Withholding taxes on foreign partners - a recurring nightmare.

Congress is increasingly relying on withholding agents (payors and their agents) to ensure the collection of tax from foreign individuals and businesses. Withholding of taxes on foreign partners requires the withholding agent to make sense out of the less than perfect integration of two of the most complex areas of Federal taxation: those governing partnerships and those involving foreign persons with income from U.S. sources. Compounding the withholding agent's difficulties are new requirements for information reporting and withholding taxes and new sanctions for failure to comply. A comparison of the historical patterns of taxation and developments since 1980 demonstrates these difficulties.

The historical pattern

There are two sets of rules for taxing the income of foreign persons (defined as a nonresident alien, a partnership or corporation organized under foreign law, and non-U.S. trusts and estates). The first covers income from carrying on a U.S. business (termed effectively connected income (ECI)), which is taxed on a net basis at graduated rates. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), in effect, treats gains from sales of U.S. real estate and from the disposition of certain real estate holding companies as ECI. The second method levies a 30% flat withholding tax on dividends, compensation, rents, royalties, certain interest income and other noncapital gain income (termed fixed or determinable annual or periodical income (FDAP)).

An applicable income tax treaty can eliminate the U.S. tax liability on ECI (but not from real estate) when not earned through a U.S. office or other "permanent establishment." Similarly, a treaty may reduce or eliminate withholding taxes on FDAP. Bear in mind that the withholding agent acts at its own risk (it will be liable for tax that should have been withheld but was not), and should receive appropriate documentation from any payee claiming an exemption from withholding for whatever reason.

The problem with earning U.S.-source income through a partnership

Partnerships are generally treated as a kind of agent for their foreign partners. Sec. 875(1) provides that a nonresident alien or foreign corporation is engaged in a U.S. business (and thereby potentially earning ECI) if it is a member of a partnership that is so engaged. The main exception to this rule covers certain partnerships limited to investing or trading in commodities, stocks or other securities under Sec. 864(b). The stakes are raised by the fact that treaty protection is likely to be unavailable to the partner of a partnership engaged in a U.S. trade or business.

The IRS has launched a vigorous attack on foreign partners. In Unger, TC Memo 1990-15, aff'd, 936 F2d 1316 (D.C. Cir. 1991), the taxpayer was a Canadian who was a limited partner in a U.S. real estate partnership that had large gains from dispositions of U.S. real estate. The court held that the partnership's U.S. office was the taxpayer's "permanent establishment," thereby defeating treaty protection. Flush with this success, the Service issued Rev. Rul. 91-32, which held that a foreign partner's gain on the disposition of an interest in a partnership engaged in a U.S. business was ECI. Moreover, the ruling held that the partnership's U.S. office was the foreign partner's permanent establishment. The first of these holdings is considered to be controversial; the second follows from Unger.

Withholding taxes

Regs. Sec. 1.1445-3(f) requires a domestic partnership to withhold tax on a foreign partner's distributive share of the partnership's income to the extent it constitutes FDAP. The partnership is required to withhold on all distributions made during the year to the extent they consist of FDAP. Such income, such as dividends from U.S. portfolio stocks, could be subject to treaty protection, depending on the application of complex rules defining what types of FDAP constitute ECI under Sec. 864(c). In addition, withholding on a foreign partner's share of real estate gains under the FIRPTA rules is required by Sec. 1445(e). The interaction of these two sets of rules with new rules adopted in 1986 and 1988 on ECI has made for a lot of headaches.

Sec. 1446 requires a partnership (whether foreign or domestic) to withhold on any foreign partner's allocable share of ECI at the highest rate specified in Sec. 1 or 1 1, whichever applies. Under rules set forth in Rev. Proc. 89-31, the partnership must compute each foreign partner's share of effectively connected taxable income (which is net ECI), as adjusted to take into account items specially allocated to domestic partners. Note that guaranteed payments, because they are not "allocated" under Sec. 704, are not subject to Sec. 1446.

Rev. Proc. 89-31 set forth detailed instructions for reporting and paying over the withheld tax under Sec. 1446. Three new and burdensome forms (Forms 8804, 8805 and 8813) have been created to enforce Sec. 1446. The effect is that any partnership that does not receive a "certification of non-foreign status" from each partner runs the risk that it will be liable if, in fact, it has one or more foreign partners and fails to withhold. Note that there are also separate procedures for publicly traded partnerships with foreign partners.

The complex rules governing withholding on foreign partners can only be summarized here. The moral, however, is that partnerships must be aware of these rules and their ramifications. From Roger D. Lorence, LL.M., New York, N.Y.