Withholding and reporting requirement for payments to foreign partnerships.
Foreign partnerships are subject to 30% nonresident alien (NRA) tax on most items of income they receive from sources within the U.S. that are not effectively connected with the conduct of a trade or business in the U.S. (non-ECI). This includes payments of interest, dividends, royalties, compensation and other fixed or determinable annual or periodical (FDAP) income. The 30% NRA withholding rate on U.S.-source FDAP payments to foreign partnerships may be reduced under the Code or an income tax treaty. Withholding is generally required at a 30% rate, however, unless the withholding agent holds certain documentation that it can reliably associate with the payment and on which it can rely to reduce the rate of withholding. For payments of U.S.-source FDAP to a foreign partnership, the documentation on which the withholding agent can rely to reduce the 30% withholding rate includes a Form W-8, Certificate of Foreign Status, from the partnership with the partnership's employer identification number, certifying that it is a withholding foreign partnership. A foreign partnership can certify that it is a withholding foreign partnership only if it has entered into a withholding agreement with the Service.
For FDAP payments to a withholding foreign partnership, the withholding agent pays the amount without any withholding and reports the payments on Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, in the name of the partnership. The withholding foreign partnership is responsible for NRA withholding at the proper rates on its partners' distributive shares of payments received. It must also file a Form 1065, U.S. Partnership Return of Income, and Forms K-1 with the IRS. A foreign partnership that receives non-FDAP payments must also file a Form 1065 and Forms K-1 if the payments consist of U.S.-source income (e.g., U.S. bank deposit interest or U.S. short-term original issue discount). If the payments consist of foreign-source income, filing or reporting is not required if there are no U.S. partners; however, the filing requirements may be different if any partner is a US. person.
Avoiding Potential Liability for 31% Backup withholding
Partners in a withholding foreign partnership are never liable for 31% withholding, because no withholding is required for payments to the partnership and a partner's distributive share of partnership income is exempt from backup withholding. (In contrast, partners in a nonwithholding foreign partnership can be liable for 31% backup withholding at the time that payments are made to the foreign partnership, if the withholding agent does not have the required documentation pertaining to the partners and the payments consist of amounts not subject to 30% withholding.) Signing an agreement with the IRS to qualify as a withholding foreign partnership eliminates the potential liability for 31% backup withholding. Foreign partnerships can also avoid the potential liability for 31% by "checking the box" as a corporation for U.S. tax purposes.
Tax Treaty Benefits
Checking the box as a corporation for U.S. tax purposes will not preclude tax treaty benefits from flowing through to partners residing in a treaty country, provided the check-the-box entity is treated as a flow-through entity in the partner's country of residence. However, if a foreign corporation is treated as a flow-through entity for foreign tax purposes and claims treaty benefits on a flow-through basis, it would have to pass the documentation for its owners through to the U.S. withholding agent.
To avoid passing documentation through to the U.S. withholding agent, a foreign partnership that has checked the box as a corporation for U.S. tax purposes may request an agreement with the Service to become a "qualified intermediary." In such a case, it may either represent eligibility for treaty benefits on behalf of its owners (and get the reduced rate at source) or assume withholding responsibility (and receive the payment free of withholding and withhold on payments to its owners).
Under the new regulations, withholding and reporting requirements have changed significantly, and time to implement the necessary changes is growing short. U.S. withholding agents making payments to foreign partnerships must exercise due diligence with respect to payments of amounts subject to NRA withholding, or face potential liability for underwithholding and related interest and penalties. Entities doing business as foreign partnerships must determine how the partnership and the partners are affected by the new rules. When appropriate, partners should be informed of changes that will affect them. Of utmost importance is the drafting of the terms of an agreement to be a withholding foreign partnership, and the negotiation of those special terms with the IRS.
An orderly transition to comply with the new withholding and reporting requirements will also include a thorough review of current forms for partnership accounts, as wed as evaluation of hardware and software in current automated systems. Internal standard operating procedures may need to be revised and training scheduled for tax personnel and other employees, to ensure understanding and compliance.
Finally, U.S. investors should determine the potential new benefits and detriments available through the use of foreign partnerships. Many will find it wise to choose non-U.S. partnerships as investment vehicles.