The secondaries market adjusts to further changes in the US ECI withholding regime

Since 30 January 2021, practitioners in the secondaries market have adapted to the logistical challenges imposed by the US ECI withholding regime, whereby purchasers have to determine whether there is a requirement to withhold an amount of the purchase price if acquiring interests in partnerships engaged in a US trade or business from a non-US seller. Effective from 1 January 2023, changes to the US ECI withholding regime have been implemented to obligate the funds themselves to assist in applying the required withholding, adding a further level of jeopardy to those purchasers that do not get the determination right.

The US Internal Revenue Code of 1986 (the “Code”) treats the gain or loss from the disposition of an interest in a partnership that is engaged in a US trade or business by a nonresident alien individual or non-US entity as effectively connected with the conduct of that US trade or business to the extent the gain or loss is allocable to the partnership's US business assets. The Code includes a mechanism for collecting the tax imposed on such effectively connected gain. It generally requires all purchasers, both US and non-US, purchasing interests in partnerships which are engaged in a US trade or business from a non-US seller to deduct and withhold 10% of the amount realized on the transfer unless an exception applies. Applicable exceptions to withholding can be established through the provision to the purchaser of certain facts-based certificates from either the general partner of the partnership or from the seller.

Beginning 1 January 2023, the Code imposes a “secondary” or “backstop” withholding obligation on both US and non-US partnerships. Under the new provisions, partnerships must withhold from future distributions to purchasers that failed to withhold as required in connection with the acquisition of partnership interests from a non-US seller. This withholding continues until the required amount, plus interest, is withheld.

The impact of these changes will be felt heavily by secondary market participants.  Not wanting to take the risk of having withholding (and interest) deducted from future distributions, purchasers will likely be more motivated to insist on withholding a portion of the purchase price in satisfaction of the withholding obligations unless a proper exemption is documented.  Sellers, in turn, will likely feel greater pressure to confirm any applicable withholding exemptions early in the sale process, which may necessitate more engagement with fund sponsors than has historically been the case.

While many fund sponsors have historically been reluctant to provide purchasers and sellers with certificates establishing that a transfer is exempt from withholding, general partners may now be more inclined to provide such certificates when factually capable of doing so, in order to eliminate their own secondary withholding obligation. Additionally, in order to manage the risk of being under an obligation to exercise withholding against a purchaser, many funds will likely seek to update their standard form transfer agreements to include additional representations and covenants from the parties which cover satisfaction of withholding requirements under the Code. This would reinforce the pressure on the  parties (particularly the buyer) to get the analysis right at the time of acquisition.

Next steps

Your Hogan Lovells team can discuss further whether withholding may be required on any secondary transaction, and what exemption certificates may be applicable in respect of any transaction. The team can also review transfer agreements and subscription documents and liaise with general partners in considering whether any particular sale is captured by the US ECI withholding regime. 

Authored by Nancy O’Neil and Caitlin Piper.