new partnership withholding rules and other international ... · pdf filenew partnership...

New Partnership Withholding Rules and Other International Compliance Issues

Transnational Taxation Network ConferenceMiami, FloridaFriday, February 17, 2006

Michael A. Silva, Esq., CPAHolland & Knight LLP

701 Brickell Avenue, Suite 3300

Miami, Florida 33131

305-789-7711

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U.S. Taxation of Foreign Persons

• The U.S. taxes foreign persons on two types of income

– U.S. source FDAPI is generally subject to U.S. tax on a gross basis (no deductions allowed) at a rate of 30%

• FDAPI includes U.S. source payments of dividends, interest, rents, royalties and other payments, but generally does not include capital gain income

– Foreign persons engaged in U.S. trade or business are taxed on a net basis (deductions are allowed) at graduated rates on income that is effectively connected (ECI) with that business

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Collection of Tax on FDAPI

• The payer of FDAPI is generally required to withhold

– Section 1441 – FDAPI of nonresident alien individuals, foreign trusts and estates

– Section 1442 – FDAPI of foreign corporations

• Rate of tax may be reduced by an income tax treaty if proper documentation is obtained

• In some cases, FDAPI may be effectively connected

• The foreign person (not earning ECI) not required to file 1040NR/1120F unless the tax liability is not covered by withholding or if a refund is due

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Collection of Tax on ECI

• Two Methods: Estimated taxes and withholding

• General Rule: Quarterly deposit of estimated taxes under section 6655

• Withholding applies in selected situations

– Section 1446 – ECTI of foreign partners

– Section 1445 – dispositions of US real property interests

– Employer withholding on ECI wages-wage tables

– 30% withholding on indep. personal services income which is ECI. Reg. §1.1441-4

• Foreign person must still file 1040NR/1120F and pay balance of tax due

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Return Requirement

• Note that if a foreign person is engaged in a U.S. trade or business, a return is required even if it did not earn any income from that activity

• If a return is not filed, the IRS may deny all deductions that might have been attributable to the activity

• Protective returns protect rights to deductions and start the statute of limitation running

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Taxation of Foreign Partners

• Section 875: Foreign partner is engaged in the US trade or business of any partnership, domestic or foreign – allocable share of partnership ECI is ECI to the partner

• Cases provide tax treaty analogue to section 875: US permanent establishment of a partnership, domestic or foreign, is attributed to foreign partner. Donroy v. US, 301 F.2d 200 (9th Cir. 1962) & Unger v. Comm., TCM 1990-15

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Need for Section 1446?

• Foreign partners in US business partnerships previously were required to file returns and deposit estimated taxes

• “The [Senate Finance] committee does not believe that a partnership's conduct of a U.S. trade or business provides any assurance that its foreign partners will comply with U.S. tax laws. In these cases, the investors are required to file U.S. tax returns and pay U.S. tax, but if they fail to do so the Service is likely to find it nearly impossible to locate them and collect the tax.” S. Rept. 313, 99th Cong. 2d Sess. 414 (1986)

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Final, Temporary and Proposed Regulations• Released May 13, 2005; published in Federal Register May 18, 2005 (Vol. 70, No. 95, pages 28702 - 45)

• Regulations effective for partnership taxable years beginning after May 18, 2005

– Partnership may elect to apply final regulations to partnership taxable years beginning after December 31, 2004

– Partnership may also elect to apply temporary regulations (dealing with special rules to reduce a partnership’s section 1446 tax) certification to partnership taxable years beginning after December 31, 2004, provided partnership also elects to apply the final regulations to those years

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Section 1446 Overview

• Partnership must pay withholding tax on foreign partner’s share of “effectively connected taxable income”

• Rate: “Highest rate of tax specified” in section 1 or section 11

• ECTI: ECI with the following adjustments:– Sec 703(a)(1) doesn’t apply

– Depletion deductions allowed but no percentage depletion under section 613

– Statute takes no account of income or other items allocable to US partners

• Statute does not consider partner level items, e.g., losses, state taxes, charitable contributions

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Section 1446: Get the Forms

• The old rules in Rev. Proc. 89-31 provided for section 1445-style certifications to determine if partner foreign or domestic

– Under prop. and final regs., partnership uses 1441 methods, i.e., Forms W-9 (US partners) and W-8BEN (foreign partners) BUT WATCH PRESUMPTION RULE!

