Participation in the resale market for venture capital funds is crucial for investors who wish to liquidate their investments earlier than initially anticipated. This requirement might be due to diverse personal or strategic financial points like a sudden demand for liquidity or a wish to rebalance one’s investment portfolio. As an increasing number of investors demonstrate a proclivity to sell shares that do not align with the designated settlement date, there is a corresponding rise in the number of prospective purchasers who are interested in acquiring these stakes.

Venture capital entities have already effectively adapted to the growing dynamism in this secondary market. They have standardized the documentation and processes to facilitate these equity transfers efficiently. Although the process is designed to be streamlined, recent regulatory changes in the U.S. have introduced some complexities. For instance, tax regulations under Section 1446(f) of the Internal Revenue Code necessitate the withholding of taxes when shares are sold by non-U.S. investors, complicating the payout process.

Suppose there is a case involving a non-U.S. investor, who is looking to divest their venture capital fund shares. According to the IRS tax guidelines, a portion of the sale proceeds must be withheld for tax purposes before distributing the remaining funds to the seller.

Tax Implications for Non-US Investors Under Section 1446(f)

In the example we discussed, where non-U.S. investor (limited partner) wants to sell their shares in a venture capital fund, they face specific tax obligations under U.S. law, particularly under Section 1446(f). This section deals with how profits from the sale are taxed if the fund itself would have made a profit in a hypothetical situation where all its assets were sold at their current market value.

Let’s break it down: suppose a non-U.S. investor sells their interest in a venture capital fund and makes a $1,000,000 profit. If the fund, in a theoretical sale of all its assets, would have made a profit where 10% of that profit was connected to U.S. business activities, then $100,000 of the investor’s $1,000,000 profit would be considered connected to U.S. business (“effectively connected income”, or “ECI”).

For U.S. investors, this ECI designation does not really change anything; they must pay U.S. taxes on all their gains regardless. However, for non-U.S. investors, whether their profit counts as ECI is crucial. If none of their profit is ECI, they typically would not owe U.S. taxes on it. But if some of the profit is ECI, as in our example, they face U.S. tax obligations.

Under Section 1446(f), when a non-U.S. investor sells their fund interest, the buyer of that interest has to act almost like a tax collector for the IRS. Specifically, the buyer must withhold 10% of the total amount the seller gains from the sale. So in our example, if a non-U.S. investor gains $1,000,000 from the sale, the buyer needs to withhold $100,000 and send it to the IRS.

If the buyer forgets or fails to withhold this amount, the venture capital fund itself is then responsible for making sure the IRS gets its due. The fund must withhold the necessary tax from any future payments it was supposed to make to the buyer related to the investment.

Moreover, the buyer has to confirm to the venture capital fund how they have met these withholding requirements. They need to provide a formal certification detailing this compliance within 10 days after the sale.

Withholding Tax Exceptions for Non-US Venture Capital Investors 

It is also important to know that there are several exceptions to these rules under Section 1446(f) that might prevent the need for withholding tax at all.

First, let’s look at exceptions related to certifications by the non-U.S. limited partner who is selling their interest. One way to avoid withholding is if this partner certifies that their sale does not result in any actual profit or gain. Essentially, if they’re not making any money from the sale, there’s no income to tax, so no withholding is necessary.

Another way is a bit more complex but comes down to the partner’s previous tax history with the fund. If the selling partner can certify that they’ve been part of the fund for the last three tax years, and during each of those years, their share of effectively connected income (ECI) was both under $1,000,000 and less than 10% of their total income from the fund, and they have correctly reported this income and paid any taxes due on it in the U.S., then withholding can be skipped. This shows the IRS that the seller has a consistent history of small-scale involvement in terms of taxable U.S. operations and compliance with U.S. tax laws.

There are also exceptions based on certifications from the venture capital fund itself. If the fund can certify that it was not engaged in any U.S. trade or business at any point during its current tax year up to the transfer date, then no withholding is required because there’s no U.S. business activity connected to any gains.

Alternatively, if the fund can prove that even if all its assets were sold at a current market value (a deemed sale), the resulting ECI would not make up more than 10% of the total gain from such a sale, or the non-U.S. partner’s share of ECI would not be moree than 10% of total income from the sale, then again, withholding is not needed. This would indicate that a connection to U.S. business activities is really minor enough not to trigger the need for tax collection.

Section 1446(f) Challenges for Non-US Investors

Applying the exceptions from withholding taxes under Section 1446(f) can be tricky and is not always so cut-and-dried, primarily due to some qualifying conditions and the need for cooperation among different parties involved.

For instance, one significant hurdle is the requirement for a non-U.S. limited partner (the seller) to have held their interest in the venture capital fund for at least three full tax years to qualify for certain exceptions. If a partner has not met this tenure requirement, they cannot use the exception related to having minimal ECI below the thresholds of $1,000,000 or 10% of their total income from the fund. This can be quite limiting, especially for newer investors who may be looking to exit earlier than this timeframe.

Additionally, the process of obtaining necessary certifications either from the non-U.S. limited partner or directly from the venture capital fund itself often requires considerable coordination and cooperation. The transferee (the buyer) relies heavily on these other parties to provide accurate and timely certifications that confirm no withholding is necessary. Any delays or inaccuracies in this process can complicate the transaction and may inadvertently lead to withholding obligations.

Moreover, if a situation arises where the required withholding was not executed by the transferee, the venture capital fund itself becomes responsible for ensuring compliance. This secondary withholding obligation necessitates the fund to know exactly how much was realized from the sale of the non-U.S. partner’s interest—a detail that the fund might not have immediate access to. This lack of information can complicate how the fund manages its subsequent distributions, particularly when it comes to withholding the correct amounts from future payments to the transferee.

Overall, while the exceptions under Section 1446(f) provide pathways to avoid withholding taxes, the actual application of these exceptions can be complex and fraught with challenges, often depending on precise documentation and the cooperative effort of all parties involved in the transaction.

Double Tax Treaty Implications

The application of double taxation treaties (DTT) may have a significant impact on the withholding tax rate stipulated by Section 1446(f) when a non-U.S. investor disposes of shares in a U.S. venture capital fund. In the absence of a tax treaty, the default rate is 10% on the gross proceeds from the sale of partnership interests by foreign partners. However, this rate can be adjusted or waived if a tax treaty between the United States and the investor’s country of residence offers more favorable terms.
The effective application of DTTs necessitates compliance with the requisite documentation and procedural requirements. For example, non-U.S. investors may be required to submit IRS Form W-8BEN in order to certify their residence in a treaty country and qualify under the “limitation of benefits” provisions of the DTT, thus enabling them to benefit from the treaty provisions. Failure to provide this form accurately and in a timely manner can result in the automatic application of the statutory withholding rate, regardless of any treaty provisions that might otherwise reduce the investor’s tax liability.