Proposed Major Expansion of Section 871(m) Would Tax Non-U.S. Investors that Access PTPs Through Swaps

By Stuart E. Leblang, Michael J. Kliegman, and Amy S. Elliott

On September 13, House Ways and Means Committee Chairman Richard Neal (D-MA) released his draft of proposed amendments^[1]to the tax code to pay for the $3.5 trillion FY2022 budget reconciliation bill (the Build Back Better Act).  As we mentioned in our September 14 report on the draft,^[2]one of the proposals would modify Internal Revenue Code (IRC) Section 871(m) to treat certain payments with respect to publicly traded partnerships (PTPs) and certain other partnerships as dividend equivalents.  Although the proposal is not estimated to raise much revenue (only $90 million over 10 years^[3]), it is likely to have a significant impact on certain foreign hedge funds and other non-U.S. investors that maintain substantial exposure to the U.S. PTP market through the use of notional principal contracts and other derivatives.

PTPs (which are often referred to as master limited partnerships or MLPs when the underlying business is associated with oil and gas extraction, transportation or distribution) are generally able to structure their affairs so that they avoid the entity-level taxation that applies to their public C corporation counterparts.^[4] There were approximately 65 PTPs (about 80 percent of which are MLPs) trading on U.S. exchanges as of August 24, 2021.^[5]

What Is Section 871(m)?

When a U.S. corporation pays dividends out to its shareholders, the U.S. generally treats the amount paid to any non-U.S. shareholder as U.S. source income^[6]and generally requires that 30 percent be withheld (so-called Chapter 3 withholding) from the payment and remitted to the Internal Revenue Service (IRS) (although the rate is subject to reduction pursuant to applicable tax treaties).^[7] Passive investment income such as dividend income is often referred to as FDAP (which stands for Fixed, Determinable, Annual, Periodic) income not effectively connected with a trade or business in the United States.  (Effectively connected income or ECI is subject to a separate withholding requirement.)^[8]

Some non-U.S. market participants that wanted to avoid the 30 percent Chapter 3 withholding tax decided that they could gain economic exposure to a dividend-paying stock through a swap (specifically, a total return swap or notional principal contract) with a U.S. broker.  The swap allowed them to receive the bulk of the dividend while—for tax purposes—not having to worry about the 30 percent dividend withholding (because the U.S. broker was treated as the dividend recipient, even though it passed the economics of the dividend on to the non-U.S. investor).^[9]

In 2010, lawmakers determined this dividend withholding tax avoidance strategy was inappropriate and enacted Section 871(m) to provide that payments made pursuant to such notional principal contracts should nevertheless be subject to dividend withholding tax.

The Section 871(m) regulations adopted a bright-line mechanical test for what constitutes a dividend equivalent subject to withholding.  Currently, only those potential Section 871(m) transactions with a high delta^[10]will constitute dividend equivalents subject to withholding, whereas those that fall just under the enumerated delta threshold will not.  Although the bright line is currently set to change over time as the IRS phases in the new regime, the current rule (which is in place through 2022) only requires withholding on so-called delta-one transactions (in 2023, the threshold goes down to delta 0.8).  Section 871(m) already applies to some PTPs.  The IRS issued Section 871(m) regulations in January 2017^[11]adopting special look-through rules for swaps and other derivatives involving some PTPs and MLPs that own dividend-paying U.S. equities).^[12]  The scope of these rules was limited to tax foreign investors who invest through derivatives in partnerships that indirectly receive the benefit of U.S. source dividends paid in respect of shares held directly or indirectly by such partnerships.

