Withholding requirements for income allocated to foreign partners.

• Author: Godfrey, Howard
• Position: Part 1

EXECUTIVE SUMMARY

* The Sec. 1446 withholding tax applies ff the partnership has ECTI allocable to any foreign partner.

* Withholding applies regardless of whether any distribution or payments are made to the partner.

* Regulations now provide relief in three situations when a partner's withholding tax exceeds the tax liability.

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This two-part article explains the computation, and payment and reporting requirements for the Sec. 1446 tax on effectively connected taxable income allocable to foreign partners. Part I explains how to identify foreign partners and calculate the income allocable to them.

Final and temporary regulations issued in 20051 contain rules for Sec. 1446 withholding on partnership taxable income from U.S. business operations (i.e., effectively connected taxable income (ECTI)) that is allocated to foreign partners. This two--part article explains the withholding requirements and the procedures for computing and reporting the tax. Part I, below, covers the framework for withholding on U.S. income that is earned by foreign persons, procedures for identifying foreign partners and the calculation of income allocations to them. This article also addresses the special procedures for a foreign partner's income tax rates, business deductions and reduced withholding rate (or exemption from withholding) due to a treaty or other factors.

Part II, in the October 2006 issue, will discuss special withholding procedures for a partnership with effectively connected income (ECI) allocated to a foreign partner that is a partnership (a tiered partnership) and the special withholding rules for publicly traded partnerships. Other matters covered in Part II include the Sec. 1446(d) deemed cash distribution of withheld tax, the partnership's liability for withholding tax, procedural matters related to tax computation and payment, and reports to foreign partners and the IRS.

Background

In 1986, Congress added Sec. 1446, which imposed 20% withholding on distributions to foreign partners. Distributions were presumed to be made first to the extent of passive income subject to withholding under Sec. 1441. Any remaining distributions were subject to withholding under Sec. 1446.

Sec. 1446 caused distributions from partnerships to be subject to withholding even when such distributions were not subject to U.S. tax. Thus, in 1988, Congress amended Sec. 1446 to apply the withholding tax to allocations of ECTI to foreign partners. ECI is income that is "effectively connected" with the operation of a U.S. trade or business; ECTI is "effectively connected taxable income" (i.e., ECI less related expenses). (2)

After the 1986 enactment of Sec. 1446, the main sources of guidance were Rev. Procs. 89-31 (3) and 92-66. (4) Final regulations under Sec. 1446 were adopted on May 13, 2005; temporary and proposed regulations were also issued. The regulations explain deductions available to a foreign partner when computing the withholding tax, and exempt a foreign partner from withholding when the annualized tax due therefrom is less than $1,000. Thus, the revenue procedures are obsolete for partnership tax years beginning after May 18, 2005. In addition, the regulations were effective on Dec. 31, 2004 for partnerships electing earlier application. (5)

Sec. 1446 withholding is a misnomer, because a partnership pays the tax on behalf of its foreign partners, whether or not it makes any payments or distributions to them. The 2005 regulations recognize this by using the term "1446 tax"

Taxation of Foreign Partners--FDAP and ECTI

The Federal income tax and alternative minimum tax apply to nonresident aliens (NRAs) only as provided in Sec. 8716 and to foreign corporations only as provided in Sec. 882. A foreign trust or foreign estate is treated as an NRA under Sec. 641(b).

Gross Basis Taxation

Sec. 871(a) imposes a 30% tax (7) on income received by NRAs that consists of fixed or determinable, annual or periodic (FDAP) income (i.e., dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments and other FDAP gains, profits and income). Sec. 881(a) imposes a similar tax on foreign corporations. The tax on FDAP is collected through withholding, generally at 30%, on: (1) NRAs under Sec. 1441, (2) foreign corporations under Sec. 1442 and (3) foreign exempt organizations under Sec. 1443.

With gross basis taxation under Secs. 871(a) and 881(a), no deduction is allowed in ascertaining the base for computing the income tax. (8) Under Regs. Sec. 1.6012-1(b) and -2(g)(2), NRAs and foreign corporations are not required to file Federal income tax returns if they are not engaged in a trade or business in the U.S. and their tax liability is fully satisfied by withholding at source under Chapter 3 of the Code.

Net Basis Taxation

This applies to foreign taxpayers earning income effectively connected with a U.S. trade or business. This taxation scheme is imposed on NRAs by Sec. 871(b) and on foreign corporations by Sec. 882. The tax is fully or substantially paid through withholding at source. The foreign taxpayer has to file a Federal income tax return and compute the tax due or the refund, taking into account deductions allowed by the Code. The foreign partner must pay any remaining balance with the return, and may obtain a refund when the credit for the withholding exceeds the tax liability. (9)

Withholding Requirements

According to Regs. Sec. 1.14463(c), certain "passive income" (FDAP income) subject to tax under Sec. 871 or 881 is not subject to withholding under Sec. 1446. Instead, such income is subject to the withholding requirements of Secs. 1441, 1442 and 1443 and the related regulations.

Determining Partners' Status

Identifying Foreign Partners

Regs. Sec. 1.1446-1(a) requires a partnership to determine if it has one or more foreign partners and, if so, whether it has any ECTI allocable under Sec. 704 to any of them. If the answer is yes to both, the partnership computes Sec. 1446 tax, pays it to the IRS and reports the amount paid to its foreign partners. Regs. Sec. 1.14461(c)(1) recognizes the following types of foreign partners: (1) an NRA, (2) a foreign partnership, (3) a...