• Treatment of foreign partners

– Amounts withheld treated as section 33 credit

– Amounts credited treated as distribution to partner

• the amount withheld either satisfies partner’s tax liability or is refunded to partner but it does not go back to partnership

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Section 1446 Basics – Installments Due

• Rev. Proc. 89-31 required 4 installments using section 6655(e)(2) annualization and final payment with annual return – see next slide

– Proposed and final regs broaden choice of annualization methods

• Safe harbor: No penalty if -

– Each installment equals 25% of section 1446 tax payable on prior year ECTI allocable to foreign partners

– Prior taxable year consisted of 12 months

– Partnership timely files or will timely file Form 1065 for prioryear, and

– Prior year ECTI at least 50% of ECTI shown on annual section 1446 return to be filed for current year

• Any excess of installments over final amount refunded to partnership – Rev. Proc. 92- 66,1992-2 CB 428

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Section 1446-Interactions

• Sections 1441/1442 – generally no overlap

– Exception: US-source independent personal services

– Regulations do not address section 1441 withholding on payment of ECI to foreign partnership

• Section 1445

– Domestic partnership – section 1445 withholding not required if section 1446 withholding applies

– Foreign partnership – section 1445 amount withheld by the transferee under section 1445(a), may be credited by the partnership against its liability to pay the 1446 withholding tax

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Trusts

• Partnership interest held by domestic trust: 2003 proposed regulations provided that the domestic trust is treated as a foreign trust and the partnership is required to pay withholding tax on the trust’s allocable share of ECTI if:

– the partnership “knows or has reason to know”

– that interest is held “through a domestic trust (and possibly other entities)” for foreign grantor

– “with a principal purpose of avoiding the 1446 tax.”Section 1.1446-3(d)(2)(iii)(B)

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Tiered Partnerships

• Lower-tier partnership (LTP) may determine 1446 tax based on status of partners in foreign upper-tier partnership partners if foreign UTP provides documentation (W-8BEN, W-8IMY, or W9)

– This was not possible under Rev. Proc. 89-31

– Compare paperwork requirements under section 1441 applicable to nonwithholding foreign partnership

– Intended to ensure that 1446 tax more closely approximates actual tax liability of upper tier partner

• 2003 proposed regulations requested comments as to whether the look-through regime should be extended to domestic UTPs.

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Publicly Traded Partnerships

• Rev. Proc. 89-31 provided distribution regime unless PTP elects back into estimated tax regime

• 2003 proposed regulations modified Rev. Proc. 89-31 regime as follows:

– PTP defined solely by reference to section 7704 (no longer have to be regularly traded via 1445(e)(1))

– PTP must obtain a Form W-8BEN, Form W- 8IMY or Form W-9 from each partner if it does not rely on other means to determine the status of its partners.

– Applicable percentage is section 1 or section 11 rate, no longer highest rate under section 1 for all partners individual and corporate – see Rev. Proc. 92-66

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Final Regulations - Basics

• Reg. §1.1446-1: Requires all partnerships to determine their partners' status

– Forms W-8BEN, W-8ECI, W-8EXP and Form W-9

– Rules largely coordinated with section 1441 regulations

– Absent reliable documentation, partner presumed foreign

• Reg. §1.1446-2: Provides rules for determining a partnership’s effectively connected taxable income allocable to foreign partners under section 704

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Final Regulations• Reg. §1.1446-3: time and manner of calculating, reporting, and paying section 1446 tax

– When a partnership may consider the character of income allocated to a foreign partner. §1.1446-3(a)(2). account for special rates for capital gains to non-corporate taxpayers, depreciation recapture and collectibles gain

