Under section 1446 a withholding tax applies on distributions by partnerships that derive income effectively connected with a US trade or business, and a 10% withholding tax applies where interests in those partnerships are sold by a non-US person.
Summary of proposed changes to QI Agreement
On 3 May 2022, the US Internal Revenue Service (“IRS”) published Notice 2022-23 which contains proposed wording for the new Qualified Intermediary (“QI”) Agreement. The proposed modifications to the QI Agreement set out a QI’s obligations in order to comply with the provisions of section 1446(a) of the Internal Revenue Code regarding distributions from Publicly Traded Partnerships (“PTPs”) and section 1446(f) regarding the transfer of interests in a PTP. Notice 2022-23 confirms that the rules will apply from 1 January 2023 onwards. The IRS accepts comments on the proposed wording for the new QI Agreement until 31 May 2022. It is then expected that the IRS will publish the final new QI Agreement timely before 1 January 2023. The Notice does not contain any news regarding the implementation of section 871(m).
The most important aspects of the new rules are described below and in the attached diagram.
Distributions by PTPs
Under section 1446(a) a withholding tax applies on a partnership’s effectively connected income that is allocable to the partnership’s foreign partners. The rate of the withholding tax varies depending on whether the foreign partner is a corporation (currently 21%) or an individual (currently 37%). The proposed changes allow a QI to assume primary withholding responsibility on a distribution from a PTP, provided the QI assumes primary withholding responsibility for the entire distribution.
Disposal of interests in PTPs
Section 1446(f) requires the buyer of an interest in a partnership from a non-US seller to withhold and pay to the IRS 10% of the gross amount paid, if the partnership conducts a trade or business in the USA (unless one of the exceptions described below applies). Where the interest in a PTP is held with a broker (usually a bank), the withholding obligation shifts to the broker. Where a broker is a QI, compliance with the section 1446(f) rules forms part of the broker’s withholding and reporting obligations under the new QI Agreement.
In the following cases, a QI does not need to withhold 10% of the amount realized on the transfer of a PTP interest:
- The transferor of the PTP interest is a US Person;
- The partnership provides the QI with a “qualified” notice to confirm that no withholding applies;
- The transferor is exempt from US withholding taxes on relevant gains under a Double Tax Treaty (“DTT”) with the USA (transferor is required to obtain a US TIN and include it on Forms W-8);
- The QI receives a payment from another broker and the other broker already withheld the full amount.
Non-US partners will have to provide a US TIN. This is to ensure that non-US partners meet their US tax filing obligations (i.e. Form 1120-F for corporate and Form 1040-NR for individual partners) for their income and gains effectively connected with a US trade or business. In practice, many investors may not be aware of their US tax filing obligations and may therefore not yet have a US TIN.
What QI banks need to do now
Non-US banks should perform the following steps to prepare for these new rules:
- Banks should review whether their clients currently invest in PTPs that generate income effectively connected with a trade or business in the USA. Certain data providers (e.g. SIX SIS) have started including that information in their offering.
- If a bank currently allows such investments for their clients, the bank should ensure it has the possibility to identify payments in relation to the sale of PTP interests as and when they occur.
- Banks should also decide whether they will adopt primary or secondary withholding responsibility under section 1446(f) (QIs can select this regardless of whether they have primary or secondary withholding responsibility under Chapters 3 and 4). The implications will differ, depending on the approach chosen by the bank:
- Assuming primary withholding responsibility means the bank needs to ensure it has the systems in place to withhold and pay the required withholding tax to the IRS. It also needs to include the amounts paid and the tax withheld in its 1042-S reporting;
- Assuming secondary withholding responsibility and deciding to become a so-called “disclosing QI” means the bank needs to ensure it has adequate processes in place to pass up the required documentation to the partnership or broker so that the withholding can be performed by them. Importantly, a QI that acts as a disclosing QI must obtain IRS Forms W-8 (including US TIN) from each non-US partner (AML/KYC documentation is not sufficient in this case). The 1042-S reporting is performed by the partnership or broker in this case and not by the bank. If a bank does not act as a “disclosing QI”, or cannot provide US TINs for all non-US partners, the bank would need to accept the 10% withholding and would need to issue a Form 1042-S to the non-US partners.
- Banks should review constellations where they hold PTP interests for clients in the capacity of a Non-Qualified Intermediary (“NQI”). In such cases a sale of PTP interests is always subject to 10% US withholding tax, even where the bank discloses information on the partners to the partnership/ broker.
- Banks should further decide whether they want to assume primary withholding responsibility under section 1446(a) regarding distributions paid by PTP. This requires assuming primary withholding responsibility for the entire distribution and including the amounts in the bank’s 1042-S reporting. Alternatively, a bank can act as a disclosing QI and pass the required documentation to the partnership or broker, who will perform the withholding and 1042-S reporting.
- Banks should provide training to employees to ensure they understand the requirements under the new regulations and the approach taken by the bank.