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Treatment of gain or loss of foreign persons from sale or exchange of interests in partnerships engaged in trade or business within the Unites States
Not only does the Tax Cuts and Jobs Act impact U.S. residents and citizens, but also affects foreign partners and companies doing business in the U.S. In particular, when foreign partners sell their interest in a U.S. partnership, there are now clear U.S. tax consequences to be settled.
There has been an ongoing debate over the appropriate treatment of the gain on the sale of a partnership by a foreign person. Under general U.S. partnership tax rules, the disposition by a partner is treated as the sale of a single capital asset based on an entity treatment of the partnership. However, under a 1991 ruling (Revenue Ruling 91-32), the IRS stated that the gain or loss resulting from the foreign partner selling or exchanging their interest in the U.S. based partnership was considered effectively connected income (ECI) to the extent its assets were used in a U.S. trade or business. By looking through the partnership, the foreign partners with ECI were subject to U.S. taxation (instead of foreign sourced income not subject to U.S. tax under the entity treatment of the general partnership rules).
In a recent U.S. Tax Court case (Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, July 2017), the Court rejected this ruling and held that any gain or loss from the sale or exchange of partnership interest by a foreign partner is actually foreign-sourced income.
The Act effectively codifies the guidance provided in Revenue Ruling 91-32, under revised Section 864(c), treating the gain on the sale or exchange of the foreign partner’s interest on or after November 27, 2017 as ECI and subject to U.S. tax. This change makes accurate tracking of 704(c) built-in gain and losses significantly more important than before.
Under new Section 1446(f), the Act also requires the buyer of the partnership interest to withhold a 10% tax on the “amount realized” by the seller on the sale or transfer of the partnership interest after December 31, 2017, if the gain is ECI and the seller does not provide a certification of non-foreign status. The “amount realized” would include the seller’s share of partnership liabilities, which could result in the required withholding amount exceeding the amount of cash paid by the buyer in the sale. Further, in certain instances, it may be challenging for the buyer to determine the seller’s share of liabilities to compute the correct withholding amount. This new withholding tax obligation creates additional complications and risks for all participants.
This codification in the Act reverts the reporting for sales and exchanges of partnership interests back to the more complex system that has been used for over 15 years, creating even more complexity for those with investments in partnerships. For further discussion regarding this change, please contact your GBQ tax advisor.