Transfer restrictions and tax in LP sales: consent, ROFR, PTP

An LP interest cannot simply be sold. The limited partnership agreement almost always requires the general partner's consent, may give the GP or other investors a right of first refusal, and often limits transfers to specified dates. In the United States, GPs also police transfers to avoid the fund being taxed as a publicly traded partnership, which caps the volume of interests that can change hands each year. Tax then follows the transfer, including US withholding on non-US sellers and capital gains treatment that in the UK looks through the partnership to its underlying assets. This article describes the general framework. It is not tax or legal advice, and a seller should take advice on its own position.

Consent, timing and rights of first refusal

Herbert Smith Freehills Kramer's guide to LP-led secondaries lists the usual LPA conditions: written GP consent, transfers only on specified dates, a possible legal opinion on the buyer's status, and seller payment of the GP's costs. Where a condition cannot be met the parties can ask for a waiver. The GP's consent is documented in a transfer agreement that the GP's counsel prepares and that seller, buyer and GP sign, under which the buyer adheres to the LPA and the seller seeks a release.

Morgan Lewis's Limited Partner Secondary Sales 101 adds the mechanics that affect timing. Many LPAs include a notice period, 30 days in its example, which the GP can waive. Where a right of first refusal exists, it must run before the sale can close, and if the holder declines, the transfer may need to close within a set window or the ROFR must be rerun. Interests that a GP refuses to transfer, or that are taken up under a ROFR, become excluded interests under the purchase agreement and the price is reduced accordingly. GP counsel fees are typically split equally between buyer and seller.

For English and Scottish limited partnerships, HSF Kramer notes that a Form LP6 and a Gazette notice are filed after transfer, usually by the GP. The commercial steps around these points are set out in how selling an LP interest works.

The US publicly traded partnership rules

A US partnership whose interests are traded on an established securities market or a substantial equivalent is taxed as a corporation. The Treasury regulations at 26 CFR 1.7704-1 provide safe harbours, and most fund LPAs are drafted so the GP can refuse any transfer that would take the fund outside them. Morgan Lewis warns that PTP-related delays can run for years in some cases and that early notice to the manager is essential.

Source: 26 CFR 1.7704-1, Legal Information Institute. The 2% test in paragraph (j) excludes transfers covered by paragraphs (e), (f) and (g).

A seller of a small interest therefore competes with other sellers for a limited annual allowance in funds relying on the 2% safe harbour, while a block transfer of more than 2% by one holder is excluded from the count.

US withholding on non-US sellers

Section 1446(f) of the US tax code requires the buyer of a partnership interest to withhold 10% of the amount realised when the seller is not a US person and any gain would be effectively connected with a US trade or business. Mayer Brown's summary of the 2020 final regulations explains that the amount realised includes relief from partnership liabilities, that the seller can avoid withholding by certifying US status on a Form W-9, and that the partnership can certify that a deemed sale of its assets would produce effectively connected gain below 10% of total gain. If the buyer fails to withhold, the partnership must withhold the shortfall from future distributions to the buyer. HSF Kramer notes that buyers, especially US structures, often require certificates or warranties on withholding even from non-US funds with no US investments, and that funds holding real estate or infrastructure may attract stamp duty or similar land transfer taxes on a change of ownership.

Capital gains: the UK look-through

In the UK, a partner disposing of an interest in a partnership is not treated as selling a single asset. HMRC's Capital Gains Manual at CG27150 summarises Statement of Practice D12: partnership dealings in chargeable assets are treated as dealings by the partners, each partner owns a fractional share of each partnership asset, and a partner whose fractional interest is reduced is treated as disposing of that reduction. A sale of an LP interest is therefore a disposal of fractional shares in the fund's underlying investments. Other jurisdictions differ, and an office with holding entities in several countries will need to map the treatment for each.

What a seller should do first

Read the transfer clause before engaging an adviser, since it sets the timetable. Tell the GP early, particularly for US funds where PTP capacity may be rationed, and prepare withholding certificates before bids are received. How these frictions compare with borrowing against the portfolio, which avoids a transfer altogether, is covered in selling versus borrowing.