The Proposed Expansion of Section 871(m)

The proposal issued September 13 would statutorily broaden the application of Section 871(m) to all PTPs and MLPs.  As described by the Joint Committee on Taxation (JCT), the proposal “treats notional principal contract income calculated by reference to the U.S. source income or gain of all publicly traded partnerships, including those that are not engaged in a U.S. trade or business, as ‘dividend equivalent amounts,’ sourced based on the residence of the payor rather than the recipient.”^[13]

The proposed change is implemented by adding new paragraph (8) to Section 871(m).  Among other things, the new paragraph provides that “any payment made pursuant to a sale- repurchase transaction, or a specified notional principal contract, that is determined by reference to any income or gain in respect of an interest in a specified partnership (or any other payment the Secretary determines to be substantially similar) shall be treated as a dividend equivalent.”^[14] This language makes clear that lawmakers are seeking to treat such payments as U.S.-source dividends for purposes of applying U.S. tax treaties.

This is written broadly enough that it would impose withholding on swap payments not tied solely to distributions or allocations of taxable income.  In fact, as drafted, the proposal would force foreigners to pay tax on any swap payment determined directly or indirectly by reference to any U.S.-source income OR GAIN in respect of a reference PTP/MLP (including certain index baskets that include PTPs/MLPs).  This means that any gain on a reference PTP/MLP that is reflected in the economics of the swap would also be subject to tax to the extent the gain would be U.S.-source if the foreign investor held the PTP/MLP directly.  Although it may not be intuitive to some that foreign persons should be subject to tax on PTP/MLP share appreciation earned through a swap, it is important to note that this treatment is generally in accord with the current law tax treatment of a foreign person who has direct ownership of an PTP/MLP that is engaged in U.S. business activity.  This is distinguishable from the general treatment of foreign persons that own corporate shares, since such persons generally are not subject to U.S. tax on share appreciation (with certain exceptions for certain U.S. real property holding companies).

In this way, the proposal seeks to approximate the tax treatment a foreign person would experience if such person owned a PTP/MLP interest directly, except that the tax rate would reflect the tax rate that would have been applicable if the U.S.-source income or gain were a dividend for tax purposes (30 percent unless reduced to 15 percent for certain qualifying foreign taxpayers pursuant to certain tax treaties).^[15] Depending on your facts, this presents tax answers that can actually be more favorable than holding an interest in the PTP directly.

For example, assume a PTP is engaged in a U.S. trade or business (it holds interests in a portfolio of businesses).  Income from any gain attributable to the increased value of the businesses would be allocated and distributed out to the PTP’s partners (taxed 37 percent in the case of a foreign individual—likely higher if the reconciliation bill passes).  However, if the foreign individual decided instead to structure its exposure to the PTP by way of a swap and this proposal were enacted, then the income described above (determined by reference to gain in respect of an interest in a PTP) would be taxed as a dividend.  As compared to direct ownership, this result might actually be better for the foreign individual, who would only be subject to 30 percent withholding (potentially reduced to 15 percent pursuant to an applicable tax treaty).  Note that the answer could be better or worse for foreign corporations, as some foreign corporations could be subject to lower or higher rates under the ECI regime.^[16]

However, the fact that this proposal would force foreign persons to suffer U.S. tax in respect of the appreciation of the underlying PTP/MLP (rather than tax solely in respect of income allocations and distributions from the PTP/MLP) results in a much more significant tax burden for foreign investors as compared to the analogous rules covering swaps over dividend-paying corporate shares.  The analogous rules seek only to tax an amount equal to the economic dividend and generally do not trigger a tax on any economic benefit tied to appreciation of the shares.

The impact of this change could be significant.  Although such statistics are not publicly available, there is a belief that a large portion of PTP/MLP interests are actually held by foreigners on swap.  Because of this, there are some who are of the view that the revenue estimate is much smaller than it should be.  It is also possible that this rule could significantly impact the stock price of PTPs/MLPs to the extent that it forces foreign persons to liquidate their positions.  In fact, it is possible that this type of rule change could induce certain PTPs/MLPs to convert to taxable C corporations to maintain or increase their investor base.

