Howdy Partner! U.S. Tax Law
Treatment of Foreign Partners
ABA Section of Taxation
Washington, D.C.
Friday, May 10, 2013
Len Schneidman – WTAS LLC, Boston (Moderator)
Panelists:
Kimberly Blanchard, Weil, Gotshal & Manges LLP, New York, N.Y.
Summer A. LePree, Holland and Knight LLP, Miami, FL
Karen Lohnes, PricewaterhouseCoopers LLP, Washington, D.C.
Government:
David Bailey, IRS Office of Associate Chief Counsel (International), Washington, D.C.
Jesse Eggert, Department of Treasury, Washington, D.C.
1
I. Background
II. Non-Investment Partnerships
III. Investment Partnerships
IV. FIRPTA
V. Sovereign Wealth Funds
VI. Transfer Taxes
2
I. Background
3
Taxation of Foreign Partners
• Aggregate vs. Entity Theory
• Whether US or foreign, partnerships are not
separate taxpaying entities
• Tax the foreign partners on distributive shares of
partnership income
• Foreign individual partners taxed like nonresident
aliens earning the income directly (with some
modifications)
• Foreign corporate partners taxed like foreign
corporations earning the income directly (with
some modifications)
4
Taxation on Formation
• Section 721
– Generally tax-free
• But see Temp. Reg. Sec. 1.897-6T(a)(3)
5
ETB/ECI Issues
• A foreign partner that is engaged in US trade
or business (ETB) and has effectively
connected income (ECI) is liable for net basis
taxation in the US at graduated rates
• Section 875: foreign partner of a partnership
that is ETB is deemed also engaged in a US
trade or business
6
Tax on Foreign Partner’s ECI
• In non-partnership context foreign persons who
are ETB must file US return and pay tax to IRS
• Section 1446: Foreign partners who are ETB are
subject to withholding tax (even if no distribution
is made)
• Partnership must withhold at highest statutory
rate
– 39.6% for foreign individual partners, 20% for LT
capital gain
– 35% for foreign corporate partners
• Partner must file US return to claim refund
7
FDAP Issues
• Foreign partner realizing US source FDAP
subject to US gross basis withholding tax at 30%
statutory or lower treaty rate
• Here, withholding is per Sec. 1441
– Usually is at source if partnership is foreign
– Partnership withholds if domestic
8
Distributions from Partnerships
• Section 731
–Generally tax-free to extent of outside basis
•But see Temp. Reg. Sec. 1.897-6T(a)(3)
9
Sale of Partnership Interest
• RR 91-32: If partnership is ETB through fixed
place of business, gain on sale of partnership
interest is ECI
– Aggregate theory
– Controversial ruling
• If 91-32 does not apply, gain is foreign source
capital gain to a foreign partner (Section 865)
and not taxable by US
– Entity theory
10
II. Non-Investment Partnerships
11
ECI
• Under section 875, a foreign partner is deemed to
engage in any U.S. trade or business in which the
partnership is engaged
• If the partnership has a U.S. permanent establishment,
a partner will be deemed to have a U.S. PE
– Donroy; Unger
• If the partnership engages in a “commercial activity”
pursuant to section 892, a partner will be treated as
engaging in a commercial activity
– But see the “limited partner” exception contained in the
Proposed Regulations discussed on pgs 46-49
• Gain from the sale of an interest in a partnership
engaged in a U.S. trade or business may be treated as
ECI (Rev. Rul. 91-32)
• Would use of a blocker be beneficial?
12
Section 1446 Withholding and Branch Profits Tax
• If the partnership is ETB, a foreign partner will
be required to file a U.S. tax return
• Section 1446 requires partnership-level
withholding on allocations of partnership
income or gain to foreign partners
– Applicable withholding rate is the highest rate of
tax imposed by the Code on the type of partner
involved.
– Partnership is the withholding agent and is
required to make installment payments of the
withholding tax on a foreign partner's distributive
share of ECTI.
13
Section 1446 Withholding and Branch
Profits Tax
• Section 1446 Withholding
– Amount withheld under section 1446 based on allocations of ECTI to
foreign partners.
– Section 1446 generally requires over withholding so foreign partner
must apply for a refund.
– New Regulations attempt to limit incidence of over withholding, but
provide limited relief.
– Withheld taxes treated as distributed to foreign partners on the last
day of the partnership's taxable year, or, if earlier, on the day such
taxes were paid by the partnership.
– Where section 1445 and section 1446 conflict, the withholding
scheme of section 1446 trumps that of section 1445.
