To file or not to file, that is the question for foreign partnerships.

The use of hybrid entities (i.e., an entity treated as a branch or partnership for U.S. tax purposes and a corporation under governing foreign law) in international joint venturing has gained widespread appeal. The new "check-the-box" regulations simplify the process by allowing eligible foreign entities to elect partnership status.

At the same time, the issues of whether and when foreign partnerships are required to file U.S. partnership returns and the consequences of failing to file remain far from clear. For example, is a foreign partnership with no direct U.S. partners that has no U.S. trade or business and no U.S.-source income required to file a U.S. partnership return? If not, how does such a partnership make partnership-level elections? The IRS has announced, as part of its 1997 business plan, that it intends to issue regulations under Sec. 6031. In the meantime, the lack of clear guidance has left practitioners in a quandary in advising clients whether foreign partnerships must file U.S. returns.

Sec. 6031 requires "every partnership" to file a US. partnership return. However, Regs. Sec. 1.6031-1(d)(1) exempts foreign partnerships that do not carry on a U.S. trade or business and have no U.S.-source income from the filing requirement, even if the foreign partnership has U.S. partners. The Service, however, may require U.S. partners to provide all necessary information to substantiate their distributive shares of partnership income and loss. Moreover, Regs. Sec. 1.6031-1 explicitly provides that if the foreign partnership has U.S. partners, any partnership-level election (including a Sec. 754 election) must be made by filing a U.S. partnership return.

Language enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) addresses the return filing issue. TEFRA Section 404 (which did not amend Sec. 6031) provides that "[e]xcept as hereafter provided in regulations ... nothing in section 6031 ... shall be treated as excluding any partnershp from the filing requirements of such section for any taxable year if the income tax liability ... of any United States person is determined in whole or in part by taking into account (directly or indirectly) partnership items of such partnership...." (Emphasis added.) Congress was concerned that, for foreign partnerships with U.S. partners, partnership return filing requirements generally did not apply under prior law and partnership records kept outside the U.S. often could not be reached.

In 1986, the IRS proposed new regulations under Sec. 6031. Under Prop. Regs. Sec. 1.6031-1, a foreign partnership with no U.S. trade or business and no U.S.-source income must file a U.S. partnership return only if 25% or more of any item of income, gain, loss, deduction or credit is allocable at any time during the year to partners that are U.S. persons. (These proposed regulations contain lookthrough rules for foreign partnership interests indirectly held through another partnership, or an estate or trust.) A foreign partnership that would have to file a U.S. return under these rules generally must only report the distributive shares of U.S. partners and must provide K-1s only to the U.S. partners (Prop. Regs. Sec. 1.6031-1(d)(2)). Under the proposed effective date provision, foreign partnerships could rely on the filing rules under the old regulations for tax years ending on or before the 90th day after the proposed regulations become final.

Because the 1986 proposed regulations have not been adopted in either temporary or final form, the language in TEFRA Section 404 may be viewed as requiring that if any U.S. person's income tax liability is determined "in whole or in part by taking into account (directly or indirectly) partnership items," the foreign partnership must file a U.S. partnership return. That is, the statutory term "except as hereafter provided in regulations" may not be deemed triggered by issuance of proposed regulations. Clouding the issue, the Service seemingly has given taxpayers inconsistent guidance in this matter. For example, the current instructions to Form 1065, U.S. Partnership Return of Income, appear to apply the rules of the earlier, final regulations. In Rev. Rul. 90-112, however, the IRS referred taxpayers to TEFRA Section 404 for foreign partnership filing requirements. The Service has not indicated whether any Sec. 6031 regulations issued this year would retain the 25% safe harbor from the 1986 proposed regulations.

Given the uncertainty in this area, the consequences of any failure to comply with Sec. 6031 should be considered. In addition to penalties for failure to timely file a partnership return and furnish K-1s to partners under Secs. 6098 and 6722, two additional consequences would be that (1) the foreign partnership would not be eligible to participate in TEFRA proceedings and (2) the flowthrough of tax losses and credits might be disallowed to U.S. partners under Sec. 6231(f).

The possibility of loss disallowance, however, may be mitigated by two additional rules (contained in Temp. Regs. Sec. 301.6231(f)-1T). First, Sec. 6231(f) does not apply if the foreign partnership's tax matters partner (TMP) resides in the U.S. and the partnership's books are maintained there. Second, losses and credits will be disallowed only if the IRS mails a notice to the TMP of the potential disallowance and the foreign partnership fails to file a U.S. partnership return within 60 days after the notice is mailed. Even if no U.S. partnership return is filed, the Service has discretion to waive the filing requirement and allow the losses and credits, if the U.S. partner establishes that the losses or credits are proper and that the partner made a good-faith effort to have the partnership file a U.S. partnership return.

In light of these uncertainties, a foreign partnership with at least one direct or indirect U.S. partner may wish to consider filing a U.S. partnership return disclosing the U.S. partner's share of partnership income and loss. Also, any entity relying on the existing eligible entity rule under the "check-the-box" regulations may wish to consider filing a partnership return to ensure it has satisfied the requirement that the entity "claimed" partnership status under the old Kintner regulations (Regs. Sec. 301.7701-3(b)(3)(ii)).

A related unresolved issue is how foreign partnerships make valid partnership-level elections. If a foreign partnership is required to file a U.S. partnership return, the partnership should make any partnership-level election on the return. Assuming that the partnership, has at least one U.S. partner, even if it does not have any U.S. trade or business or U.S.-source income, Regs. Sec. 1.6031-1(d)(2) and at least one ruling (Letter Ruling (TAM) 8142017) seem to suggest that the U.S. partner must file a partnership return on behalf of the partnership to make a valid election. However, the issue of how a foreign partnership with no U.S. partners makes valid partnership-level elections has not been addressed by the IRS. At least one case, Atlantic Veneer Corp., 812 F2d 158 (4th Cir. 1987), suggests that failure to file a U.S. partnership return may prevent a valid Sec. 754 election.

Another U.S. filing requirement that has not received much attention is found in Sec. 6046A, which generally requires a U.S. person to report the acquisition or disposition of an interest in a foreign partnership within 90 days after the transaction "except to the extent otherwise provided by regulations." Sec. 6679 imposes a $1,000 penalty for failure to file such a return, unless the failure is due to reasonable cause. In 1982, the Service announced that it planned to issue regulations under Sec. 6046A providing that any return filed on or before the 90th day following publication of such regulations would be considered timely filed (even if the filing is more than 90 days after the acquisition or disposition). Consistent with this announcement, no form has been issued under Sec. 6046A, and the instructions for Form 106-0 do not mention the reporting requirement. To date, however, no regulations under Sec. 6046A have been issued. It is unclear whether the IRS plans to issue regulations under Sec. 6046A along with the expected new regulations under Sec. 6031.