MLPs May Be Harder Hit than PTPs

The proposed change treating certain payments as dividend equivalents is not as broad as it might initially seem.  It technically only applies in the case of certain income or gain realized in respect of partnerships.  If there is a payment that is determined by reference to income or gain that would otherwise be “exempt from taxes under this subtitle” or “treated as income from sources without the United States,” then—assuming implementing regulations so provide— such a payment may fall outside the reach of this broadened Section 871(m).  For example, if the income and gain would be non-U.S.-source if the partnership were directly held by a foreign person,^[17]then such income or gain generally would be exempt.

Most MLPs have income associated with U.S. oil and gas pipelines.  Because of this, it will generally be the case that MLP income and gain will be considered effectively connected with the conduct of a trade or business in the United States.^[18] (And arguably this proposal could convert such ECI into dividends subject to Chapter 3 withholding.) However, some PTPs (for example, Compass Diversified Holdings (NYSE:  CODI)) own controlling interests in various businesses, some of which have operations or conduct business outside of the United States.  In those cases, we might expect that, to the extent a payment is attributable to foreign-source income (assuming that can even be determined), it may be exempt.

Further, only delta-one transactions are subject to withholding under the current Section 871(m) dividend equivalent rules applicable to derivatives over dividend-paying corporate shares.^[19] The threshold prescribed by Treasury regulations is slated to go down to 0.8 delta in 2023.  The proposed statutory expansion of Section 871(m) to cover derivatives over PTPs/MLPs does not, by its terms, seem to include any delta limitation.  Therefore, there is a risk that any notional principal contract that references a PTP/MLP could be impacted no matter the delta.

The proposal grants Treasury clear authority to exclude non-abusive transactions, and it seems logical that Treasury would promulgate a delta-based exclusion similar to the exclusion that applies to swaps over dividend-paying corporate shares.  However, there is no certainty that such a regulation would be promulgated before the proposal starts to apply.  It is also unclear whether Treasury would elect to utilize the same delta-based exclusion (or the same delta threshold).  We note that certain banks offer derivative products in respect of dividend-paying corporate shares designed to satisfy the applicable delta threshold in order to allow foreign investors to avoid U.S. tax.  We would expect that banks would consider similar products if a delta threshold is provided in respect of PTP/MLP swaps.

Another issue with the proposal is that it applies automatically only to notional principal contracts and stock repurchase agreements in respect of PTP/MLP interests.  It arguably would only cover other derivatives such as forward contracts and options if regulations explicitly provided for such an extension.  Regulations designed to extend this type of swap anti-abuse to other derivatives already exist with respect to derivatives over corporate shares.  Two important questions are whether the IRS will extend the existing rules to generally cover derivatives in respect of PTP/MLP interests and whether such rules would be effective by the time the proposal kicks in (with respect to payments made on or after 180 days after the date of enactment).

It took the IRS several years to finally implement the current regulations in respect of corporate stock derivatives, and it is unclear whether a similar delay could occur with respect to implementation of the new proposal (although Treasury will probably try to promulgate rules fairly quickly).  We think it is relatively clear that the statutory change, as drafted, would be self- executing with respect to any PTP/MLP notional principal contract.  In contrast, the analogous rule for swaps over corporate shares was, for the most part, non self-executing and inoperable until regulations were issued.  Even though we think the application of the rule for PTP/MLP swaps is self-executing, the IRS could limit its scope by applying a delta test or other limitation on the types of swaps that are impacted.  It is harder to see how the IRS could interpret the current proposal as providing authority to delay implementation and effectiveness of the rule in respect of swaps altogether.

The number of PTPs that are not MLPs is much smaller than it was several years ago.  After the 2017 Tax Cuts and Jobs Act reduced the top corporate tax rate from 35 percent to only 21 percent, nearly all of the financial PTPs (and even some MLPs^[20]) abandoned their flow- through form of taxation, in part because it made them more attractive to a broader group of investors (and they were eligible for inclusion in more mainstream indices and related funds).^[21]

U.S. private equity firms Apollo Global Management, Inc. (NYSE:  APO), Ares Management LP (NYSE:  ARES), The Blackstone Group Inc. (NYSE:  BX), The Carlyle Group Inc. (NASDAQ:  CG) and KKR & Co. LP (NYSE:  KKR) all went from being taxed as PTPs to being taxed as corporations between 2017 and 2020.

