January 11, 2018 US information reporting and withholding affected by Tax Cuts and Jobs Act The Tax Cut and Jobs Act (TCJA), which was signed into law on December 22, 2017, introduces numerous changes to US information reporting and withholding and related matters, including: — A revised backup withholding rate — Revised withholding rates on distributions to foreign partners by publicly traded partnerships (PTPs) attributable to effectively connected income — A revised withholding rate on "look-through" distributions paid by real estate investment trusts (REITs) and other qualified investment entities (QIEs) — New substantive and withholding tax on sales of certain partnership interests (with a delayed withholding tax implementation for sales of PTP interests) — Restrictions on certain IRA conversions Backup withholding rate The TCJA reduces the backup withholding rate from 28% to 24%, effective January 1, 2018. Section 3406 ties the backup withholding rate to the "fourth lowest rate of tax applicable under [Section] 1(c)." While TCJA does not amend Section 1(c) (which contains the personal income tax rates for unmarried individuals that will once again apply in 2026), it states that the revised unmarried individual rates in the TJCA should be applied when the Internal Revenue Code (Code) cross-references Section 1(c). The revised fourth lowest rate for unmarried individual tax rate is 24%. As a result, the backup withholding tax rate has been reduced from 28% to 24%.
EY observes: This change will require system updates to reflect the reduced rate, which was effective January 1, 2018. However, to the extent overwithholding occurs after December 31, 2017, and before systems can be modified, any overwithheld tax should be refundable to the account holder. PTP distribution withholding rates The TCJA reduces the withholding rates under Section 1446 on PTP distributions of effectively connected income to foreign partners. The rates decline from 35% to 21% for corporate partners and from 39.6 % to 37% for individuals and other non-corporate partners, effective January 1, 2018. These rate changes follow the changes in the corporate and individual tax rates. When the old rates in Section 1 return in 2026, the rate of tax on distributions to non-corporate partners will revert to 39.6%. The new corporate rate, on the other hand, is permanent.
EY observes: Before the TCJA, the rate of withholding on foreign partners was always greater than the statutory rate of 30% under chapters 3 and 4. Thus, it was conservative to apply the Section 1446 rates until the PTP made a "qualified notice" announcing the portion of the distribution attributable to effectively connected income. The new rates change this risk analysis for distributions to foreign corporate partners, but not for non-corporate partners. Systems will need to be updated to reflect the new withholding rates and incorporate new logic regarding how to treat distributions to corporate partners in the absence of a qualified notice. "Look-through" REIT and QIE capital gains distribution withholding rate The TCJA reduces the withholding rate on capital gain distributions from REITs or other QIEs from 35% to 21%, effective January 1, 2018. A distribution by a REIT or other QIE to a foreign person attributable to gain recognized by the QIE on the sale or exchange of US real property interests (USRPIs) may be considered a "look-through" distribution under Section 897(h) and subject to withholding under Section 1445(e)(6). The rate of withholding follows the new 21% corporate tax rate.
If a foreign investor meets certain conditions (owning not more than 10% of the relevant class of shares of a REIT or not more than 5% of the relevant class of shares of a QIE during the one-year period ending on the distribution date), and the class of shares is regularly traded on an established US securities market, the look-through distribution is taxed like a regular dividend, and thus is subject to withholding at 30% or a lower rate specified in a tax treaty. EY observes: REIT and QIE distributions were already challenging, as issuers often reclassify distributions after the end of the calendar year, close to the March 15 due date for Form 1042-S reporting. Ordinary dividends paid throughout the year are often reclassified as gain on the sale or exchange of a USRPI. Under the old rate structure, the most conservative approach was to always treat the distribution as a look-through distribution and withhold 35% on a foreign investor until it was either clear that the distribution did not represent USRPI capital gains or the investor certified that its holdings were under the relevant threshold. Now investors who do not have the benefit of a reduced treaty rate are actually better off if the distribution is treated as a look-through distribution.
