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by Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP
New York, New York
This is the sixth in a series of commentaries intended to highlight some of the questions that arise in modern practice under FIRPTA where the answers are unclear, and where the Treasury Department and the IRS could usefully provide guidance addressing a host of questions that has existed for many years. This article will focus on the application of the Code's withholding rules in situations involving partnerships having one or more partners who are foreign sovereigns entitled to the benefits of §892 of the Code. 1
1 Throughout, it will be assumed that the §892 partner is not a “controlled commercial entity,” including by reason of Regs. §1.892-5T(b)(1). But see the concluding paragraph, and a forthcoming installment on that regulation.
Two Common Situations. This article will focus on two common fact patterns where the application of the Code's withholding rules is unclear, and which require IRS guidance.
Situation One. A §892 investor, F, is a 3% limited partner in Partnership XYZ, which owns, as its sole asset, 100% of the single class of shares of stock in Corporation C, which is a U.S. real property holding corporation (a “USRPHC”) within the meaning of §897(c). Corporation C is not a “controlled commercial entity” with respect to F. 2 F sells its partnership interest in Partnership XYZ to an unrelated person, B, at a substantial gain. Must B withhold tax under §1445?
2 See the definition in §892(a)(2)(B).
Situation Two. Same facts as in Situation One, except that Partnership XYZ sells all the C shares to an unrelated party at a substantial gain, 3% of which is allocated to F. Must Partnership XYZ withhold tax under §1446 or §1445 on the allocation of the gain to F?
Situation One — Regular FIRPTA Withholding. As a matter of law, F should be exempt from U.S. tax on the sale of its partnership interest. Although §892 does not extend to sales of partnership interests, 3 the §892 regulations generally treat partnerships as aggregates. Therefore, F should be treated as selling its share of the C stock. It is clear that gain on the sale of stock of a non-controlled entity, even a USRPHC, is exempt under §892. 4
3 Regs. §1.892-3T(a)(2).
4 Regs. §1.892-3T, including -3T(b), Ex. (1).
In PLR 9643031, the IRS ruled without discussion that “[t]he disposition of an interest in [a partnership] by [a §892 entity] will not qualify for the exemption under section 892. Section 1.892-3T(a)(2).” The ruling did not state that the sale of the partnership interest was taxable to the §892 partner, and indeed it would clearly not have been, because the partnership in question owned only passive investment assets. A foreign person thus would not have been subject to tax on the sale whether or not §892 applied. To the extent the ruling somehow implies that the sale would have been taxable if the partnership had owned a USRPHC, in my view the ruling is simply wrong.
Pity the poor withholding agent B (and pity B's tax advisor even more). Section 1445(a) requires B to withhold FIRPTA tax if F is selling a U.S. real property interest (a “USRPI”). Section 897(g) provides authority to the IRS to write regulations pursuant to which F is treated as selling a USRPI to the extent F's interest is attributable to USRPIs held by the partnership (here, 100%). The regulations provide that if 50% or more of the value of the gross assets of a partnership consists of USRPIs and 90% or more consists of USRPIs plus cash, withholding will be required upon a sale by a foreign partner of his partnership interest. 5
5 Regs. §1.1445-11T.
However, another regulation issued in the same Treasury Decision contains a special rule for §892 entities. According to that regulation, a §892 entity is not subject to withholding if it “disposes of a U.S. real property interest that is not subject to taxation as specifically provided by the regulations under section 892” and presents a certificate to the buyer to such effect. 6 The clear intent of this regulation is to exempt §892 entities from FIRPTA withholding when they sell stock of a non-controlled USRPHC. But, for two reasons, it is difficult to conclude with certainty that the exemption applies where the §892 entity is selling a partnership interest.
6 Regs. §1.1445-10T(b)(1).
First, the §892 regulations arguably do not “specifically provide” an exemption that covers this case. Those regulations state that the sale of a partnership interest is not covered by §892; it is only by proper application of the aggregate theory (which by the way is embedded in the FIRPTA withholding regulations) that one can conclude such a sale would be covered. Second, it is not entirely clear that the sale of a partnership interest is the sale of a USRPI; the statute merely says that it should be treated as the sale of a USRPI to the extent attributable to USRPIs. For some withholding agents, this may be enough to convince them that failure to withhold will not land them in jail. For others, the §892 seller may well be told to secure a withholding certificate from the IRS in advance of the purchase, or suffer withholding and apply for a refund.
If Partnership XYZ is a publicly traded partnership (a “PTP”), the regulations extend the benefit of the publicly traded USRPHC rules to the partnership. Under Regs. §§1.897-1(c)(2)(iv) and 1.1445-2(c)(2), B will not be required to withhold tax as long as F owns less than 5% of the interests in Partnership XYZ. Moreover, the §892 regulations treat an interest in a PTP as a “security,” 7 although it is unclear whether that makes any difference to the analysis, since those same regulations exclude from the scope of §892 any gain from the disposition of a partnership interest. 8 The regulations are internally inconsistent. It is difficult to guess why one portion of the regulations would go out of its way to treat an interest in a PTP as a security while the preceding portion of the same regulations treats the gain from the sale of any partnership interest as outside the scope of §892.
