On May 13, 2005, the Treasury Department issued final and temporary regulations (T.D. 9200) and proposed regulations (REG-108524-00) as guidance on the withholding tax obligation – under section 1446 – of partnerships that are engaged in a U.S. trade or business and have one or more foreign partners.
A foreign person that conducts a trade or business in the United States generally is subject to U.S. tax on the income that is effectively connected with that trade or business. Similar rules apply to income earned by a foreign person through a partnership that is engaged in a U.S. trade or business.
A partnership that is engaged in a U.S. trade or business is required to withhold and pay over tax to the extent that its net income that is effectively connected with its U.S. trade or business is allocable to a foreign partner. The amount of the tax due generally is computed by applying the foreign partner’s highest marginal income tax rate to the amount of the partnership's effectively connected income that is allocable to its foreign partners.
The regulations are generally favorable and have incorporated some of the recommendations of practitioners. One area where relief was not provided is in the context of cancellation of indebtedness.
The following is a summary of significant aspects of the newly issued regulations:
Lower Tax Rates For Capital Gains
The prior revenue procedures did not address income subject to special rates of tax, such as the 15% maximum tax rate for long-term capital gains for non-corporate taxpayers. The final regulations favorably provide that partnerships may consider the type of gain or other special items of income allocable to a foreign partner during the taxable year when computing its section 1446 obligation. For example, a partnership can give a foreign partner other than a corporation the benefit of preferential capital gains tax rates. Certain certification will be required to obtain the reduced rate.
Since the quarterly payments are necessarily based on estimates, it is quite possible that, viewed at the end of the year, too much tax will have been withheld. The prior revenue procedures allowed a partnership to obtain a refund of the section 1446 tax. The 2003 proposed regulations would have dropped this rule, so that only the partners could obtain refunds. The final regulations return to the approach of the prior revenue procedures, permitting refunds at the partnership level.
Because a partnership is only required to perform section 1446 withholding with respect to its foreign partners, a partnership has to determine whether a partner is foreign. The prior guidance included a process to certify status but the process was not integrated with the nonresident alien withholding rules for interest and dividends under Code sections 1441 and 1442. The documentation requirements under the final regulations are generally consistent with the nonresident alien withholding rules for interest and dividends. For example, U.S. individuals and corporations may certify their status on Form W-9, and foreign individuals and corporations may certify their status on Form W-8BEN. However, there are two significant differences. First, a partner that is a domestic grantor trust with a foreign beneficiary will be treated as a foreign partner for purposes of section 1446. Second, a foreign simple trust will be treated as an entity for purposes of section 1446, whereas it is treated as a flow-through entity for purposes of sections 1441 and 1442. These rules will require domestic grantor trusts and foreign simple trusts to be doubledocumented, using one kind of documentation for section 1446 and another kind for sections 1441 and 1442.
When a foreign partner has losses and deductions (that are effectively connected with a U.S. trade or business) outside of the partnership, withholding at the maximum rate on his share of the partnership’s taxable income frequently will result in the overstatement of his liability. Such an overstatement of liability can be particularly burdensome if the partnership income in question is non-cash income, such as cancellation-of-indebtedness income or income from a deed in lieu of foreclosure – the partnership may not have any cash to make section 1446 payments. There was no relief provided in such circumstances in the prior revenue procedures, and the IRS noted the issue in the proposed regulations. Under the new temporary regulations, certain foreign partners will be able to certify that they have losses, loss carry-forwards, etc., outside of the partnership that will reduce their tax liability on their share of the partnership’s income, which will enable the partnership to reduce withholding accordingly. The partnership will be liable if such certification proves to be wrong, however, and so this alternative may not be used often, except in related-party situations or where an adequate indemnity is provided. More general relief from withholding in the case of cancellation-of-indebtedness income, deeds in lieu of foreclosure, and other distress situations has not been provided in the new regulations.
Foreign Partnerships Owning Interests in U.S. Partnerships
If a foreign partnership is a partner in a U.S. partnership, prior revenue procedures required withholding on the foreign partnership’s entire share of ECTI from the U.S. partnership, even if some of the partners in the foreign partnership were U.S. persons who would have been exempt if they had been direct partners in the U.S. partnership. This situation is alleviated in the final regulations: the foreign partnership can now pass through documentation from its partners to the lower-tier U.S. partnership, so that the U.S. partnership will only withhold on income allocable to the foreign partners of the upper-tier foreign partnership.
Tiered U.S. Partnerships
Ordinarily, if one U.S. partnership is a partner in a second U.S. partnership, the upper-tier partnership is responsible for any section 1446 obligations. Under the final regulations, if both partnerships agree, the upper-tier U.S. partnership can pass along documentation about its partners to the lower-tier U.S. partnership, which will take over any necessary section 1446 withholding with respect any foreign partners of the upper-tier U.S. partnership. There was no comparable prior procedure.
If a U.S. partnership with foreign partners sells real estate, in principle withholding could be required under section 1446 as well as the section 1445 (FIRPTA) rules. The final regulations reconfirm that any necessary withholding will be done under the section 1446 rules, not the section 1445 rules. Thus, it will not be possible to obtain a special certificate under the section 1445 procedures to reduce or eliminate withholding under section 1446.
The final regulations are effective for partnership tax years beginning after May 18, 2005. However, a partnership may elect to apply the provisions of the final regulations to partnership tax years beginning after December 31, 2004.
The final regulations render the prior revenue procedures, i.e., Rev. Proc. 89-31 (1989-1 C.B. 895) and Rev. Proc. 92-66 (1992-2 C.B. 428) obsolete for partnership tax years beginning after May 18, 2005, or for partnership tax years beginning after December 31, 2004, if the partnership makes an election under Treas. Reg. section 1.1446-7.
The temporary regulations are effective for partnership tax years beginning after May 18, 2005. However, a partnership may elect to apply the temporary regulations to partnership tax years beginning after December 31, 2004, provided the partnership also elects to apply the final regulations under Reg. sections 1.1446-1 through 1.1446-5 to partnership tax years beginning after December 31, 2004.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.