Private Equity withholding regulations released

Here's the good news: The IRS referenced well-known regulations in order to implement the new withholding provision applicable to dispositions of certain partnership interests.​

Here’s the bad news: Those well-known regulations are the not very well-loved FIRPTA regulations for withholding on dispositions of US real property interests.

This blog will set out and review the following related matters:

• The background to the new statutory withholding provision;
• The questions emerging from it;
• The contents of IRS Notice 2018-29, addressing those questions; and
• The consequences for affected funds and investors in the Swiss marketplace.

Background to §§ 864(c)(8) and 1446(f)
Amongst the strategic transformations and pork barrel addenda that collectively define the 2017 tax bill, the US Congress enacted one provision, §864(c)(8) that stood out in by squarely addressing a specific problem with a mainly uncontroversial solution (see my earlier review of the new provision). In summary, the provision overruled a Tax Court decision from last summer called Grecian Magnesite. The ruling had challenged the IRS interpretation that the sale or other disposition of an interest in partnership that could earn effectively connected income (ECI) likewise qualifies as ECI. The new statutory provision codified the IRS interpretation.

In addition to affirming the IRS position, Congress added a new withholding dimension, §1446(f), obliging the buyer of an interest (referred to as the “transferee”) to withhold 10% (a seemingly arbitrary percentage) of the acquisition price from any non-US seller (referred to as the “transferor”). The amount realized is calculated via a deemed sale hypothetical - i.e. as if the partnership had sold all its assets at current FMV - in order to determine the amount, if any, of ECI it would have earned. If such withholding is not conducted by the transferee/buyer at the time of the acquisition, then the fund itself must withhold on subsequent distributions to the transferee/buyer.

The Practical Issues Arising from the Statutory Text
The statutory provisions settled the theoretical question posed by Grecian Magnesite, while generating a host of practical ones. Primarily these practical questions concern the exceptions to the withholding requirement and the determinants of the amount to be withheld, such as the following:

• How can the transferee/buyer confirm that the transferor/seller is a US Person and thus not subject to the withholding requirement?
• Where withholding is conducted, how (and how soon) must the revenue be deposited with the U.S. Treasury?
• How does the transferee/buyer report the withholding activity to the IRS?
• What if the transferor/seller enjoys no gain on the sale and, if so, how is such a loss position evidenced?
• Is there a de minimis exception if the value of the partnership’s assets yielding ECI is relatively small in proportion to the total value of the assets held by the partnership?
• What if the partnership makes a distribution to a partner in excess of the partner’s adjusted basis in the partnership interest (which is conceptually regarded as a partnership interest disposition under §731)? 
• How do the fund’s liabilities (the transferor/seller’s share of which transfers to the transferee/buyer along with the sale of the interest) affect the calculation of the amount realized and thus the withholding due?
• How is the value of the sale calculated when the partnership’s expenses were not yet allocated to the transferor/seller?
• Will the withholding rules apply (and if so, how) to a non-recognition transaction, where taxation is deferred?

Release of Notice 2018-29
The absence of any guidance on such fundamental operational matters helped persuade the US Treasury Department to swiftly suspend the application of the new withholding rules to the sale of publicly-traded partnership (PTP) interests at the end of December 2017, while inviting comments on other similarly-affected transactions. This uncertainty for the sale of non-PTP interests lingered until April, when the IRS released Notice 2018-29, addressing - in full or in part - the key questions emerging from the new statute (see list above) and inviting taxpayers to rely on the Notice until formal regulations could be prepared, proposed and published. By referencing the FIRPTA regulations as the source for guidance, supplemented by a few additions specific to the text of §864(c)(8), the IRS erected a short-term bridge across the holes in the statute.

Further, the Notice suspended the operation of the residual withholding obligations imposed on the funds themselves to withhold on subsequent distributions to any transferee/buyer that neglected to apply the 10% withholding at the time of the transaction. Finally, it waived the application of interest and penalties for any deposits due but not made prior to 31 May (tolling them until 31 May).

