U.S. tax relief for foreign partners.

The IRS's focus on the U.S. taxation of foreign individuals and foreign corporations has attracted much attention. The issues have ranged from transfer pricing and earnings stripping to treaty shopping and generation-skipping transfer taxes, with generally consistently bad news for foreign taxpayers. But don't despair, not all news is bad news. IRS Letter Ruling 9331012 may provide certain foreign taxpayers with relief from U.S. taxation. Although the letter ruling does provide a breath of fresh air, its application will be limited and will probably require some advance planning to benefit from its findings.

The letter ruling involved a German law partnership with a branch in the United States since 1988. The partnership has filed U.S. partnership tax returns reporting the operating results of the activities conducted through the U.S. branch. The partnership has had a partner resident in the United States. The resident partner has filed U.S. income tax returns. In addition, the nonresident partners filed nonresident U.S. income tax returns.

The U.S. resident partner performed services only in the United States and not in Germany on behalf of the partnership. A ruling was obtained from the German tax authorities informing the resident partner that he was taxable only in the United States while residing in the United States because his services were performed only in the United States and not in Germany. Further, the partnership and the resident partner have executed an agreement allocating all of the profits of the U.S. office to the resident partner.

Under Sec. 875, a nonresident alien individual or a foreign corporation that is a partner in a partnership engaged in a trade or business in the United States is considered engaged in a trade or business within the United States nonresident alien individual engaged in a trade or business in the United States is taxable in the United States on the income effectively connected with the conduct of a trade or business in the United States (Sec. 871(b)(1)). Thus, the nonresident partners in the German partnership would generally be treated as engaged in a trade or business in the United States and would be taxable on income effectively connected with that trade or business, i.e., their share of the partnership's income from the U.S. branch. This is consistent with the approach taken by the nonresident partners for the years preceding the ruling request when the nonresident partners filed nonresident U.S. income tax returns.

In the ruling request, however, the nonresident partners were seeking to alter this result by applying Article 14 of the U.S.-German income tax treaty. Under that article, income derived by an individual from the performance of personal services in an independent capacity is taxable only in the individual's country of residence unless the services are performed in the other country and the income is attributable to a fixed base regularly available to the individual in the other country for the purpose of performing the activities. Independent personal services include activities of lawyers. The technical explanation elaborates on this point by indicating that personal services performed by an individual include all services performed by an individual for his own account, whether as a sole proprietor or a partner. Therefore, Article 14 applies to income for services performed by lawyers as partners.

The treaty's technical explanation also provides that a resident of a country (Germany) who derives income from the performance of personal services in an independent capacity is exempt from tax in the other country (United States) unless certain conditions are satisfied. The income may be taxed in the United States if the services are performed there and the income is attributable to a fixed base in the United States that is regularly available to the individual for the purpose of performing the services.

Since the resident partner performs services for the partnership only in the United States, he should be taxable only in the United States on his distributive shares of partnership income. The nonresident partners, on the other hand, should be taxed only in Germany on their distributive shares of partnership income because they do not perform any services in the United States. In the ruling, the Service concurred with this analysis.

The reporting requirements under Sec. 6114, for treaty-based tax returns, were also addressed. The IRS held that the reporting requirements for the nonresident partners would be waived provided that the partnership disclosed the position taken by the nonresident partners pursuant to the U.S.-German income tax treaty.

What does all this mean? The letter ruling provides an interesting tax planning strategy that can be used by foreign partnerships with U.S. resident partners. If there is an income tax treaty between the country in which the nonresident partners are resident with a provision similar to Article 14 of the U.S.-German income tax treaty, there may be an opportunity for the nonresident partners to claim the benefits of the treaty and avoid a U.S. income tax liability. In addition, with appropriate disclosure on the partnership's U.S. income tax return, the nonresident partners can avoid filing U.S. treaty-based tax returns. This would typically be applicable to a foreign service business, like the German law firm in the letter ruling. Depending on the number of nonresident partners involved, the reduction in compliance costs can be significant.

Bear in mind that the facts in the letter ruling should be closely followed. A U.S. resident partner is necessary. In some instances, the individual assigned to the United States may not be a partner in the foreign partnership. The partnership agreement should also provide that the profits of the U.S branch office are all allocable to the resident partner. This will probably require an amendment to the partnership agreement and may not be justifiable from an economic viewpoint. However, if these tow items are present and there is an appropriate treaty provision available, a result similar to the letter ruling should be achievable.

The "no opinion" section of the ruling is particularly interesting, especially in trying to understand how the Service came to its conclusions. For example, no opinion was given about the allocation of the partnership's income and expenses, including whether the partnership agreement allocating all profits of the U.S. branch to the resident partner had substantial economic effect. Furthermore, the IRS concluded that this determination was unnecessary based on its other conclusions: (1) Article 14 applied to exempt the nonresident partners from U.S. tax on partnership income attributable to the U.S. branch and services performed by the resident partners and (2) the resident partner was taxable only in the United States because he performed services only in the United states for the partnership.

It would appear that a key factor in arriving at these conclusions was the agreement allocating all the profits to the resident partner. Yet, the letter ruling stated that a determination of the substance of the partnership's income allocation was unnecessary.

If the Service were to accept the partnership's allocation of all its profits from the U.S. branch to the resident partner, the nonresident partners might not even need the treaty to avoid U.S. taxation. Although the nonresident partners would be engaged in a trade or business in the United States pursuant to Sec. 875, they would have no gross income effectively connected with the conduct of a trade or business within the United States. The letter ruling appears to rely on the fact that the nonresident partners were not performing services in the United States without considering whether there would be any income in the U.S. branch beyond the amounts attributable to the services of the resident partner. It is curious why the substance of the partnership agreement was not considered. If the profits of the U.S. branch exceeded an amount that the IRS would deem appropriate for the resident partner's services, the excess should be exempt from U.S. tax, provided that the nonresident partners did not actually perform services in the United States.

All foreign partnerships should carefully review their U.S. filing positions in light of Letter Ruling 9331012. In the right set of circumstances, it may be possible to reduce the U.S. tax exposure of the nonresident partners.