– Withheld tax treated as distribution to foreign partner

– Confirms section 1446 trumps section 1445

– Requires quarterly notification to partners of amounts withheld

– Explains the accrual of interest, penalties, and additions to tax for failure to withhold (§1.1446-3(e))

• Penalties not waived if partner pays tax that partnership shouldhave withheld

– Special rules for domestic grantor trusts and foreign simple trusts

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Final Regulations

• Reg. §1.1446-4: Rules for publicly traded partnerships

– Withholding based on distributions, not income allocations

– Preferential rates may not be used

– Rules not extended to other large partnerships

– Reporting on Form 1042 and 1042-S

• Reg. §1.1446-5: Provides rules tiered partnership structures, where a partnership (LTP) has a partner that is itself a partnership (UTP)

– Look-through by LTP permitted separately based on documentation provided by each UTP partner

– Domestic UTP may elect LTP look-through to domestic UTP’s foreign partners but LTP consent required

– Public LTP may look through non-public UTP but no partnership may look through public UTP

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Proposed and Temporary Regulations• When a partnership may consider partner-level deductions and losses to reduce its 1446 tax obligation (The “Good Driver”Rule)

– Partners may certify carryovers and reversals of suspensions from prior years

– Current year partner-level items may not be considered, even if derived from or paid by the partnership, e.g. state taxes, charitable contributions

– Partner must have filed timely returns for preceding 4 years (or, in the case of the preceding year, will file timely return)

– Detailed provisions cover required updates and consequences of incorrect certificates

• De minimis investment certification (partner may certify that it is engaged in only one partnership and partnership estimated tax on ECTI is less than $1,000)

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Certification of NOLs

• Procedure is voluntary – partnership is not required to consider the certificate

• NOL deduction limited to 90% of allocable ECTI

• Loss claimed must have been reflected on a prior-year K-1 or from another source (i.e., a K-1 from another partnership)

– Suspended losses allowed only to reduce ECTI from the partnership from which such losses were derived

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Certification of NOLs

• Contents of Certificate

– Identification of partnership and partner

– Amount and relevant character of the loss/deduction

– Representations concerning

• Eligibility of partner, losses and deductions and filing of returns or intention to file timely returns

– Modifications – Must be filed within 10 days from event

• Return filed

• Return not filed

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Overwithholding Examples - Assumptions

• Partnership P has 2 equal partners, FP and USP

• Highest rate of tax is 35%

• Long-term capital gains rate for individuals is 15%

• For simplicity, AMT limitations on NOL carryovers ignored

How the Final Regulations Address Overwithholding and Tiered Entities

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Overwithholding – Rates

Final Regulations

No change to the base case. This result occurs because section 1446 requires a partnership to pay withholding tax at the “highest rate”applicable to a foreign partner. No exception is mandated to approximate a progression through tax brackets

• Example 1: P allocates $100,000 ordinary income to FP. FP has no other effectively connected income

Rev. Proc. 89-31/ 2003 Proposed RegulationsP pays a withholding tax of $35,000 even though:If FP were a corporation with no other income, tax on FP would be $22,500, ignoring branch profits taxIf FP were a married NRA, tax would be approximately $23,500 (2004 rate table) or about $1,000 less if FP were a single NRA

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Overwithholding – Rates

Rev. Proc. 89-31/ 2003 Proposed Regulations

P pays a withholding tax of $35,000 even though, if FP were an individual NRA, tax on FP would not exceed $15,000 (or $25,000 or $28,000 if gains were attributable to section 1250 recapture or collectibles)

Final Regulations

Section 1.1446-3(a)(2) permits a partnership to consider preferential rates for capital gain, unrecaptured1250 gain, collectibles gain etc. provided the foreign partner has provided documentation (e.g., Form W-8BEN) in accordance with §1.1446-1

• Example 2: P allocates $100,000 long-term capital gain to foreign partner

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Overwithholding – Losses


P pays a withholding tax of $35,000 even though, if FP were an individual NRA, tax on FP would not exceed $15,000 (or $25,000 or $28,000 if gains were attributable to section 1250 recapture or collectibles)

