On May 19, 2023 the Internal Revenue Service (IRS) released AM 2023-003 (the Memo or GLAM) holding that the Foreign Investment in Real Property Tax Act's (FIRPTA's) 5% publicly traded exception (the 5% exception) applies at the partnership level and not at the partner level, potentially subjecting the partnership to additional reporting and withholding requirements with respect to its non-U.S. partners, and subjecting the non-U.S. partner to U.S. federal income taxes and reporting obligations.
The Memo describes a nonresident alien (NRA) that holds a 25% interest in a partnership (PRS) and presents two different scenarios. In the first scenario, PRS holds 8% of the outstanding stock of a publicly traded corporation (the Corp) and NRA holds no other direct or indirect interest in Corp. In the second scenario, PRS holds 4% of the outstanding stock of Corp, and NRA also directly owns 4.5% of the outstanding stock of Corp. In the first scenario PRS disposes all its interest in the Corp at a gain, and in the second NRA disposes of all its direct interest in the Corp at a gain. Corp is a U.S. real property holding corporation (USRPHC). The Memo concludes that under both scenarios, the gain is subject to the application of FIRPTA and is treated as effectively connected income.
The Memo first describes the rules under FIRPTA, which generally provide that gain or loss of a nonresident alien individual or foreign corporation from the disposition of a U.S. real property interest (USRPI) is taxed as if the gain or loss is effectively connected with a U.S. trade or business. A USRPI generally means an interest in real property located in the U.S. or the Virgin Islands and any interest (other than an interest solely as a creditor) in any U.S. corporation unless the non-U.S. person establishes that such corporation was at no time a USRPHC during the shorter of (i) the period which the foreign person held such interest or (ii) the five-year period ending on the date of the disposition of such interest (the Time Period). A USRPHC means any corporation if the fair market value of its USRPI equals or exceeds 50% of the fair market value of its (i) USRPIs, (ii) interests in real property located outside the U.S., and (iii) any other assets which are used or held for use in a trade or business. The 5% exception provides that a person who holds a 5% or less interest in a class of stock of a corporation that is regularly traded on an established securities market will not be treated as owning. Furthermore, for purposes of the 5% exception, constructive ownership rules apply, so that stock owned directly or indirectly by or for a partnership will be treated as owned proportionately by its partners.
The Memo notes that the FIRPTA rules do not define who a "person" is for purposes of the 5% exception, but that the Internal Revenue Code in another section provides that "person" includes a partnership. A partnership, though, can be viewed either as an entity or as an aggregate of its partners. The sale of a partnership interest, for example, is generally viewed as a sale of an interest in an entity, whereas the income of a partnership is treated as income of its partners. It's not always clear when the entity versus aggregate approach should be applied and the Memo examines various provisions of the Internal Revenue Code and underlying Treasury regulations dealing with the issue. The Memo then concludes that entity approach is appropriate for applying the 5% exception.
The GLAM concludes that in both scenarios, NRA's gain is effectively connected income under Section 897(a). Specifically, in the first scenario, the GLAM reasons that since PRS owns more than 5% of Corp stock, the 5% exception does not apply to the stock owned by PRS. Therefore, gain on the sale by PRS of the Corp's stock that is allocated to all the partners of PRS (including those that constructively own less than 5% of Corp) is effectively connected income. The GLAM reasons in the second scenario that since NRA is treated as owning its proportionate share of the Corp stock owned by PRS (1%) and NRA directly owns 4.5%, NRA's total ownership exceeds 5% and does not qualify for the 5% exception.
Implications of the Memo
The GLAM provides some guidance as to applying the 5% exception to stock that is held by a partnership. The guidance is helpful to taxpayers, but its value is somewhat limited given that the GLAM may not be used as precedent. Nonetheless, non-U.S. investors investing in publicly traded corporations through partnerships should review the GLAM and consider it in evaluating their positions as to whether they qualify for the 5% exception.
We note also that the conclusions in the Memo have practical implications for partnerships that own stock of publicly traded corporations, as well as for purchasers of publicly traded stock from foreign sellers. In the first scenario, PRS would be required to pay a withholding tax under Section 1446 of the Internal Revenue Code for the effectively connected income allocated to NRA. For non-U.S. partners that are not corporations, the tax rate is the highest noncorporate tax rate and for non-U.S. corporate partners the rate is the highest corporate tax rate. PRS would make the tax payment using Form 8813, and would also be required to file Form 8804 to report the total liability under Section 1446 for PRS's tax year. Form 8804 is also the transmittal form for Form 8805, which shows the amount of effectively connected income and the total tax credit allocable to the non-U.S. partner for the partnership's tax year. A separate Form 8805 is used for each non-U.S. partner. Non-U.S. partners need to attach the Form 8805 to their U.S. income tax returns to claim a withholding credit for their shares of the Section 1446 tax withheld by the partnership.
In the second scenario, NRA disposes of its direct interest in Corp stock and since that disposition is subject to FIRPTA, the proceeds from the sale would be subject to withholding under Section 1445. Section 1445 generally provides that the purchaser of a USRPI must withhold 15% of the amount realized on the disposition. The purchaser must report the amount withheld on Form 8288 and Form 8288-A, and deposit with the IRS the amount withheld by the 20th day after the transfer.
Under both scenarios, NRA will be required to file a federal income tax return reporting its gain attributable to the disposition of the Corp stock. NRA will need to attach either its Form 8805 or the stamped Copy B Form 8828-A, as applicable, to its tax return. To the extent that the withheld amount exceeds NRA's tax liability, NRA may obtain a refund.
By the issuance of the Memo, the IRS has stated its position with respect to the 5% exception and partnerships. However, the Memo does not have the force of law and the courts are not required to follow it. A taxpayer may be able to take a contrary position and argue that the 5% exception applies at the partner level and not the partnership level. A taxpayer should be aware that the IRS likely will challenge such a position, and the purchaser should tread carefully since the purchaser is the party that would be liable for the failure to withhold. We would expect that most partnerships and purchasers would be conservative and want to withhold. Furthermore, it may be good practice for partnerships that own stock in publicly traded corporations to avoid potential withholding and reporting issues to obtain representations and agreements from their non-U.S. partners that they do not and will not own directly or indirectly any of the stock that the partnership owns that could be subject to the FIRPTA rules.