer does not withhold, section 1446(f)(4) provides that the partnership must withhold from distributions to the transferee.
The codification of Rev. rul. 91-32 has brought complexity to the world of funds. Private equity is often structured as a limited partnership in the United States: foreign investors, including Canadian pension funds, often participate in a US fund as limited partners. Canadians must now revisit their exit strategy, which typically involved a sale of their US partnership interests. IRS guidance has not yet been provided to determine the portion of a gain from the sale of a US partnership attributable to a US trade or business. Furthermore, it is not clear how to value a partnership interest: must the entire partnership undertake an asset valuation to accommodate the sale by the 0.1 percent partner? Also, the withholding obligations of the partnership when the buyer partner fails to withhold place pressure on the partnership.
The new rules are burdensome and will ultimately require a US partnership to track all of its interests held by foreign partners if it is to be cognizant of a foreign partner's sale of an interest to another partner. The new provisions of the Code apply FIRPTA treatment to a partnership interest in the United States that is not tied to real estate. This tracking is onerous for the partnership and impedes a non-US partner from selling a US partnership interest that is not tied to US real estate to another non-US partner. One would expect that this new measure will diminish the commercial appeal of investing in a US partnership.
The Trump government succeeded in codifying Rev. rul. 91-32; the Obama government sought to do so in the government's 2012 Green Book. At the time of writing, the IRS had not provided relief from withholding on the sale of a private partnership interest as it had for certain public partnerships in IRS Notice 2018-08.
TaxChambers LLP, Toronto
TaxChambers LLP, Toronto