Withholding taxes on foreign partners - a recurring nightmare.

• Author: Lorence, Roger D.

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)...