Therefore, the most conservative position for a withholding agent to take is now tied to the rates that apply to the particular investor — sometimes 30%, sometimes 21%, and sometimes a treaty rate between 21% and 30%. Withholding agents will need to decide how to balance risk versus operational viability to impose appropriate withholding. Sales of partnership interests The TCJA added a substantive tax for foreign partners that have an interest in a partnership engaged in a US trade or business. The TCJA also imposes a new 10% withholding tax on the amount realized by a foreign partner on the sale of an interest in a partnership engaged in a US trade or business. Withholding also applies to redemptions of the partnership interest. As drafted, the withholding tax would apply after December 31, 2017. On December 29, 2017, however, the US Treasury and IRS issued Notice 2018-8, which suspended the 10% withholding tax requirement for PTP interests until regulations (or other guidance) are issued. Substantive tax The TCJA adds new Code Section 864(c)(8), which treats gain (and loss) from the sale of an interest in a partnership that is engaged in a US trade or business as effectively connected income to a foreign partner, to the extent the partner would receive a distributive share of the gain (or loss) on a hypothetical sale of the partnership's assets at fair market value. This provision effectively overrules Grecian Magnesite Mining, Industrial & Shipping Co. v. Commissioner, 149 T.C. No. 3 (2017) and reinstates the IRS's position under Revenue Ruling 91-32. New Section 864(c)(8) applies to sales, exchanges, or other dispositions of partnership interests on or after November 27, 2017. Foreign sellers of partnership interests must file US income tax returns to pay the new tax. Withholding tax The TCJA also adds a new provision in Section 1446(f) requiring 10% withholding on sales of partnership interests by foreign persons "if any portion of the gain (if any)" would be taxable under new Section 864(c)(8). The buyer of the partnership interest must withhold 10% of the amount realized on the disposition (i.e., the sale price, not the amount of gain) unless the selling partner provides an affidavit that it is not a foreign person or the IRS agrees in advance to a reduced amount that "will not jeopardize the collection of tax," presumably upon a showing that the tax on the gain would be less than 10% of the sale price. In the event that the buyer/new partner fails to withhold the full amount, the partnership must withhold on distributions to the new partner in an amount equal to the underwithholding, plus interest. As drafted, new Section 1446(f) requires withholding on dispositions after December 31, 2017. EY observes: The withholding tax is separate and distinct from the substantive tax. Foreign partners must file a tax return, even if subjected to the withholding tax by a broker. Partnerships will need to be aware of the interplay between the withholding tax and the substantive tax, for example, the mechanics of the partnership providing withholding tax details to the foreign partner, which will then be used for purposes of completing their tax return (and the determination of whether any additional tax is owed). Delayed withholding tax effective date The Conference Report to the TCJA makes clear that the provision is intended to apply to sales of interests in PTPs, including master limited partnerships (MLPs), but suggests that the IRS somehow address the inherent problem that the buyer of a publicly traded interest in a partnership will not know who the seller is and thus is not in a position to effectively withhold. The Treasury Department and IRS received feedback from industry groups that implementing the new withholding requirement without specific guidance presents significant operational and practical problems. Accordingly, the IRS issued Notice 2018-8, which delays withholding on sales of PTP interests until regulations are issued. Several of the challenges highlighted in the Notice include: — The need for brokers to develop (or enhance) withholding systems for when a PTP interest is sold by a foreign partner through that broker, and withholding is performed on behalf of the transferee — The inability to determine whether the partner is foreign or US, and what portion of the gain would be treated as effectively connected under Section 864(c)(8) because PTP interests are typically held in street name and transferred through a clearing house — Difficulty in determining whether withholding is required because a sale may be aggregated with other sales and purchases of partnership interests by multiple customers at the same broker The Treasury Department and the IRS intend to issue regulations (or other guidance) on how to withhold, deposit and report the tax withheld under Section 1446(f). The Notice indicates that this guidance will be prospective and allow for a transition period with "sufficient time to prepare systems and processes for compliance." EY observes: The 10% withholding tax applies to non-publicly traded interests effective January 1, 2018. This requires identifying non-PTP partnership interests, and ensuring the appropriate withholding tax is applied. Partners in non-publicly traded MLPs and other partnerships will therefore not benefit from the delay. However, Notice 2018-8 specifically requests comments on whether withholding on non-publicly traded partnership interests should also be delayed. It is therefore unclear what the current expectation of withholding on sales of these interests is without any guidance, and why full relief was not provided. The delay also does not apply to Section 864(c)(8). Therefore, the substantive tax continues to apply to sales of partnership interests on or after November 27, 2017. EY observes: Foreign partners must file returns to pay the appropriate amount of tax. The effect of the substantive tax is to treat the gain as effectively connected income. Accordingly, the substantive tax rate is determined by Section 1 (non-corporate partners) or Section 11 (corporate partners) and may be greater or less than 10% of the amount realized. Foreign investors with longstanding positions in PTPs may be surprised to learn that they owe US tax on the sale of their PTP interests, even if no tax is withheld, and this may cause them to have an economic loss, depending on the creditability of the US tax in their home countries. IRA contributions The TCJA prevents a conversion contribution to a Roth IRA from being recharacterized back into a traditional IRA, effective for tax years after 2017. Under current law, IRA contributions to one type of IRA (either traditional or Roth) can be recharacterized as a contribution to the other type of IRA before the due date of the contributor's tax return. This allows the investor to determine later whether to take a deduction for a contribution to a traditional IRA or let the investment grow without further taxation in a Roth IRA. This ability to recharacterize contributions even applied to conversions of entire traditional IRAs to Roth IRAs, allowing investors to turn back the clock if the investment performed poorly before the due date of the return. The TCJA prevents a conversion contribution to a Roth IRA from being recharacterized back into a traditional IRA. Recharacterization is still permitted, however, for other IRA contributions. ———————————————
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