In this Ropes & Gray podcast, tax partners Adam Greenwood and Dan Kolb, and asset management partner Isabel Dische discuss the recently finalized ECI withholding regulations and their implications for secondary transactions, including both portfolio sales and fund recapitalizations.
Dan Kolb: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. I'm Dan Kolb, a tax partner based in New York and co-head of our sovereign investor practice. Joining me today are Adam Greenwood and Isabel Dische, fellow tax and asset management partners also based in our New York office. Today, we are going to be discussing the recently finalized ECI regulations and how they will apply in the secondary fund context. We will start with a bit of history and why the regulations exist. Then move on to how and when the regulations apply, the certifications used for withholding exemptions and a discussion as to how the underlying funds will respond to these rules.
Adam, do you want to start by providing some background on why these regulations exist?
Adam Greenwood: Sure. For many decades, the U.S. government took the position that if a non-U.S. person sold an interest in a partnership that was engaged in a U.S. trade or business (i.e., that the partnership had what we refer to as "ECI") the seller was subject to tax on the indirect sale of the ECI assets. While the position was logical, the underlying law was not perfect and in 2017 the U.S. lost a tax case on the subject – this case is commonly known as Grecian Magnesite.
Not taxing such income would provide non-U.S. persons with a competitive edge over American taxpayers owning interests in U.S. trades or businesses. As a result, the December 2017 tax reform bill, commonly know as the Tax Cuts and Jobs Act, provided specific authority to tax non-U.S. persons that sell interests and partnerships with ECI assets. And to ensure payment of the tax, Congress implemented a new set of withholding rules in section 1446(f) of the Code. Over the last several years, the IRS has issued various forms of preliminary guidance on these rules and in the latter half of 2020 issued final regulations.
Dan Kolb: Very generally, there are two key active parts to these regulations. First, a buyer is required to withhold on a seller unless the buyer receives one of several types of certificates providing for a specific exemption. This part of the regulations will be effective in January and will apply to January 31 transfers. Second, starting in 2022, an underlying partnership will be required to withhold on a buyer if the buyer has failed to withhold properly.
It is important to understand that the scope of these rules is much broader than you would expect. Because the U.S. government does not know if any given partnership has ECI or not, the rules apply to all partnership interest transfers regardless of whether the relevant partnership has any contact with the U.S. As an example, if a French seller sells a UK partnership interest with only UK assets to a German buyer, the rules apply unless the parties comply with certain certification requirements. Further, underlying funds will have great latitude to withhold even in cases where the ECI risk is remote and in 2022 and beyond are actually required to withhold if the parties are not eligible for a specific exemption.
Adam Greenwood: There are a number of different exemptions that may apply. U.S. sellers benefit from the easiest exception. If a seller can provide a valid IRS Form W-9, the rules do not apply.
Many non-U.S. sellers will also be able to provide a certificate to the effect that the last three K-1's from an underlying partnership they received reflected little or no ECI. The availability of this exemption has been broadened from earlier guidance to make it easier to provide in the case of non-U.S. persons holding interests in partnerships that have never had ECI. However, the Treasury Department ignored comments requesting that the three-year requirement not apply in cases where a partnership has not existed for three years or the seller has not owned the partnership interest for three years. As a result, it is impossible to use this certificate in many cases and even if a seller has held a main fund interest for many years, sellers need to consider whether a sale involves interests in an AIV that may be less than three years old and for which a seller cannot provide this certificate.
In certain cases, a seller may also provide a certificate stating that the transfer is tax free. This certificate is quite helpful in the context of contributions and distributions to other entities, but will not help directly with respect to a typical third party sale.
Dan Kolb: It is worth noting that the underlying partnership may be able to help, too, as in many cases, the underlying partnerships can also provide an exemption certificate stating that there is minimal or no ECI, or that the partnership is not engaged in a U.S. trade or business at all. This certificate could be very useful, but historically, most general partners have not been helpful with respect to transfers. Some are now providing these certificates to larger investors, but in classic secondary transactions, many are still resisting or just ignoring the requests from buyers and sellers. It will be interesting to see if the funds shift on this point as we move closer to 2022 and the requirement that the fund withhold on buyers.
