New withholding rules for partnerships with foreign partners. (International Taxation)by Wittenstein, Harlan
Sec. 1446 Withholding
Under Sec. 875, a nonresident alien individual or a foreign corporation is considered to be engaged in a U.S. trade or business if they, own an interest in a partnership which is so engaged. Thus, the U.S. trade or business of the partnership is imputed to the foreign partners. Sec. 1446 was adopted by the Treasury, pursuant to TRA 86. This provision was added to the IRC to ensure that foreign persons who invest in the U.S. through a partnership paN their U.S. tax liabilities. Prior to TRA 86, many foreign persons who invested in the U.S. through partnerships did not comply with U.S. tax laws and did not pay U.S. taxes on their partnership interests. Although prior law required that a foreign partner file a U.S. tax return, the IRS found it nearly impossible to enforce the law and collect the taxes. Therefore, Congress decided to impose a withholding tax on a partnership's effectively connected income.
As originally enacted under TRA 86, withholding under Sec. 1446 was imposed on the gross amount of distributions made to foreign partners. This approach proved to be inequitable since amounts would be withheld on all distributions regardless of the fact that the partnership might not have generated any effectively connected taxable income during the taxable year. Consequently, Sec. 1446 was rewritten as part of TAMRA 88 to require withholding only when a partnership with foreign partners generates effectively connected income during the taxable year. The TAMRA version of Sec. 1446 is retroactive to the effective date of Sec. 1446 under TRA 86.
Sec. 1446, as amended, requires a partnership (either U.S. or foreign) to withhold on any portion of the partnership's effectively connected taxable income (ECTI) which is allocable under Sec. 704 to foreign partners. This provision is effective for taxable years beginning after 1987. Thus, if a U.S. or foreign partnership has any ECTI that is allocable to a foreign partner, then the partnership must pay. a withholding tax equal to the applicable percentage of the ECTI allocable to those foreign partners. The applicable percentage is normally the highest tax rate applicable under U.S. tax law to the recipient partner. In the case of a corporate partner the rate is 34%. The applicable percentage for partnerships, individuals, and estates is 28%. A foreign partner is defined for purposes of Sec. 1446, as a nonresident individual, foreign corporation, foreign partnership, or foreign trust or estate.
On April 21, 1989, the IRS issued Rev, Proc. 89-31, setting forth procedures for computing, paying, and reporting tile withholding tax based on effectively connected taxable income allocable to foreign partners. Although Rev. Proc. 89-31 sets forth different rules for withholding with respect to publicly traded partnerships, those requirements will not be addressed in this article.
Certifying Non-Foreign Status
The revenue procedure obliges tile partnership to determine whether any partner is a foreign partner subject to Sec. 1446. A partnership may rely upon a certification by a partner of non-foreign status. If a partnership relies in good faith upon a certification of non-foreign status, the partnership will not be subject to liabilities for a failure to withhold and remit amounts pursuant to Sec. 1446. These liabilities include the withholding tax and penalties and interest that would accrue upon the failure to make a timely remittance of the withholding tax. The partnership may not use the same certificate for more than three years following the Near of the partnership for which the certificate was obtained. The certification may expire earlier if the partnership obtains knowledge of the changed circumstances of a partner s status. Other means maN, be utilized to determine a partner's non-foreign status. However, if a partnership erroneously relies upon such other means, then it will not be held harmless from the previously described liabilities. To ease the burden for large partnerships, a partnership with more than 200 partners, including a publicly traded partnership that has elected to pay a withholding tax based on ECTI, max, rely upon information provided by the partners on Form 1001, Form W-8 or Form W-9. A widely held partnership that relies, in good faith, on these alternative forms will not be subject to the liabilities described above.
There is no specific form for the certification of non-foreign status but it must contain the following information:
1. A statement that the partner is not a foreign person;
2. Name of partner, U.S. identification number and address; and
3. A statement that the partner will notify the partnership within 60 days of a change to foreign status. it must also be signed under penalties of perjury.
Determination of ECTI
Since withholding is imposed on a foreign partner's share of ECTI, the determination of this withholding base is critical. ECTI is defined as the taxable income of the partnership which is effectively connected with the conduct of a trade or business in the U.S., after taking several adjustments into account. These adjustments are described below.
* Certain items described in Sec. 702(a) which are normally stated separately for individual partners must be included in ECTI. These items include capital gains and losses, Sec. 1231 gains and losses, creditable foreign taxes under Sec. 901 and certain other items;
* The partnership shall he allowed a deduction for depletion with respect to oil and gas wells, but without regard to Secs. 613 and 613A;
* There shall not be taken into account any item of income, gain, loss, or deduction to the extent allocable to any partner that is not a foreign partner; and
* A partnership shall not take into account NOL carryovers and charitable contributions.
