ECI and FIRPTA

Tax issues do sometimes come up in other jurisdictions, but U.S. tax matters are by far the centre of attention in LP secondaries and also the focus of this guide. The type of taxes relevant for withholding are Effectively Connected Income (ECI) as per Sec. 1446(f) and FIRPTA (Foreign Investment in Real Property Tax Act) as per Sec. 1445. The purpose behind the rules is to ensure that certain types of gains derived from the U.S. are subject to U.S. taxation. As such, both ECI and FIRPTA seeks to tax the seller. However, in order to enforce the taxation, the rules make the buyer responsible for withholding part of the purchase price paid for LP interests under certain circumstances. If the buyer fails to withhold where it should have, it will become responsible for payment of the tax plus penalties and interest. In addition, if the buyer fails to withhold as required under the ECI rules, the fund in which the transfer was made will be required to withhold amounts from future distributions to the buyer.

Process Overview

In a majority of cases, it is relatively straightforward to ascertain whether or not the buyer is obliged to withhold, for instance if the seller is a U.S. taxable or tax-exempt person and provides a valid Form W-9, this confirms that no withholding is required. However, in some cases in-depth due diligence and tax analysis will be required. An overview of the key steps in determining whether tax withholding applies are in the following decision tree:

Purchase Agreement Protection

Given that ECI and FIRPTA are seller’s taxes, it would generally be considered to be an Excluded Obligation under the purchase agreement meaning that the seller will remain liable for those taxes relating to the seller’s ownership period, or the sale of the interests. Further, the seller would typically indemnify the buyer promise to indemnify may not always help where, e.g., the seller will cease to exist shortly after the sale.

In addition to that, the purchase agreement governs how the parties will go about tax withholding in connection with closing. In essence, the typical mechanism is that the buyer is provided with evidence that there is no withholding applicable. If such evidence cannot be provided, the buyer would have the right to withhold amounts from the purchase price to satisfy any withholding obligation.

The exact evidence to be provided, and what the consequence of not receiving such evidence is however often subject to negotiations between the parties. When it comes to ECI, the common position in the market is that the seller needs to provide no-ECI certification signed by either the seller or the fund. If such certificate cannot be provided, the buyer would still be obliged to close, while retaining the right to withhold as required by law.

Regarding FIRPTA, most buyers would accept a position where they do not have the right to withhold if the fund or its managers have confirmed in writing that the fund does not hold U.S. real property interests above certain thresholds.

Fund/Seller Certification & Due Diligence

When ECI withholding is potentially applicable, most sellers would in the first instance attempt to obtain a no-ECI certification from the fund. If the fund does not agree to certify, the seller would consider if it were in a position to certify itself, which typically depends on the availability of K-1s (that have been filed with the IRS).  In cases where a no-ECI certification is unavailable, the remaining option to avoid withholding is to assess the assets and income of the fund. Specifically it should be assessed whether a hypothetical sale of the fund’s assets would result in any ECI being allocated to the selling LP. After making such assessment, buyers can often be reasonably assured regarding not withholding, but it usually takes time and incurs expenses to get all detailed information from the fund to make that assessment.

When FIRPTA withholding is potentially applicable, buyers often have no choice but to assess the assets of the fund to determine whether FIRPTA withholding is required. (Historically, fund sponsors have resisted providing FIRPTA certificates.) This, too, usually takes time and incurs expenses to get all detailed information from the fund to make that assessment.

Buyer Certification

As mentioned above, the fund/its GP can under some circumstances become liable for ECI withholding tax on distributions in case the buyer has failed to withhold in connection with the transfer. To protect its own position, many GPs require the buyer and seller to sign representations and indemnities in the transfer agreements. Often the GPs also require the buyer to certify whether or not ECI withholding applies and include the evidence that the buyer has relied on in case the buyer has decided not to withhold. In cases the buyer needs to provide ECI certification, additional considerations need to be made in terms of the buyer’s position and the evidence that the buyer can rely on (for example “allocable debt” amounts of the seller may need to be checked by a buyer).

Withholding & Filing

The usual amount to be withheld for ECI is 10% of the “amount realized”, which includes the amount of cash paid, the value of other assets transferred, the amount of any liabilities assumed by the transferee or to which the fund interest is subject and the reduction in the transferor's share of partnership liabilities. For FIRPTA, the standard withholding is 15% of amount realized.

If the buyer has withheld amounts from the purchase price, they must file Form 8288 and make a payment to the IRS within 20 days after closing the transaction. The seller could thereafter claim a refund from the IRS, if applicable.   Special attention is needed when a transfer of AIVs occur as part of the main fund – these require in depth analysis.

Conclusion

Withholding tax considerations play a critical role in many LP secondary transactions, with both buyers and sellers typically seeking to avoid withholding where possible. This process often requires collaboration between the parties and coordination with the fund to assess whether withholding applies to the purchase price. While the key aspects of tax withholding outlined in this article provides a general understanding, each transaction presents unique circumstances that may require more detailed due diligence and tax analysis. Buyers must remain vigilant and ensure that all necessary certifications and filings are in place to mitigate risks and comply with U.S. tax requirements.

Disclaimer: The information provided in this article is for general informational purposes only and does not constitute legal, tax, or financial advice. Readers should consult with a qualified professional for advice tailored to their specific circumstances. DMX Partners Limited is not responsible for any actions taken based on the content herein.