• Example 3 - Losses: In 2003, P allocates $100,000 ordinary loss to FP; zero tax is withheld; in 2004, P allocates $100,000 income to FP

Temporary RegulationsSection 1.1446-6T provides a procedure whereby a foreign partner with a four year filing history (among many other requirements) can certify deductions and losses to the partnership to reduce the partnership’s 1446 obligation

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Overwithholding – Charitable Contributions


P allocates $100,000 income to FP and separately states $10,000 share of contribution. Therefore, withholding is $35,000

Final and Temporary Regulations

Certification procedure under 1.1446-6T specifically does not permit certification of charitable deductions, including carryovers of excess charitable contributions

• Example 4 – In 2004, P earns $200,000 and contributes $20,000 to charity

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Overwithholding – State Income Taxes

Rev. Proc. 89-31/ 2003 proposed regulations

State tax is ignored, even if paid by P. Therefore, withholding is $35,000.

Final and Temporary Regulations

A foreign partner can certify available deductions and losses but not deductions and losses from the current taxable year, even for amounts paid by the partnership. The deductions and losses must generally be reflected on a prior year return of the partner. See §1.1446-6T(c)(1).

No relief even if partnership withheld state tax as required by CA, NJ, NY, PA and about 24 other states – see 2005 STT 34-2.

• Example 5 – P allocates $100,000 to FP. FP (or P on FP’s behalf) pays state tax of $6,000

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Overwithholding – COD and Insolvency

Rev. Proc. 89-31/ 2003 proposed regulations

Bank forecloses. Result – gain of $200,000 and section 1446 withholding of $35,000. P has no cash to pay withholding

In workout, bank forgives $100,000. Result – ordinary income of $50,000 for each partner and section 1446 withholding of $17,500. P has no cash to pay withholding

Final Regulations

Partnership required to pay 1446 taxComment: Final Regs did not accept comments that rules similar to Treas. Reg. § 1.1445-2(d)(3)(B)(ii) should apply and not require withholding when the partnership has received no cash from which to withhold. Query as to what a General Partner should do in this situation?

Temporary Regulations

Foreign partner can certify deductions and losses that will be available to offset the allocated COD income or foreclosure gain

• Example 6 – P buys building for $1 million with $200,000 from FP and USP and $800,000 loan. Building depreciates to $600,000. Building declines in value to $700,000

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Limitation on Capital Losses

• PRS partnership has two equal partners, A and B. A is a nonresident alien and B is a U.S. citizen. PRS has the following annualized tax items for the relevant installment period, all of which are effectively connected with its U.S. trade or business and are allocated equally between A and B: $100 of long-term capital gain, $400 of long-term capital loss, $300 of ordinary income, and $100 or ordinary deductions. Accordingly, A’s allocable share of PRS’seffectively connected items are:

– Long-term capital gain $ 50

– Long-term capital loss $200

– Ordinary income $150

– Ordinary deductions $ 50

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Limitation on Capital Losses

• A’s share of partnership ECTI allocable under Section 704 pursuant to Reg. 1.1446-2 is $100, calculated as follows:

– $100 - ordinary income of $150 less ordinary deductions of $50

– $ 0 - long-term capital gain of $50 less long-term capital loss of $50*

• *Deduction limited to amount of long-term capital gain

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Special Allocations Respected

• PRS has two equal partners, A and B. Both are nonresident aliens. PRS has the following annualized tax items for the relevant installment period, all of which are effectively connected with its U.S. trade or business:

– Long-term capital gain $200

– Long-term capital loss $200

– Ordinary Income $400

• According to the partnership agreement, A and B have equal shares of ordinary income, but all long-term capital gain is allocated to A and all long-term capital loss is allocated to B

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Special Allocations Respected

• Allocations must be respected under section 704(b)

• A’s share of partnership ECTI under Reg. 1.1446-2 is $400 – ordinary income of $200 plus long-term capital gain of $200

• B’s share of partnership ECTI is $200 – ordinary income of $200 less long-term capital loss of $0*

– *Deduction limited to amount of long-term capital gain

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Overwithholding and Section 199

• Section 199 provides for a deduction for qualified production activities of 9% (3% for taxable years beginning in 2005 and 2006; 6% in 2007, 2008 and 2009)

• Section is applied at the partner level – section 199(d)(1)(A)

• Question: May partnership take deduction into account in computing 1446 tax?