Despite the significant color daubed on the withholding picture by the Notice, several big questions remain outstanding. The most seismic is the treatment of PTPs. In a comment letter from SIFMA (the “voice of the [US] securities industry”) dated 2 August 2018, SIFMA outlined the impracticability of the FIRPTA-based approach to PTPs due to the current set-up for holding PTP interests, namely, the non-visibility of the relevant parties to one another. As an alternative, SIFMA proposes a system similar to the Qualified Intermediary (QI) regime for US publicly traded equities which imposes the withholding obligation on the client-facing custodian of the PTP interests, and relief for funds from any residual withholding responsibility. 

A second consideration overlooked by the Notice is the impact of the withholding regime on non-US flow-through entities with US partners/owners. This omission most notably implicates US partners in non-US funds of funds with investments through multiple tiers that ultimately yield ECI. Under international and flow-through taxation principles, such US partners are not subject to ECI taxation. Accordingly, the possibility ought to avail for the non-US partnership to provide a certification and underlying documentation that correspondingly reduces the withholding due on the disposition of lower tier partnership interests. For chapter 3 (QI) purposes, the Form W-8IMY and accompanying withholding statement collectively serve this objective. Therefore, the solution is at hand, even if not yet formally blessed by the IRS.

While more of a niche topic for non-PTP interests, doubts prevail concerning the correct treatment for the lending of partnership interests under §1058. Presumably, the general understanding for securities lending - that it does not constitute a sale or other disposition of the asset - applies to partnership interests with respect to §864(c)(8). However, the absence of any express expansion of the §1058 standard to the lending of partnership interests may distort or deter the sec lending market.

The single most outstanding question is, of course, whether the final regulations dedicated to withholding under §1446(f) will continue in this FIRPTA vein or swerve in another direction. While it would be unlikely (and ferociously vexing) for the IRS to compel the affected parties to adopt and implement a temporary withholding regime based on FIRPTA and then abandon it in favour of something else entirely for the permanent one, it is not inconceivable.

Considerations for Affected Swiss Parties
Swiss-based parties involved in US-based private equity investments may be impacted by the new rules in myriad ways depending on their specific role in such investment. Each role entails its own areas of concern, as follows:

• Swiss-based private equity fund managers/sponsors with US holdings yielding ECI, for example, need to:
  • Assess their holdings in order to identify relevant holdings and develop a sense of their risk exposure;
  • Develop the various certifications that their investors will request from them in order to evidence crucial factors, such as ECI amounts, expenses and liabilities;
  • Update their offering memoranda and other legal documentation;
  • Issue communications to investors; and
  • Begin to consider residual withholding operations for once the suspension expires for funds to withhold on subsequent distributions to neglectful transferees/buyers.
• Swiss-based, non-US investors, for example, need to:
  • Investigate their holdings by re-reviewing offering memoranda and K-1s to determine their exposure to §1446(f) withholding;
  • Evaluate the economic impacts on their investment strategies and cash flow scenarios;
  • Identify their own eligibility for withholding exceptions and prepare or obtain the certifications needed to evidence such eligibility; and
  • Set up a withholding function for acquisitions implicating §1446(f) that can determine if withholding required (i.e. request, obtain and validate relevant certifications), calculate the correct amount of withholding, withhold, deposit and report all on a strict timeline.
• Swiss-based funds of fund managers/sponsors, for example, need to:
  • Implement both sets of activities above for Swiss-based funds and Swiss-based investors;
  • Settle on an approach to self-documentation (e.g. Forms W-8IMY plus withholding statements) as a non-US flow through entity with US beneficial owners (if relevant); and
  • Conduct an historical review for any retrospective withholding due on prior acquisitions.
• Swiss-based, US investors, for example, need to:
  • Investigate their holdings by re-reviewing offering memoranda and K-1s to determine any exposure to possible §1446(f) withholding; and
  • Liaise with the fund managers in order to ensure that will not suffer undue §1446(f) withholdings as refunds will be a hassle.

In the end, the reliance on FIRPTA principles is as useful in Switzerland as elsewhere: Potentially beneficial, but mainly for those affected parties that have some experience with them. For the rest, the Notice introduced a new set of challenging regulations that will need time, resources and patience to master.