• A partner that is a foreign corporation will be subject
to branch profits taxes, as modified by the applicable
treaty
14
Collaborations
• Possible for collaboration agreements and other
arrangements to be recast as U.S. tax partnerships
• Withholding requirements
– Withholding required but not taken into account
– Potential for a U.S. partner to be treated as the
withholding agent
• Potential Remedies
– Indemnities from foreign partners
• Indemnification can relate to position that the arrangement is not
a partnership for U.S. tax purposes
• Indemnification that if treated as a partner, foreign partner will
pay its tax
• CCA 200606035- Distribution agreement did not give
rise to a partnership
• Other issues
15
Section 704(c) Issues
• Where a U.S. corporation seeks to form a joint venture with
a non-U.S. party and will own less than 80%, it will want the
JV to be treated as a partnership for U.S. tax purposes to
avoid tax leakage on non-consolidated dividends
• Often, both parties will contribute appreciated property to
the JV, with the result that section 704(c) will apply
• The non-U.S. party – who probably conceives of the JV as a
corporation - may be shocked to learn that, due to section
704(c), taxes on contributed assets will not be borne in
proportion to the economic deal
• If amounts are distributed to a contributing party to pay the
“corporate level” tax on contributed assets, a gross-up is
necessary to get back to “substantial economic effect”
16
Sale of a Partnership Interest and Rev.
Rul. 91-32
• Where U.S. partnership is ETB, foreign
partner’s gain on sale of partnership interest is
ECI
• Issues
– Aggregate v. entity theory
– No withholding mechanism in place
• FAA 20123903F (Mar. 8, 2013) follows Rev. Rul.
91-32
17
Potential Codification of
Rev. Rul. 91-32
• The Administration’s Fiscal Year 2014 Revenue Proposal includes the
codification of Rev. Rul. 91-32
– Gain or loss from the sale or exchange of a partnership interest is ECI to the extent
attributable to transferor partner’s distributive share of the partnership’s
unrealized gain or loss that is attributable to ECI property.
– Secretary would be granted authority to specify extent to which distribution from
the partnership is treated a sale or exchange of an interest in the partnership and
coordinate with current nonrecognition provisions.
– Transferee of a partnership interest would be required to withhold 10% of the
amount realized on the sale unless the transferor certified that the transferor was
not a nonresident alien individual or foreign corporation.
– If transferee did not withhold the correct amount, the partnership would be liable
for the under withholding. Partnership would satisfy the obligation by withholding
on future distributions that otherwise would have gone to the transferee partner.
– Query the result if the partner (as is usual) sells its entire interest and ceases to be
a partner
18
Master Limited Partnerships
• An MLP is a limited partnership that trades on a
security exchange or is readily tradable
• Holding an MLP Unit
– Holder taxed as a partner and subject to ECI
– Allocation method used by MLP may affect a foreign
partner’s ECI
– Filing Obligations
• Selling an MLP Unit
– Unitary basis
– Potential application of Rev. Rul. 91-32
19
Master Limited Partnerships
• Foreign investment in MLPs is increasing
– Continued strong yield
• Direct Investment
– Cash distributions cut back under section 1446 at the maximum
rate and refunds still cause struggles
• MLP Investment through blockers
• MLP Mutual Funds
– Generally treated as C corporations because they fail the mutual
fund income test
– Not subject to section 469
– Create an avenue for foreign taxpayers to gain access to the
MLP sector by utilizing a public U.S. blocker structure
20
III. Investment Partnerships
21
Investment Partnerships
• Section 875 provides that a foreign partner of
a partnership that is engaged in a US trade or
business (“ETB”) is deemed engaged in a US
trade or business
• In general, a foreign person who invests in a
private equity, buyout or similar fund is not
engaged in a US trade or business, because
the fund is merely an investor or trader
22
FDAP Withholding
• Items of US source FDAP (interest, dividends, etc.) flow
through the partnership and must be withheld upon at the
statutory 30% rate or such lower rate as may be provided
by an applicable treaty or exemption
– Portfolio interest exemption
– Section 892 exemption
• The source rules are in some respects unclear:
– What is the source of a §707(c) guaranteed payment for
services? Presumably where the services are performed
– What is the source of a §707(c) guaranteed payment for
interest? Does it turn on the “residence” of the partnership?
Note that interest paid by a foreign partnership not out of US
ECI is foreign source; §861(a)(1)(B)
23
FDAP Withholding
• What is the source of cancellation of indebtedness
income?