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Tiered Structures• Proposed rule for foreign UTP allows LTP to look through foreign UTP. Domestic LTP may allocate ECTI to upper tier partners and withhold on receiving valid Form W-8IMY and can reliably associate ECTI with Form W-8BEN, W-8IMY or W-9 for each upper-tier partner

• Final regulations: Clarify that look through rules may apply in part or to the entire allocable share of a UTP

• Extend the availability of the look through rules to upper-tier domestic partnerships that make an election and if the election is accepted by the LTP

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Tiered Structures - Example

• UTP is a foreign partnership, which is owned 70% by a nonresident alien (NRA) and 30% by foreign corporation (FC).

• UTP holds a 40% interest in LTP, a lower-tier partnership. NRA owns the remaining 60% interest of LTP.

• UTP has no income other than the income allocated from LTP.

• LTP has $100 of annualized ECTI for the relevant installment period, all of which is ordinary income and is subject to withholding at the highest applicable rates.

• UTP provides LTP with a valid Form W-8IMY indicating it is a foreign partnership and attaches valid W-8BENs from NRA and FC, as well as a statement describing the allocation of UTP’s ECI among its partners. NRA also provides LTP with a valid W-8BEN

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• LTP must pay 1446 tax on the $60 allocable to its direct partner NRA using the applicable percentage for non-corporate partners (the highest rate in section 1).

• LTP will pay 1446 tax on the $28 allocable to NRA, as determined by looking through UTP ($40 x 70%) using the applicable percentage for non-corporate partners.

• LTP will pay 1446 tax on the $12 allocable to FC, as determined by looking through UTP ($40 x 30%) using the applicable percentage for corporate partners.

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• LTP’s payment of the 1446 tax is treated as a distribution to NRA and UTP, its direct partners, that those partners may credit against their respective tax obligations.

• UTP will report its 1446 tax obligation with respect to its direct foreign partners, NRA and FC, on the Form 8804 and Forms 8805 that it files with the IRS and will credit the amount withheld by LTP on its Form 8804.

• This credit will satisfy UTP’s 1446 tax liability as reported on the Form 8804 it files because UTP’s only income is from LTP, and LTP paid 1446 tax with respect to all of UTP’s allocable share in LTP by looking through to UTP’s partners, NRA and FC.

• Further, UTP will pass along the credit for the 1446 tax withheld by LTP to its partners, NRA and FC on the Form 8805 (Line 6b) issued to each partner.

• The credit passed to each partner on Form 8805 will be treated as a distribution to respective partners.

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Other Partnership Compliance Issues

• When is a partnership required to file a return?

• When is a foreign partner required to file a return?

• If returns are required, when are they due?

• Is the partnership engaged in a U.S. business?

• What income is effectively connected with that business?

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When is a partnership required to file a return?

• General rule – every partnership is required to file a return stating its gross income, allowable deductions, and the names and addresses of its partners entitled to share in distributions of taxable income

• Exceptions

– Domestic partnerships – the partnership has no items of income, deductions, or credits for the year

– Foreign partnerships

• The partnership has no U.S. source income and

• The partnership has no ECI

• De minimis U.S. source income ($20,000 or less), no ECI, and U.S. partners entitled to less than 1% of items, and U.S. partners include activity on their returns

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• Foreign partnership modified filing requirements

– U.S. source income, but no U.S. partners

• Partnership is not required to file a U.S. return

– U.S. source income, U.S. partners, but no ECI

• Return required

• Sch K-1 required only for direct U.S. partners and pass-through partners (whether U.S. or foreign) through which U.S. partners hold an interest

– Other requirements

• Partnership is not a WFP under Reg. 1.1441-5(c)(2)(i); Forms 1042 and 1042-S are filed by the partnership and amounts are properly reported AND the tax liability of the foreign partners has been fully satisfied by withholding

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When is a foreign partner required to file a return?