The proposal does not target U.S. tax exempt entities that use swaps to avoid other adverse tax consequences of owning interests in PTPs/MLPs (namely, unrelated business taxable income (UBTI)).  Note also that the proposal arguably would not impact foreign sovereigns including many sovereign wealth funds that hold PTPs/MLPs on swap, because these types of taxpayers generally have an exemption with respect to U.S.-source dividends, as such dividends are considered income received from investments in domestic securities.^[22] Foreign sovereigns that hold PTPs/MLPs directly would continue to suffer a worse tax result, as such taxpayers would be subject to U.S. tax on their allocable share of PTP/MLP current earnings in respect of a PTP/MLP that is held directly rather than on swap.

Complications of Application

If this broad expansion of Section 871(m) to PTPs is enacted, the proposal gives little time for the industry to adjust, as the provision is currently drafted to be effective for “payments made on or after the date that is 180 days after the date of the enactment of this Act.”

Further, it remains unclear how exactly the withholding agent (and the taxpayer, who would be on the hook even if the withholding agent fails to comply) would determine what portion of the notional principal contract payment is attributable to income and gain determined to be dividend equivalent under the expanded Section 871(m) statute.  While the JCT description states simply that “the publicly traded partnerships themselves must provide relevant information in notices to the relevant withholding agent,”^[23]that statement may give a false impression of the complexity of the task.

^{[1] Press Release, Chairman Neal Announces Additional Days of Markup of the Build Back Better Act, House Ways and Means Committee (Sept. 13, 2021) (https://waysandmeans.house.gov/media-center/press-releases/chairman-neal-announces- additional-days-markup-build-back-better-act); for a section-by-section summary of the tax changes (Subtitle I), see https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SubtitleISxS.pdf; for the legislative text, see (starting on page 525) https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/NEAL_032_xml.pdf.}

^{[2] “Tax Provisions in Ways and Means Reconciliation Draft Could Have Far-Reaching Impacts on the Markets.”}

^{[3] JCX-42-21 (September 13, 2021) (https://www.jct.gov/publications/2021/jcx-42-21/).}

^{[4] PTPs qualify for the exception to being taxed like C corps if at least 90 percent of their income is qualifying (§7704(c)).}

^{[5] According to the Energy Infrastructure Council (https://eic.energy/uploads/mlpsonexchanges_08242021.pdf).}

^{[6] As dividend income is generally sourced to the place of incorporation of the payor.}

^{[7] See, generally, §1441(a).}

^{[8] Some FDAP income is effectively connected with a U.S. trade or business and some is not.  FDAP income that is not effectively connected is generally subject to 30% withholding tax.  FDAP income that is effectively connected is generally subject to tax rates that vary based on the recipient of the income.  In the case of partnerships, because investors in partnerships are treated as engaged in the underlying business of the partnership (IRC §875), if the partnership is a U.S. trade or business, the foreign investor could have effectively connected income or ECI (per IRC §871(b), a foreign investor is subject to U.S. federal income tax on its allocable share of the partnership’s income that is “effectively connected” with a U.S. trade or business).  When ECI is allocated to foreign partners, the partnership is required to withhold (at rates that vary based on the partner) and the partner could have a reporting obligation (https://www.irs.gov/individuals/international-taxpayers/withholding-on-specific-income).}

^{[9] Treas. Reg. §1.863-7(b)(1) generally provides that “the source of notional principal contract income shall be determined by reference to the residence of the taxpayer.”}

^{[10] The highest delta is a delta-one transaction, which is characterized as such because, at the time the notional principal contract was issued, the derivative’s value was generally calculated in a way that it matched (one-for-one) changes in the price of the underlying asset.}

