The secondary market for limited partner interests in venture capital funds has witnessed robust growth in recent years as an increasing number of existing venture fund investors seek an early exit from their positions for one reason or another (e.g., liquidity needs, portfolio rebalancing, end of their own term, etc.). That demand for an early exit has been met by an equally robust growth in secondary capital looking to acquire existing interests at a discount. For the most part, the secondary market has operated pretty efficiently as many venture funds have become accustomed to dealing with a higher number of transfer requests, particularly towards year end, and have developed template transfer and admission documents and procedures to process such requests. The relative smoothness of the secondary market has experienced some minor turbulence as of late, however, as new regulations under Section 1446(f) of the Internal Revenue Code have imposed potential withholding requirements on transfers of interests by non-US limited partners.
Withholding Obligations Under Section 1446(f)
Under US tax law, when a limited partner sells its interest in a venture capital fund and realizes a gain on such sale, a portion of such gain is treated as being effectively connected income with a US trade or business (“ECI”) if the venture capital fund would have recognized ECI on a deemed sale of its assets for their fair market value. For example, if (i) a limited partner sold its interest in a venture capital fund for a $100 gain and (ii) a deemed sale of the venture capital fund’s assets for their fair market value would have resulted in a gain of which 10% constituted ECI, then 10%, or $10, of the limited partner’s $100 gain on the sale of its interest would be treated as ECI. If the limited partner is a US limited partner, the ECI question is not really relevant, as a US limited partner will be required to report and pay tax on its gain in the US regardless. However, if the limited partner is a non-US limited partner, the ECI question is important, as a non-US limited partner would generally not be required to report and pay tax on its gain in the US if no portion of such gain was treated as ECI.
When the transferor of a venture capital fund interest is a non-US limited partner, then subject to certain exceptions as described below, Section 1446(f) effectively enlists the transferee of that interest as a collection agent for the IRS and requires the transferee to withhold 10% of the amount realized by the transferor on the transfer of its interest. Should the transferee fail to withhold when required, then the venture capital fund itself has a secondary obligation to withhold the required amount out of future distributions that are attributable to the transferred interest.
In addition, the transferee is required to certify to the venture capital fund the manner in which the withholding obligations under Section 1446(f) have been satisfied. Such certification must be provided within 10 days of the transfer in question.
Exceptions to 1446(f) Withholding Obligations
Fortunately, there are multiple exceptions potentially available under Section 1446(f) that would allow a transferee to avoid having to withhold proceeds in connection with the transfer of an interest in a venture capital fund by a non-US limited partner. Potential exceptions include the following:
Certifications by the Transferring Non-US Limited Partner
- The transferring non-US limited partner certifies that the transfer of its interest in the venture capital fund would not result in any realized gain.
- The transferring non-US limited partner certifies that:
- It was a partner in the venture capital fund for the entirety of the three tax years immediately preceding the transfer;
- Its share of ECI from the venture capital fund for each of those prior three years was (i) less than $1 million and (ii) less than 10% of such non-US limited partner’s share of gross income from the venture capital fund; and
- Its share of any ECI in each of those three prior years was timely reported on a US income tax return and all amounts due have been timely paid.
Certifications by the Venture Capital Fund
- The venture capital fund certifies that it was not engaged in a trade or business within the United States at any time during its current tax year through the date of the transfer.
- The venture capital fund certifies that a deemed sale of its assets for fair market value would either (1) not result in ECI in an amount that exceeds 10% of the venture capital fund’s gain from the deemed sale or (2) not result in the transferring non-US limited partner’s share of any ECI that would result from such deemed sale being 10% or more of such partner’s share of the venture capital fund’s gross income from such deemed sale.
Potential Difficulties in Meeting Available Exceptions
Despite the fact that multiple potential exceptions are available under Section 1446(f), depending on the circumstances, it may be difficult to qualify for an exception. For example:
- If a transferring non-US limited partner has not held its interest in the venture capital fund for three entire taxable years, then the exception whereby it could simply certify that its share of ECI from the venture capital fund has been less than $1 million or 10% of its gross income from venture capital fund would not be available.
- The transferee may need to rely on the cooperation of the transferring non-US limited partner or the venture capital fund itself in order to obtain the certifications required to alleviate the transferee’s withholding obligation.
- If a venture capital fund’s secondary withholding obligations are triggered (i.e., in the event the transferee fails to withhold when required), the fund would need to know the amount realized by the transferring non-US limited partner on the transfer of its interest in order to determine the amount the fund must withhold from future distributions to the transferee (which is information the venture fund is often not privy to).
Takeaways
The task of processing transfers of limited partner interests in venture capital funds has been made more difficult as a result of the new withholding requirements under Section 1446(f). From the venture capital fund’s perspective, it will need to make sure that it receives information from the transferee regarding the manner in which the withholding obligations under Section 1446(f) have been satisfied, because if it does not, the venture capital fund may have to withhold from future distributions to the transferee. In addition, venture capital funds should be prepared to start receive requests from transferring parties asking them to provide certifications about whether, and if so, to what extent, their activities have or would result in the generation of ECI. Historically venture capital funds have been generally reluctant to venture (no pun intended) down the path of providing certifications of this nature, but this is likely something that venture capital funds will need to revisit in light of the new withholding obligations under Section 1446(f) if they want to be supportive of non-US limited partners.
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