Short before the American tax reform of December, 2017, known as Tax Cuts and Jobs Act (TCJA), the United States Tax Court had ruled the case of Grecian Magnesite Mining Indus. & Shipping Co. v. Comm’r, 149 TC No. 3 (July 13, 2017) in favor of taxpayers so there would be no tax withholding on the sale of interests in US LLCs by non-resident members.
US LLCs are companies organized in the USA whose income is taxed directly to the person who represents the member, whether a natural person or a company. The so-called LLCs are usually a format of legal entity often adopted by Brazilians and other foreigners who wish to invest in the USA. Among the reasons for the investors to warrant certain preference for the LLCs is the fact that the American taxation on income occurs only once, instead of two in the so-called corporations. Furthermore, similarly as with corporations, in the LLCs the personal assets of the members are not affected by the companies’ debts.
In December, 2017, only five months after the ruling in Grecian Magnesite, an American reform (TCJA) was approved to include Sec.1446(f) in the American revenue code, deviating from the precedent created in Grecian Magnesite, and making the withholding of 10% on the sales of interests in US LLCs by members not residing in the USA mandatory. However, it is worth stressing that the withholding shall only be mandatory when the profits are connected to what American rules call US trade or business.
It should be noted that, long before the TCJA, Sec. 1446(a) already existed, which establishes the withholding of the income connected to the United States that the LLC (or another fiscally transparent company) may have. According to this provision, 37% shall be withheld for members that are natural persons and 21% for members that are legal persons. However, until then, there were still doubts if the sale of interests in such companies would be subject to withholding, a doubt that was resolved in favor of the taxpayer with the Tax Court ruling in the Grecian Magnesite case and, a few months later, it went in the opposite direction, with the creation of Sec.1446(f).
The purchase is required to withhold 10% on the amount realized by the foreign member, that is, on the total sale value, not only on the profit. For that purpose, both the amount paid in cash, and the non-financial assets received in connection to the sale, must be calculated.
It is important to point out that Sec.1446(f)(4) stipulates that if the purchaser fails to perform the withholding, the company whose interest in on sale shall perform the legal withholding with interests. Contrary to the purchaser’s obligation to withhold that has been in force since January 29, 2021, the LLCs’ responsibility to withhold shall enter into force on January 01, 2022.
Despite the scope of the 10% withholding on the total sale value rule, the American law and the applicable regulation include exceptions that release such withholding, whether by the purchases, or by the company itself. Among such exceptions, are the existence of a W-9 form (or another USA resident status or nationality certification) regarding the member the lack of a US trade or business of the LLC during the fiscal year, the lack of profit, or even if the purchaser is actually aware of false information in the certification obtained for withholding purposes.
It should also be noted that the withholding is released when the purchaser has the seller’s certification informing that the portion of the income connected (to the USA) of the LLC, distributable to the seller and reported in the so-called schedule K-1, was lower than US$1 million in each of the 3 previous years and lower than 10% of the total amount of the distributable portion of the gross income to the seller.
In the context of reorganizations, payments characterized as earnout, the preamble of the final regulation of the sec.1446(f) rule ratifies that, in the event of exception to the withholding rule, the following payments pertaining to the same transfer shall also not be subject to withholding.
If the LLC whose interest is on sale owns real properties in the United States, the withholding liability follows different rules (and exceptions). In this case, the withholding rate shall be of 15% on the sale value.
In the American LLC’s shares are listed, there are no provisions for tax withholding if the transferor does not reside in the United States. It is expected that, in principle, as of 2023, the role of the Qualified Intermediary should be created for the purposes of withholding in such cases. The Qualified Intermediates are foreign people who, based on a contract called Qualified Intermediary Agreement, undertake before the IRS the role of withholding agents of the American tax.
As for brokers, they are required to withhold tax if the amount realized is paid to another broker that happens to be a foreign entity, or if the broker pays such realized amount to a foreign seller who is their client.
If the intermediary is a U.S. clearing organization (equivalent to the Brazilian Clearing & Depository Corporation – CBLC), there is no requirement to withhold tax on the realized amount of the sale. However, the U.S. clearing organization shall report such sales in Form 1042-S (Foreign Person’s U.S. Source Income Subject to Withholding), except if any exception is applicable.
Written by Roberto P. Vasconcellos, Senior Tax Consultant at Drummond Advisors