7 Regs. §1.892-3T(a)(3).
8 Regs. §1.892-3T(a)(2) and (b), Ex. (1).
Situation Two — FIRPTA and Partnership Withholding. Both §§892 and 1445 treat a partnership as an aggregate. Therefore, one would expect that if a partnership were to sell stock of a USRPHC that was not a controlled commercial entity as to any §892 partner, that partner's share of the partnership's gain would not be subject to FIRPTA or to withholding. However, there is no clear path to arrive at such a conclusion, at least as to the absence of a withholding obligation.
When a partnership sells a USRPI, both §§1445 and 1446 apply concurrently. The relevant regulations make clear that when both Code sections apply, §1446 and the regulations thereunder “trump” §1445 and the regulations thereunder. 9 The §1446 regulations specifically refer to §892 partners, but appear to have been written by a drafter who either: (1) was unaware of the exception for sale of stock of USRPHCs; or (2) was aware of the exception, but for some reason thought it inapplicable where the partnership is the seller. Those regulations provide that “the submission of a Form W-8EXP will have no effect on whether there is a §1446 tax due with respect to such partner's allocable share of partnership ECTI.” 10
9 Regs. §1.1446-3(c)(2).
10 Regs. §1.1446-1(c)(2)(ii)(G).
Regs. §1.1445-5(c)(1)(ii) requires a partnership to withhold FIRPTA tax on any disposition of a USRPI to the extent of a foreign partner's distributive share of gain. The §1445 regulations, as noted above, contain a special rule for §892 entities. However, the exception by its terms applies only when a §892 entity sells a USRPI. And not surprisingly, §892 and the regulations thereunder are silent on the question. 11
11 The §892 regulations contain a rule that attributes a partnership's commercial activity to its partners, rendering any partner that is not an “integral part” of the foreign government a controlled commercial entity if the partnership engages in any commercial activity. Regs. §1.892-5T(d)(3). However, this rule is not implicated here, because the mere ownership of C shares is not a commercial activity.
It thus appears that Partnership XYZ must withhold a full 35% tax under §1446 on the gain allocable to F. There is no provision in the regulations for avoiding withholding by delivery of a withholding certificate or any other form of affidavit. F's sole remedy would appear to be to file a U.S. tax return and apply for a refund. 12
12 Regs. §1.1446-2(b)(2)(iii) provides that a foreign partner's allocable share of a partnership's ECI does not include income or gain exempt from U.S. tax. It can be argued that this provision excuses the general partner from withholding on the §892 partner's share of the gain. However, this provision does not appear designed to cover partner-level exemptions like §892, and the applicable operative provision (cited at footnote 10 above) appears to require withholding even where the partner is a §892 organization. Moreover, even if this provision excused withholding under §1446, there is nothing that would excuse withholding under §1445.
It should be obvious that this is an unhealthy state of affairs. It breeds contempt for the tax law and regulations. It may also encourage highly wasteful planning. Some §892 investors may insist that, before the partnership sells any non-controlled USRPHC stock, the partnership distribute in kind to the partner the number of shares allocable to it, so that the partner can sell the shares directly and benefit from §892. 13 In those cases where the USRPHC shares are not the sole asset of the partnership, and there was no intention to distribute all of the cash proceeds of the sale, or in any case in which allocations are not purely “straight up,” this will entail an undertaking by the partner to recontribute the sale proceeds back to the partnership. Talk about form over substance! What a waste!
13 Regs. §1.1445-11T(c) allows the in-kind distribution of a USRPI to be made without withholding tax.
Conclusion. It's obvious I don't think much of these regulations — or really the absence of regulations. The discontinuities presented by these simple examples can be traced to several shortcomings in the regulatory approach. First, the §892 regulations need to be rewritten from the ground up to deal comprehensively, and in an internally consistent way, with partnerships. Second, the FIRPTA regulations need to deal with foreign governments in all contexts to which FIRPTA applies, not just the few that happen to occur to the drafter. Third, although it's probably too late to say it again, the decision that was made to allow the §1446 regulations to trump the §1445 regulations was a mistake.
The narrower and more specific rule should always trump the broader rule, and Situation Two is a good illustration of the mischief that can ensue when this is not done. If we're stuck with the §1446 regulations, a new section should be added to them to deal specifically with §892, and to provide that the sale of stock of a non-controlled USRPHC will not be subject to withholding upon the receipt of a properly-filed Form W-8EXP claiming the benefits of that section. The present coordination rule of Regs. §1.1446-4(f)(4) is woefully inadequate and should be rewritten.
It is possible — but unlikely — that the strange absence of withholding tax relief in these cases is attributable to some concern on the part of the IRS that foreign investors may be claiming to be described in §892 when in fact they are not entitled to the benefits of that section. In particular, it seems possible that the IRS believed, at least at one time, that the rule of Regs. §1.892-5T(b)(1), mentioned in footnote 1, would render most partners ineligible for the exemption. If these are or were concerns, they should be abandoned. Section 892 investors take great pains to avoid the latter regulation, and it is easily avoided, once one is aware of it, by ensuring there are other assets in the investing entity. And the answer to the “false claims” concern is that we have a system designed to minimize such occurrences. In any case, ignoring the problem is not a solution.
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