– NYSBA report #1070 (Nov. 5, 2004)
• The source of guarantee fees has now been clarified by
statute
– §861(a)(9) provides a source rule analogous to interest –
look to residence of person whose debt is being
guaranteed
• Note §871(m) will treat “dividend equivalents” as US
source dividends; compare treatment of substitute
dividends and interest vs. payments on notional
principal contracts
24
FDAP Withholding
• Who withholds?
• A domestic partnership is a withholding agent
• A foreign partnership is not a withholding
agent unless it has a “withholding foreign
partnership” agreement in effect with the IRS
– Absent such an agreement, the original payor of
the item must get a Form W-IMY from the foreign
partnership accompanied by Forms W-8BEN from
its partners in order to withhold at less than 30%
25
Treaties and Hybrids
• If a foreign person invests through a hybrid
entity treated as transparent in the US but
opaque at home, treaty benefits are denied
under §1.894-1(d)(1)
– This is a trap for foreign investors from countries
that view LLCs as opaque, which is common
– The solution is to avoid LLC aggregators and invest
only through non-hybrid partnerships
– The §894 regulations apply only to FDAP; branch
tax issues are unclear
26
Treaties and Hybrids
• Note that an entity may be a hybrid in some but not all jurisdictions
of its owners. The §894 regulations permit treaty benefits to be
claimed in two cases:
– Where the hybrid entity itself qualifies for treaty benefits, as might be
the case where it is organized in a treaty country and is opaque at
home
– Where an owner of the hybrid entity qualifies for treaty benefits
because the hybrid is transparent at home
• Suppose foreign investor A from country A and foreign investor B
from country B invest in a US partnership through Entity B formed
in country B, and that Entity B is treated as transparent in country A
but as opaque in country B
– Foreign investor A can claim treaty benefits under the A-US treaty
– Entity B can claim benefits as to foreign investor B’s share of its income
27
Treaties and Hybrids
• The §894 regulations also address “domestic reverse hybrid”
(“DRH”) structures
• If a domestic entity is treated as a corporation for US tax purposes
but as a partnership for foreign purposes, its foreign owners cannot
claim treaty benefits for items of income that their county sees as
passing through the DRH
• Payments by the DRH to its foreign owners are characterized using
US principles (i.e. as dividends)
• As a practical matter, this rule bites only if the foreign owners have
lent money to the DRH; if instead the DRH borrows from a third
party, both it and its foreign interest holders will get the benefit of
an interest deduction (one deduction in each country)
– But see Article IV, ¶7(b) of the US-Canada treaty, denying treaty
benefits to a Canadian owner of a DRH on payments made by the DRH
28
Use of Blockers by Funds
• Where a partnership is not itself engaged in a US trade
or business, and owns only stock of portfolio
companies, only the FDAP rules apply
• But if the partnership invests in a partnership
conducting a US trade or business, §875 dictates that
each foreign partner is engaged in a US trade or
business
– Moreover, the partnership’s permanent establishment will
be attributed to all partners for tax treaty purposes
• This problem is normally solved by inserting a
“blocker” corporation somewhere between the
operating partnership and the foreign investor
29
Use of Blockers by Funds
• A blocker can be put “above the fund” or “below the
fund”
• While below the fund blockers may facilitate an IPO
exit through the blocker, there is a risk that they may
present an requirement that the foreign partner file a
US tax return
– Reg. §1.875-1 states that a foreign person that is a partner
of a partnership having ECI is considered to be ETB (and
hence must file?)
– While the foreign partner in a below the fund blocker has
no economic interest in the ECI-generating investment,
literally it is a partner in a partnership that does
30
Use of Blockers by Funds
• Note that a REIT can function as a blocker even
though it is not taxable (assuming it distributes
most of its income each year)
– A REIT is a character converter and thus distributions
will be dividends rather than having the character of
the REIT’s underlying income
– But see §897(h)(1)
• Since most US blockers are US corporations
subject to tax, it is common to leverage blockers
with shareholder debt
31
IV. FIRPTA
32
FIRPTA
• Gain from sale of USRPI taxed as if:
– Foreign seller is ETB and gain is ECI (but no branch profits
tax)- Sec. 897
– Foreign sellers taxed at same rates applicable to U.S.
sellers
– Gain can qualify for long-term capital gains treatment, for
individuals
• Sec. 1445 imposes on buyer 10% withholding on
amount realized in a direct sale of USRPI
• Sec. 1445(e)(1)- withholding on gain from sale of USRPI
by US partnership with one or more foreign partners
– 35% of gain if corporate partner; 20% if individual
33
FIRPTA Applies to:
• Real estate
– Including USRPHCs- 5 year look back
• Loans with Equity Kickers
– But not to contingent interest; only to sale of loan
• But not to:
– Foreign Corporate Stock
– Interest solely as a creditor (pure debt)
– Publicly Traded Stock/PTP
– Domestically Controlled REIT
– The Administration’s recent Budget Proposals include a proposal to exempt
gains realized by “foreign pension plans” from FIRPTA. Query if this exemption
applies to foreign government, as well as private, pension plans?
