Withholding Requirements for Income Allocated to Foreign Partners. .

• Author: Godfrey, Howard
• Position: Part 2

EXECUTIVE SUMMARY

* The regulations allow the partnership making the initial allocation of earnings to "look through" intervening partnerships to determine the withholding rate.

* A partnership's payment of Sec. 1446 tax is treated as a distribution; thus, the partner recognizes gain if the distribution exceeds its basis.

* If a partnership fails to make required Sec. 1446 payments or file the forms, it is liable for the tax, additions to tax, interest and penalties.

**********

This two-part article explains how to compute, pay and report the Sec. a1446 tax on effectively connected taxable income allocable to foreign partners. Part II covers special withholding rules for tiered and publicly traded partnerships, partnership liability, and tax payment and reporting.

This two-part article explains the U.S. requirements for withholding on income allocated to foreign partners, procedures for computing and paying the tax, and related reporting requirements. Part I, in the September 2006 issue, covered the framework for withholding on U.S. income earned by foreign persons, procedures for identifying foreign partners and how to compute their income allocations. It also addressed 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, below, covers special withholding procedures for (1) a partnership with effectively connected income (ECI) allocated to a foreign partner that is a partnership (i.e., a tiered partnership) and (2) publicly traded partnerships (PTPs). It also discusses the Sec. 1446(d) deemed cash distribution of withheld tax, a partnership's liability for withholding tax, and procedural matters related to computing, paying and reporting the tax.

Lookthrough Procedures and PTPs

The Sec. 1446 withholding regulations (16) focus on accurate withholding on taxable income from U.S. business operations that is allocated to foreign partners. To withhold accurately, the tax rates of the taxpayer with the final responsibility for the income tax must be considered. When a foreign partner is a partnership, the income allocation flows through at least two partnership entities before flowing through to the partner that ultimately files the return. The partnership making the initial allocation of earnings can "look through" intervening partnerships when determining the applicable withholding rate.

PTPs have to withhold on actual distributions to foreign partners, not on allocations to them. The lookthrough rules do not apply to certain tiered partnerships that include a PTP.

Tiered Partnerships

Allocation to a Foreign Partner that Is a Partnership

When a lower-tier partnership (LTP) is owned partly by a foreign partnership (upper-tier partnership (UTP)), the LTP may look through the UTP to the partners when computing the Sec. 1446 tax. Under Regs. Sec. 1.14465(c), the LTP treats the foreign UTP's allocable share of the LTP's effectively connected taxable income (ECTI) as being allocable to the UTP's foreign partner(s). In effect, the UTP's foreign partners are treated as partners of the LTR The Sec. 1446 tax on ECTI allocated to a foreign partner of the UTP is based on the classification of the partner (i.e., individual). The amount of the tax also may depend on:

1. Whether, the income is ordinary or capital gain under Regs. Sec. 1.1446-3(a)(2);

2. The amount of certified losses and deductions available to the foreign partner; and

3. Whether the foreign partner qualifies for an exemption from withholding under Temp. Regs. Sec. 1.1446-6T.

   This lookthrough procedure is usable only when the LTP obtains adequate information about the UTP's partners, as noted under Regs. Sec. 1.1446-5(c). (17)

   Domestic UTP

   Regs. Sec. 1.1446-5(a) states that an LTP generally has no withholding responsibility for ECTI allocated to a domestic UTP, even if the UTP has foreign partners. A domestic UTP is responsible for withholding on its total ECTI allocation to its foreign partners. This responsibility extends to its own ECTI and the ECTI allocation it receives from the LTP. However, if a domestic UTP makes a lookthrough election under Regs. Sec. 1.1446-5(e)(3) and the LTP consents, the LTP has to pay the withholding tax on its ECTI allocated to the UTP's foreign partners.

   UTP's Lookthrough Election

   When electing the lookthrough procedures described in Regs. Sec. 1.1446-5(e)(1), the domestic UTP must provide Form W-9, Request for Taxpayer Identification Number and Certification, to the LTP to establish its nonforeign status and written election. The LTP must consent to the election in writing and agree to apply the rules. If the LTP declines, it must treat the domestic UTP as a U.S. person for Sec. 1446 purposes, according to Regs. Sec. 1.1446-5(e) (3); as a result, the UTP would retain primary responsibility for paying withholding tax.

   Election's Effect

   The LTP has withholding responsibilities for foreign partners (including foreign UTPs), regardless of whether the lookthrough procedures are used. When there is a foreign UTP, the lookthrough rules may potentially reduce the LTP's tax payment. When a domestic UTP elects the lookthrough rules (and the LTP consents), the primary responsibility for paying the withholding tax transfers from the domestic UTP to the LTP, as was noted.

   Regardless of whether the UTP is a domestic or foreign partnership and whether the LTP looks through the UTP in computing its withholding tax, the UTP is still obligated to report and pay its Sec. 1446 tax liability. The UTP can claim a credit for withholding tax paid by the LTP, which may fully cover its Sec. 1446 liability.

   PTP's Use of Lookthrough Rules

   According to Regs. Sec. 1.1446-5(d), the lookthrough procedures may apply to a PTP (or its nominees required to pay Sec. 1446 tax) that is an LTP, but they do not apply to a PTP that is a UTP. Exhibit 1 on p. 599, illustrates the documentation needed to use the lookthrough procedures for tiered partnerships based on the information presented in Example 1 below. The lookthrough procedures in the exhibit would not be available if the UTP were publicly traded.

   ...