ECTI also includes taxable income of the partnership which is treated as effectively connected. Thus, ECTI income is attributable able to a partner's election to treat real property income as effectively connected with a U.S. trade or business under IRC Secs. 871(d) or 882(d). It also includes any partnership income derived from the disposition of a U.S. real property interest which has been treated as effectively connected with the conduct of a U.S. trade or business pursuant to Sec. 897. It also includes other items of partnership income treated as effectively connected under other IRC provisions, without regard to whether those amounts are taxable to the partner. A partner's allocated share of ECTI shall not include amounts that are exempt from U.S. tax by operation of a treaty or a provision of the IRC.
Rev. Proc. 89-31 provides that the amount of an installment payment under Sec. 1446 is to be computed by applying the principles of Sec. 6655(e)(2). Under these rules, each foreign partner's share of the partnership's ECTI is annualized for purposes of determining the amount to be withheld. Partnerships are permitted to base the amount of withholding upon the prior year's ECTI. Four requirements must be satisfied in order to qualify for this safe harbor:
1. Each installment payment must equal 25% of the withholding tax that would be payable on the ECTI allocable to foreign partners for the prior year;
2. The prior taxable year must consist of 12 months;
3. A partnership tax return must have been filed for the prior taxable year; and
4. The amount of ECTI for the prior year must not be less than 50% of the ECTI shown on the annual return (discussed below) of Sec. 1446 withholding tax that must be filed for the current year.
A partnership must generally remit payments to the IRS in Philadelphia, PA, on or before the 15th day of the fourth, sixth, ninth and twelfth months of the partnership's U.S. taxable year. Any additional amounts determined to be due are to be paid with the filing of the Sec. 1446 annual return. Rev. Proc. 89-31 provides transitional rules. Payments of withholding tax that were required to have been made during 1988 under Sec. 1446 would have been considered to be timely paid if made on or before the later of june 15, 1989, or the last date for filing (including extensions) the annual return required by the revenue procedure. For partnership tax years that began and ended in 1988, the payment had to have been made along with the annual report for the partnership. For taxable years beginning in 1988 and ending in 1989, any payments that were required to be made prior to june 15, 1989, would have been treated as timely if made on or before june 15, 1989. Payments due after june 15, 1989, were to be remitted on a basis which is consistent with the general rules described above (i.e., remitted on or before the 15th daN. of the fourth, sixth, ninth and twelfth months of the partnership's taxable year).
Annual Returns are Required
Rev. Proc. 89-31 requires filing of an annual return. This filing is required of every partnership that has foreign partners and ECTI, without regard to the amount, if any, which is allocable to the foreign partners for the taxable year. Thus, the annual return is required even if all U.S. source ECTI is allocated to domestic partners. The annual return is separate from Form 1065 and should not be filed as part of Form 1065. The annual return must provide information relating to the partnership withholding agent, as well as an attachment relating to the amounts withheld for each foreign partner. A format for the annual report is provided in the revenue procedure.
Rev. Proc. 89-31 also requires that a partnership notify each foreign partner of its allocable share of Sec. 1446 tax paid to the IRS. This should be done upon the remittance of each installment payment.
Amounts withheld under Sec. 1446 will be treated as distributions to that partner on the last day of the partnership's taxable year for which it was paid. The tax withheld will he allowed as a credit against each partner's U.S. tax liability for the partner s tax year in which the partner is subject to U.S. tax on that income. Tile annual statement given to each foreign partner must he attached to the partner's tax return to receive credit for the withholding.
FDAP Also Requires Withholding
While Sec. 1446 imposes withholding upon a foreign partner's share of a partnership's ECTI, not all income generated by a partnership may constitute ECTI. A foreign partner's share of a partnership's FDAP is subject to withholding under either Secs. 1441 or 1442. In Rev. Rul. 89- 33 the IRS reiterated language contained in Treasury regulations which require that partnerships withhold upon all FDAP attributable to foreign partners regardless of the fact that such FDAP may not have been distributed to the foreign partner. Of more practical importance is Rev. Rul. 89-17, prescribing the proper time for a partnership to withhold upon FDAP which has not been distributed. Neither the IRC nor the regulations state when a partnership must withhold and pay over amounts withheld under Sec. 1441. The ruling holds that a distribution is deemed to occur under Sec. 1441 on the last day of a partnership's taxable year. Consequently, the ruling holds that withholding should occur as soon as reasonably possible following the deemed receipt of the distribution. Therefore, the ruling concludes that withholding on a foreign partner's distributive share of FDAP shall be made and paid over by the date on which Schedule K or Schedule K-1 is sent to the foreign partner. However, in any event, withholding shall be made and paid over by the fifteenth day of the third month following the close of the partnership's tax year. As, a practical matter, this payment deadline may impose an onerous burden upon widely held partnerships and tier partnerships since a partner's distributive share of FDAP may not be known until a date later than the deadline.