34
FIRPTA
• Sale of interest in partnership owning USRPI
triggers ECI under Sec. 897
– Sec. 897(g), Notice 88-72
• But no 1445 withholding unless 50/90 test met
• Temp. Reg. Sec. 1.897-7T(a)- “50/90
partnerships”:
–if >=50% of partnership assets are USRPI and >=90% of
partnership assets are USRPI, cash, and cash equivalents,
entire partnership interest classified as USRPI for Section
1445 purposes (but not 897 purposes)
–Withhold on entire amount realized
–Or apply for withholding certificate
35
FIRPTA Withholding
• Sections 1445 and 1446 overlap as to USRPI
sales by domestic partnerships, both providing
for withholding at maximum US rate
• Section 1445 generally subordinate to Section
1446
–Reg. Sec. 1.1446-3(c)(2)(i)
• No availability of FIRPTA withholding certificate
to reduce withholding
36
Taxation on USRPI Contribution?
• Temp. Reg. Sec. 1.897-6T(a)(3)
Sec. 721 : contributions of USRPI to partnership in
exchange for partnership interest generally tax-free,
if all assets of the partnership are USRPI
• Temp. Reg. Sec. 1.897-6T(a)(3): 721 applies only to extent
sale of partnership interests received would be taxable
under 897(g)
• If foreign partner contributes appreciated USRPI, and other
partners contribute non-USRPI, partial tax on contributing
partner?
• Sec. 704(c) would apply at partnership level, so
contributing partner ultimately taxed on gain from sale of
USRPI by partnership
• But if foreign partner sells her partnership interest, 897(g)
doesn’t appear to incorporate 704(c) principles
37
Late Admissions- Disguised Sale?
• Most fund documents say that where a partner is
admitted late and cash goes to preexisting partners, e.g.,
to refund their capital contributions, treated as sale across
• If partnership owns USRPI and one or more existing
partners are foreign, deemed to sell USRPI under 897(g)
• If 50/90 partnership, 1445 withholding applies unless
obtain withholding certificate (which some do)
• If not 50/90, no 1445 withholding, but filing obligation
for foreign partners under 897(g)
–Withholding certificate to eliminate filing obligation?
38
Impact of Drafting?
• Some fund docs say later admitted partners pay
same price as original partners, but pay interest
charge
–Here, looks more like partner was admitted on day
one, but paid late. No sale? No 897(g) issue?
• Some fund docs say the later partner has to pay
FMV for her interest
– Here, need to obtain appraisal, and if underlying
USRPI has appreciated, FMV is increased
– Is this an 897(g) sale?
39
Leveraged Distributions and FIRPTA
FP
U.S.
Blocker
Fund
USRPI
GP
• Assume USRPI is appreciated
• Blocker borrows from bank
against value of property,
distributes cash to FP
• Blocker has no e&p, and
USRPI is appreciated, so part
of distribution is gain under
301(c)(3)
• No branch profits tax (but no
e&p, so not significant)
•But gain is ECI and FIRPTA
applies
40
Leveraged Distributions and FIRPTA
FP
Non-U.S.
Blocker
Fund
USRPI
GP
• Assume USRPI is appreciated
• Blocker borrows from bank
against value of property,
distributes cash to FP
• Blocker has no e&p, and
USRPI is appreciated, so part
of distribution is gain under
301(c)(3)
• Here, branch profits tax (but
no e&p, so not significant)
•But now gain is not ECI and
FIRPTA does not apply
41
V. Sovereign Wealth Funds
42
US Taxation of Foreign Governments – General
• A foreign government is taxed in the same manner as a
foreign corporation on income that is not exempt from
tax under Code Section 892
– 30% withholding tax on non-exempt fixed and
determinable, annual and periodic income, subject to
reduction under an applicable bilateral US income tax
treaty
– Graduated rates on income effectively connected with the
conduct of a US trade or business
– 30% branch profits tax
43
US Taxation of Foreign Governments –
Code Section 892
• Exemption for U.S. source income received by foreign
governments from:
– Stocks and securities
• No exemption for:
– Income derived from commercial activity anywhere in the world
• Received by a controlled commercial entity;
– Control means 50 percent or more direct or indirect interest by vote or
value or any other interest which provides effective control of such
entity to the foreign government
• Received directly or indirectly from a controlled commercial entity;
or
• Derived from the disposition of any interest in a controlled
commercial entity.