• General rule – every nonresident alien individual and foreign corporation is required to file a U.S. income tax return if

– They have U.S. source income the tax on which is not fully satisfied by withholding

– They are engaged in a U.S. trade or business at any time during the taxable year

• Even if no ECI, even if no U.S. source income, even if all income is exempt under a treaty.

• on 875(1) provides that if a partnership is engaged in a U.S. business, its foreign partners are deemed to be engaged in such business

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Examples

• FP1 and FP2 are 50/50 partners in LLC, a Delaware limited liability company treated as a partnership for U.S. income tax purposes. LLC operates a production company and all of its activity takes place outside the U.S.

• Is LLC required to file Form 1065 if either:

– It does not have an office in the U.S. or

– It has an office in the U.S.?

• Are FP1 and FP2 required to file?

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• Every domestic partnership is required to file a return unless it has no activity. Even though LLC has no U.S. source income and no ECI, it is required to file a return

• If LLC is engaged in a U.S. business, FP1 and FP2 are deemed to be so engaged and would be required to file a return

– In the first example, although it’s a U.S. partnership, it’s not engaged in a U.S. business

– In the second example, since LLC has a U.S. office a U.S. trade or business likely exists

• What if LLC was foreign?

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• USP and FP are 50/50 partners in LLC, a Delaware limited liability company treated as a partnership for U.S. income tax purposes. LLC purchases products outside the U.S. and sells them to customers in the U.S. All products are drop shipped directly to the U.S. customer. LLC maintains a U.S. bank account.

• Is LLC required to file Form 1065 if either:

– It does not have an office in the U.S. or

– It has an office in the U.S.?

• Is FP required to file?

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• Answer depends on the source of the income and whether such income is ECI

– The source of income from the sale of personal property is generally the place where the rights, title and interest of the seller in the property are transferred to the buyer (the “title passage” rule). Reg. 1.861-7(c).

– Foreign source income from the sale of inventory can be ECI if

• The seller has an office or other fixed place of business in the U.S.

• The income is attributable to such office (under the rules of section 864(c)(5) and

• If the property is sold for use, consumption or disposition outside the U.S., an office in a foreign country materially participated in such sale. Section 864(c)(4) and Reg.

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What are the due dates for the returns?

• General rule – the partnership return is due on the 15th day of the 4th month following the close of the partnership’s taxable year (April 15)

– If the partnership keeps its books and records outside the U.S. and Puerto Rico, there is an automatic extension to the 15th day of the 6th month (June 15)

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• General rule – the return for a nonresident alien individual is due on the 15th day of the 6th month following the close of the partnership’s taxable year (June 15)

– Exceptions – if the NRA elected to be treated as a U.S. resident under section 6013 or if the NRA had wages subject to withholding under section 3401, the due date is the 15th day of 4th month (April 15)

– Unlike the rule for partnerships, this is a change in the due date, not an extension

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• General rule – the return for a foreign corporation that does not have an office in the U.S. is the 15th

day of the 6th month following the close of the partnership’s taxable year (June 15 for a calendar year corporation)

– If the foreign corporation has an office in the US, the due date is the 15th day of the 3rd month (March 15)

– Unlike the rule for partnerships, this is a change in the due date, not an extension

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• Extensions

– IR-2005-131 – Beginning with returns due after December 31, 2005 the old two-month and three-month extensions have been eliminated and all extensions for corporations, individuals and partnerships will be for 6 months

• To September 15 for a partnership or a foreign corporation with a U.S. office; to December 15 for a NRA or a foreign corporation without a U.S. office

– Partnerships will file Form 7004 (Forms 8736 & 8800 to be retired)

– Individuals will file Form 4868 (Form 2688 is being retired)

– The new 6-month extension will also be available for other information reports including Forms 8804 and 1042

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