Swiss banks, Fund Managers and Investors: What the §1446(f) Proposed Regulations Demand of Each Party
The §1446(f) Proposed Regulations for the withholding tax due on sales of designated partnership interests spreads the compliance burden across multiple Swiss market participants. Swiss banks, fund managers and investors all incur their own separate - but interrelated - duties under the new regulations released on 7 May. Satisfaction of these obligations necessitates a mixture of updated documentation, new withholding awareness and adjusted reporting processes. The following paragraphs examine the provisions and pitfalls for Swiss banks, fund managers and investors, respectively, due to the §1446(f) Proposed Regulations.
Background to IRC §1446(f) and the §1446(f) Proposed Regulations
Of the numerous substantive provisions contained in the 2017 tax bill, §864(c)(8) stands out by resolving a specific problem with a direct solution. The statutory provision overruled a US Tax Court decision from summer 2017 called Grecian Magnesite. The ruling had challenged the long-standing IRS interpretation that the sale or other disposition of an interest in a partnership that could earn effectively connected income (ECI) likewise qualifies as ECI. The new statutory provision codified the IRS interpretation: The proceeds from sales of such Specified Partnership interests are treated as effectively connected gain or loss and thus taxable by the IRS.
As such, the new provision essentially re-affirmed the substantive status quo. Except that Congress also added a new withholding dimension, imposing on any buyer of an interest subject to §864(c)(8) the obligation to withhold 10% of the gross proceeds paid to any non-US seller. The §1446(f) statutory provision, however, did not explain how that ought to work in practice, least of all for Publicly-traded Partnerships (PTPs), where the buyer and seller are typically invisible to one another. As such, the Treasury Department promptly suspended the withholding regime for PTPs. Shortly thereafter, via Notice 2018-29, the Treasury invoked a pre-existing set of regulations for withholding on US real property income to serve as a temporary bridge until Treasury could conjure an appropriate set of rules for withholding around PTPs, private equity funds and other myriad types of investments captured by the new provisions. The stop-gap rules will remain in effect until the Treasury Department publishes final regulations announcing their expiration dates (see the last section of this blogpost for further elaboration on the timeline for the §1446(f) regulations).
Previously, I addressed the preliminary and subsequent developments of §§ 864(c)(8) and 1446(f) in several blogs (available here) and at the Operational Taxes for Banks, Europe Conference in Zurich last November (available here).
Prior to last month’s release of the Proposed Regulations, however, material doubts remained as to the final rules, their impact on various affected parties and their manner of implementation. As set out below, with several crucial exceptions, those doubts are now settled.
Swiss Banks (see generally, Prop. Regs. §1.1446(f)-4)
Swiss banks will need to renovate their withholding and reporting mechanisms in order to encompass the withholding and reporting required by qualifying brokers on the sale or other disposition of in-scope PTPs by non-US Person investors. A common aim for bank associations in submitting comments to the IRS on 1446(f) was to fold the new PTP withholding regime into the existing Qualified Intermediary (QI) regime. To a large extent, they were successful as the overall structure, documentation and reporting Forms and deposit procedures are lifted from the QI regime.
However, they were not completely successful in achieving this common aim and so, major operational and legal issues will arise. The need to withhold on unpredictable sales proceeds, rather than on stable periodic income flows, will complicate the identification of withholdable payments for banks custodying PTPs. Also, and more dramatically for Swiss banks, the Form 1042-S reporting will oblige them to list sellers on a named, individuated basis - rather than on a pooled and anonymized basis - which will collide with Switzerland’s bank confidentiality laws. Several industry groups (e.g. SIFMA, the Swiss Bankers Association) submitted comment letters to the IRS explaining the fallibility of the approach as set forth in the Proposed Regulations. It is scant exaggeration to assert that the on-going viability of the PTP market in Switzerland depends on the malleability of these provisions.
Swiss Investors (see generally, Prop. Regs. §§ 1.1446(f)-1, -2)
Swiss investors will face a double-edged sword that cuts at them coming and going. When they buy a Specified Partnership interest, the obligation to withhold and report on the gross amount of sales proceeds applies. When the Swiss investors sell the same or any other Specified Partnership interest, they will need to understand the exceptions to withholding and/or the mechanics of claiming a credit for the amount withheld under 1446(f). The foremost goal for affected Swiss investors is to ensure that they are not taxed needlessly or twice under the regime. The outstanding challenge will be to calculate the correct amount of tax due per the §864(c)(8) regulations and then to navigate the multiple forms and operational pitfalls in their path to preventing inappropriate withholding and/or claiming appropriate tax credits.
Swiss Fund Managers (see generally, Prop. Regs. §§ 1.1446(f)-2, -3)
Swiss fund managers will have limited foreground duties. They need to prepare for back-stop withholding in case the buyer neglects the primary duty and to conduct primary withholding duty in the limited circumstance that a distribution from the fund is treated as sales proceeds. On the other hand, their background duties will be considerable.
The other parties mentioned above will request certain information from their fund managers and that information must be provided in the timeframe and format mandated by the IRS. Accordingly, fund managers must become fluent in a variety of official IRS Forms and unofficial notifications, statements and certifications and their correct usages. By my count, the Proposed Regulations reference 7 new or amended IRS Forms and 7 new notifications, statements or certifications, each with its own delineated purpose.
More strategically, Swiss fund managers will need to consider how and how much of the burdens imposed on the others, notably their investors, they wish to assume on their behalf. In order to preserve the market for in-scope fund offerings, fund managers may need to disencumber their clients and counterparties at their own expense.
Finally, to the extent Swiss fund managers operate over-the-top blocker corporations on behalf of their clients in Cayman or Luxembourg, these will qualify as non-US Persons for purposes of §1446(f) and be subject to the range of compliance duties set forth in the Swiss Investors’ section above.
Timeline and Action Items
One more aspect of the §1446(f) Proposed Regulations that has drawn scrutiny from commentators is the implementation schedule. As set out above, Swiss banks and fund managers must adjust or invent processes and procedures in order to cope with novel developments under §1446(f). However, rather than grant these financial institutions ample implementation leeway, the §1446(f) Proposed Regulations declare that the new rules will come into effect only 60 days following publication of the Final Regulations in the Federal Register. With the comment period window already shut, affected parties ought to anticipate Final Regulations – and the subsequent activation of this compliance regime in full - in the near term.
This aggressive timeline compels affected parties to initiate their compliance plans in advance of the publication of the Final Regulations. In so doing, they ought to consider the following concrete steps towards readiness:
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