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 Sale FG 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