If an exemption does not apply, the buyer is required to withhold 10% of the amount realized. While initially if the purchase price in a deal was $100 you might think that the buyer must withhold $10 – this may not be correct. The term "amount realized" includes both the purchase price and the seller's indirect share of partnership debt. As a result, if the purchase price is $100, and the seller's share of underlying debt is $400, 10% of the amount realized is $50. While in theory the required withholding could exceed the purchase price if there is a very substantial amount of partnership debt, the Treasury Department has clarified that a buyer never needs to withhold more than the entire purchase price. While the Treasury Department has provided some help with safe harbors, it is worth noting that it can be very hard to determine a seller's share of partnership debt, and even harder when the relevant partnership is a fund of funds or otherwise has a tiered structure.
Adam Greenwood: Sellers should also be aware that while they may benefit from a withholding exception, they are still subject to tax if the underlying partnership did actually have ECI assets. The Treasury Department has issued a complicated set of regulations with respect to how the parties calculate the relevant tax amount.
The practical application of these rules also varies considerably with respect to fund recapitalizations as opposed to classic secondary transactions. As noted earlier, a GP normally has limited concern with minimizing the withholding taxes in a classic secondary transaction—as they view permitting the transfer as an accommodation to the LP—but GP's are actively involved in recap transactions, and as a result, tend to be more accommodating.
Dan Kolb: Secondary buyers also need to exhibit substantial care with respect to the new rules because many recaps are structured as "disguised sale transactions." In a disguised sale transaction, buyers contribute the purchase price to a partnership, and the partnership redeems the selling partners. However, for U.S. tax purposes, the buyers are treated as buying interests directly from the selling LPs and are thus withholding agents. In a disguised sale recap, there can be a very large number of selling LPs – the buyers will not even know their names and most buyers will not be equipped to properly withhold on such a large number of seller's on short notice. Fortunately, because the GP's have an incentive to complete the recap, GP's will normally provide whatever certificates they can to reduce or eliminate unnecessary withholding. In cases where a regular exemption is not otherwise applicable, parties will also often work together to cause non-U.S. sellers to contribute their interests to a new Delaware limited partnership that can provide a W-9.
Finally, what happens if you fail to withhold or withhold properly? Helpfully, the new regulations make clear that the buyers can avoid liability if they can prove there was no ECI. This excuse could be very helpful in the future, and will, to some degree, reduce the need to comply with the rules in cases where they make no sense. However, we do not know how strict the IRS will be with respect to proving that no ECI existed.
Isabel Dische: As Dan noted, these rules are drafted incredibly broadly, and accordingly, secondary buyers and sellers alike will want to incorporate ECI-withholding analysis into their deal processes. A non-U.S. party that is considering a sale of fund interests will want to confirm precisely which vehicles taxed as partnerships it is invested in (including any AIVs), and gather the past three years' K-1s to be able to confirm the analysis. (A seller's agent can often help chase copies of the K-1s from the underlying funds, along with copies of the portfolio property agreements.) Where a non-U.S. seller does not have those forms, it may want to consider asking the underlying sponsor if it can give the necessary certificates.
Likewise, secondary buyers will want to make sure that the receipt of an acceptable certificate is a precondition to closing, or if they conclude withholding is required, to obtain the underlying fund's blessing of the amount withheld (particularly once the underlying fund's withholding obligation comes into effect next year).
For fund recapitalizations, parties will want to be sensitive to potential disguised sales and employ structural solutions to avoid putting the buyers in the position of having to withhold on selling LPs. As Dan noted, buyers are unlikely to be in a position to handle that withholding, and even if they could, it is not a role we'd expect most fund sponsors to want a recap buyer to assume (as, among other things, it would involve sharing a level of information about those selling LPs with the buyer that the sponsor may not want to share).
Dan Kolb: Needless to say, there's a lot to consider. Thank you, Adam and Isabel, for joining me today for this discussion, and thank you to our listeners.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.