^{[11] T.D. 9815; specifically, see Treas. Reg. §1.871-15(m), which provides that “[w]hen a potential section 871(m) transaction references a partnership interest, the assets of the partnership will be treated as referenced by the potential section 871(m) transaction only if the partnership carries on a trade or business of dealing or trading in securities, holds significant investments in securities (either of which is a covered partnership), or directly or indirectly holds an interest in a lower-tier partnership that is a covered partnership.” A broader rule was included in re-proposed REG-120282-10, published in the Federal Register Dec. 5, 2013, but not included in the final regulations.  Prop. Treas. Reg. §1.871-15(m)(1), provided that, absent an applicable exception, “ if a transaction references an interest in an entity that is not a C corporation . . . , the transaction references the allocable portion of any underlying security or potential section 871(m) transaction held, directly or indirectly . . . , by the referenced entity.  When a transaction references any underlying security as a result of the application of this paragraph, the transaction also references the payment of any dividends from those underlying securities and has a dividend equivalent equal to the allocable portion of any dividend or dividend equivalent received, directly or indirectly . . . , by the referenced entity.”}

^{[12] See our prior Akin Gump Tax Alert, “U.S. Withholding on Synthetic Trades over U.S. Equities (Section 871(m)) – Additional Delay of Full Implementation until 2023” (Dec. 18, 2019) (https://www.akingump.com/en/news-insights/u-s-withholding-on- synthetic-trades-over-u-s-equities-section.html).}

^{[13] JCX-43-21 (Sept. 13, 2021) (https://www.jct.gov/publications/2021/jcx-43-21/).}

^{[14] The proposed change also gives Treasury regulatory authority to provide an exception for “any contract or transaction the Secretary determines does not have the potential for tax avoidance.”}

^{[15] While Chapter 3 withholding at 30% (which can be reduced by treaty) often applies to dividends directly paid to a foreign investor, a different withholding regime (§1446, at rates that vary based on the recipient of the income) applies if a partnership has income effectively connected with a trade or business in the United States (§864) allocable to a foreign partner.  The withholding rate on ECI is designed to mimic the applicable tax rates for U.S. individuals or corporations that directly held partnership interests respectively (and generally are not eligible for reduction by treaty).}

^{[16] Foreign corporations could be subject to the 21% tax rate (likely higher if the reconciliation bill passes) plus another 30% branch profits tax in the case of certain distributed earnings.  However, the branch profits tax rate could be reduced by tax treaty.}

^{[17] Per the following language in the proposed statutory change:  “if paid to a nonresident alien individual.”}

^{[18] Under the asset use and business activities tests in Treas. Reg. §1.864-4(c), an item of FDAP income from sources within the United States can be treated as ECI if “the income, gain, or loss is derived from assets used in, or held for use in, the conduct of the trade or business in the United States” or “the activities of the trade or business conducted in the United States were a material factor in the realization of the income, gain, or loss.”}

^{[19] Treas. Reg. §1.871-15 and Notice 2020-2 (https://www.irs.gov/pub/irs-drop/n-20-02.pdf).}

^{[20] “EnLink Actively Considering Roll-Up as Evidence of Market Discount Fueling MLP-to-C Corp Conversion Trend Grows” (May 2, 2018); “Antero Resources to Restructure Its Midstream Business and Abandon MLP in Favor of a Corporate Structure” (November 9, 2018); “MLP Roll-Ups Roll On:  UGI to Acquire the 75 Percent of AmeriGas It Does Not Already Own” (April 4, 2019).}

^{[21] See our prior report “KKR to Convert to C Corporation—First Major Financial PTP to Change Legal Structure, Not Just Check- the-Box” (May 11, 2018).}

^{[22] §892(a)(1) provides, among other things, that “[t]he income of foreign governments received from--(A) investments in the United States in--(i) stocks, bonds, or other domestic securities owned by such foreign governments . . . shall not be included in gross income and shall be exempt from taxation under this subtitle.”}

^{[23] JCX-43-21 (Sept. 13, 2021) (https://www.jct.gov/publications/2021/jcx-43-21/).}