44
US Taxation of Foreign Governments –
Code Section 892
• The definition of “commercial activity” is broad and
its parameters are unclear
– However, activity that does not rise to the level of a “trade
or business” may, nevertheless, constitute “commercial
activity”
• “Commercial activity” may be imputed to a SWF as a
result of its investment in a partnership
– Particularly important where a SWF invests in a private
equity or hedge fund partnership
45
Proposed Regulations – Treatment of Partnerships
• The Proposed Regulations modify the existing rule
that attributes the commercial activities of a
partnership to all of its partners, to provide an
exemption for any entity that is considered to own
“an interest as a limited partner in a limited
partnership”
– Test in Proposed Regulations is if the holder of such
interest does not have rights to participate in the
management and conduct of the partnership’s business
– The Proposed Regulations provide that they may
be relied on currently
46
Limited partner exception • An entity that is not otherwise engaged in
commercial activities will not be deemed to be
engaged in commercial activities solely because it
holds an interest as a limited partner in a limited
partnership
• A foreign government member’s distributive share of
partnership income will not be exempt from taxation
under Section 892 to the extent that the partnership
derived such income from the conduct of a
commercial activity
47
Limited partner exception (cont.) • An interest in an entity classified as a partnership for US federal
income tax purposes shall be treated as an interest as a limited
partner in a limited partnership if the holder of such interest does
not have rights to participate in the management and conduct of
the partnership’s business at any time during the partnership’s
taxable year under the law of the jurisdiction in which the
partnership is organized or under the governing agreement
– Potentially extends to LLCs
• Rights to participate in the management and conduct of a
partnership’s business do not include consent rights in the case of
extraordinary events such as admission or expulsion of a general or
limited partner, amendment of the partnership agreement,
dissolution of the partneership, disposition of all or substantially all
of the partnership’s property outside of the ordinary course of the
partnership’s activities, merger, or conversion
– Other rights?
48
Attribution Exception for Passive LPs
• Any flexibility for limited involvement not on day-to-day
basis?
– Participation on advisory committee (limited oversight)
– Side letter
Example: FG investor negotiates side letter requiring fund
manager to use reasonable best efforts (whatever that means)
to avoid making any investments that would cause the fund
(and thus FG) to be engaged in commercial activities anywhere
in the world.
Comment: In the event that the fund nevertheless ends up so
engaged, it would be ironic if the side letter precluded access to
the attribution exception for passive LPs.
49
Proposed Regulations – Treatment of Partnerships
• The Proposed Regulations expand certain existing safe
harbors for trading activities conducted directly by a
foreign government so that they similarly apply to
trading activities of a partnership in which a foreign
government is a partner.
• The Proposed Regulations do not address the
application of the Code Section 892 exemption to
either income earned through partnerships or income
arising on the sale of a partnership interest.
50
Sale of LLC Interest
FG
Sale
“Gain on the disposition
of an interest in a
partnership or trust is
not exempt from
taxation under Section
892”. Temp. Treas. Reg.
Sec. 1.892-3T(a)(2)
LLC
USRPHC stock
Other stocks,
bonds
51
VI. Transfer Taxes
52
Gift Tax
• Foreign persons are subject to US gift tax only on
gifts of US situs tangible assets
• Since 1991, IRS ordinarily will not rule on whether
a partnership interest is tangible or intangible for
gift tax purposes
–Rev. Proc. 2013-7, Sec. 4.01(28)
–Why? Isn’t this a legal issue?
• Assume NRA parent owns US real estate through a
partnership. Is transfer of partnership interest to
child taxable gift?
• Will we ever have an answer to this issue?
53
Estate Tax
• Foreign persons are subject to US estate tax only
on US situs assets
• Situs of partnerships not clear, though most recent
[very old] guidance suggests IRS applies entity
theory
–RR 55-701 (citing Blodgett v. Silberman, 277 US 1, 1928)
• Assume NRA dies owning US real estate through a
foreign partnership that is not engaged in a US
trade or business. Does decedent own a US situs
asset at death?
– Entity vs. aggregate theory
54