Arthur S. Cohen
Allocation of Foreign Income Taxes
Foreign taxes must be allocated to each separate foreign income category in computing the Sec. 904 foreign tax credit limitation. This allocation can make a significant difference in the determination of the amount of the allowable foreign tax credit. However, many practitioners have not focused on how the foreign tax allocation rules (Reg. Sec. 1.904-6, promulgated 7/15/88) can operate to the advantage of most taxpayers. As a result, significant tax benefits may be lost. Prior Law Treatment
For many years prior to TRA 86, it was standard practice to prorate foreign income taxes based on the amounts of the corporation's U.S. taxable income in each of the separate limitation categories. This generally produced reasonable results. First, under prior law, there were fewer and less significant foreign income categories. Second, with proper tax planning, any U.S. residual tax in a separate category could be reduced or eliminated without consideration of foreign income tax apportionment. However, as can be seen in the example which follows, the "standard practice" under prior law is likely to produce less than optimal results after TRA 86. Example: Prior Law
"Our Company" is a controlled foreign corporation which is principally engaged in manufacturing, although it earns a sizable amount of interest on its excess cash. All of its business is in foreign Country A" which has an income tax rate of 40%.
In the first year, "Our Company" earns $200 of income under the laws of Country A and computes a foreign income tax liability of $80. Our Company's foreign taxable income is attributable to its manufacturing operations ($100) and interest income ($100). In computing its U.S. earnings and profits, Our Company adds back a special first year depreciation allowance of $300 which it was allowed to deduct under Country A law with respect to its manufacturing activities.
Our Company's first year U.S. earnings and profits are $500 of which $400 is attributable to manufacturing activities and $100 to passive activities. Our Company prorates its foreign income tax to each category based on earnings and profits which results in $16 being allocated to the $100 of passive income (i.e., $80 x $100/ $500). Since Our Company's subpart F/passive income exceeds 5% of its gross income, the $100 of passive income is taxed to Our Company's U.S. shareholders who owe residual U.S. taxes of $18 (i.e., $100 x 34% less the $16 credit).
Applying the New Regulations
Our Company should follow Reg. Sec. 1.904-6 under which this residual U.S. tax on its shareholders would be eliminated. Reg. Sec. 1.904- 6(a)(ii) provides that if a foreign tax is related to more than one separate limitation category, the tax shall be apportioned based on the ratio of the net income in the separate category over the total net income (in all categories). Net income is computed under the tax laws of the foreign country and only includes the income which is subject to the foreign tax.
Foreign gross income is categorized based on U.S. principles. Foreign deductible expenses are allocated to each separate category as follows. First, related person interest expense must be netted against any passive income Reg. Sec. 1.904-5(c)(2). Second, expenses are directly allocated to a separate category if the foreign tax law so provides. Third, if expenses are not specifically allocated under foreign law, expenses are apportioned among separate categories if the foreign tax law so provides. Finally, any remaining expenses are allocated under U.S. principles Reg. Sec. 1.861-8 and Sec. 954(b)(5) to the extent that the foreign tax statutes do not provide for such allocation or apportionment.
Example: New Law
Using the example above, Our Company has foreign taxable income of $200. Since foreign income tax law does not differentiate between manufacturing and passive/ interest income, U.S. tax law concepts are used to properly apportion Our Company's foreign taxable income and expense to each U.S. category. As discussed above, this results in Our Company's $200 of foreign taxable income being allocated $100 to manufacturing and $100 to passive income. Our Company's foreign income tax liability is therefore apportioned to each category pro rata, or $40 to manufacturing and $ 0 to interest. The apportionment of $40 of foreign tax to the passive category will completely eliminate the residual U.S. tax which Our Company's shareholders would otherwise pay on this passive income (i.e., $100 x 34% less $40 available foreign tax credit).
The application of the rules contained in Reg. Sec. 1.904-6 should nearly always be taxpayer beneficial. This is principally due to the following. First, excess passive category credits generated in one taxable year cannot offset U.S. residual taxes in the passive category in a carryover year (under the high tax kick out rule, Secs. 904(d)(2)(A) and F)). Therefore, a taxpayer is more likely to obtain the full benefit of passive category foreign tax credits to the extent that variations in the taxpayer's effective foreign tax rate on its passive income from year to year are minimized. Second, adjustments to convert foreign taxable income to U.S. taxable income are most likely to he attributable to business income. Consequently, the amount of passive income computed under foreign and U.S. tax principles is likely to he the same. Therefore, by allocating tile foreign income tax based on the amount of foreign (instead of U.S.) table income in each separate category, the taxpayer's effective foreign tax rate on passive income is most likely to remain relatively constant. This will general' result in the maximum utilization of foreign tax credits ill the passive income category.
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