Regulations that govern United States income tax return filings for foreign venture capital partnerships that invest or trade in stocks, securities and commodities and certain related derivatives were adopted in November and went into effect Jan. 1.
Under the new regulations, and with exceptions noted below, a U.S. partnership income tax return must be filed by a foreign securities or commodities partnership that has:
(a) U.S. source income (even if such income is exempt from U.S. income tax to foreign recipients), and;
(b) One or more U.S. partners (even if only indirectly, through tiers).
This rule is similar, but not identical, to those contained in previous regulations, except no filing is required if:
(1) all U.S. partners, in the aggregate, do not have at least 1% of any item allocated to them, and;
(2) the partnership has no more than $20,000 in U.S. source income.
For venture capital partnerships created outside the U.S., regardless of whether they invest in foreign or U.S. corporations, these rules usually will require that a U.S. partnership income tax return be filed even if there is only one U.S. partner – and even if indirectly through tiers of foreign pass-through entities. This results from treating capital gains as U.S. source income to the extent such gains are allocated to U.S. partners. The Internal Revenue Service understands full well that such filings generally were not made in the past and are not likely to be made in the future by most foreign investing or trading partnerships, and thus has created a monster for no good reason. But if sufficient, detailed information is provided to U.S. partners, the penalty provisions appear to have no teeth.
Limited Filings After 2000
For 2001 and later years, even when tax returns are filed for foreign partnerships – Schedules K-1 are required for direct U.S. partners and pass-through foreign partners in which one or more U.S. persons holds an interest. It is unclear how a partnership is expected to know who stands behind a pass-through entity. The safe course of action would be to file Schedules K-1 for all pass-through entities, although the knowledge of which foreign entities are pass-through because someone filed a “check-the-box election” may itself be unavailable to the partnership.
This limited Schedule K-1 reporting is available only if the withholding agent, or the partnership, files the required Forms 1042 and 1042-S (even when no tax is due), and pays any associated withholding tax.
Unfortunately, this limited Schedule K-1 filing will not be available before 2001 tax returns because the IRS has tied this to certain withholding tax rules taking effect at that time. These new withholding rules would for the first time require foreign partnerships to provide information about their partners to U.S. withholding agents for dividends and other withholdable items. Under these new rules, a foreign partnership is treated as transparent and the U.S. withholding tax rate, if less than 30%, would depend on the country of residence for each partner.
Also, a foreign partnership with no U.S. partners but with U.S. source income – not business income – will have no U.S. income tax return filing requirement beginning with 2001 provided that it is not a withholding foreign partnership and any withholding taxes are paid and the required forms are filed.
Unfortunately, this rule does not apply for 2000, which appears to be a rather strange partnership filing requirement for certain foreign partnerships with no U.S. partners, simply because prior to 2001, withholding rules are focused on the partnership rather than upon its partners. The foreign partnerships affected are those whose only U.S. source taxable income is completely covered under withholding rules or is exempt from tax to non-U.S. persons. This requirement is especially curious since the penalty provisions for non-filing would appear to be of little consequence in these circumstances.
U.S. Source Income
Since there is no U.S. income tax return required for a foreign partnership unless it has “U.S. source income,” the definition of that term is important.
Interest and dividends paid by most U.S. entities constitute U.S. source income As a general rule, a partnership with both U.S. and foreign partners will have, respectively, U.S. and foreign source gains at the partner level (sourced at the partner’s country of residence), requiring that a U.S. partnership income tax return be filed.
The penalty for non-filing could be severe to the U.S. partners. Thus, a U.S. person who invests in a foreign partnership that generates gains from stock or securities, should make certain that the partnership return is filed, or it can be demonstrated that the U.S. partner made a reasonable attempt to have the partnership file a return. Sufficient detailed partnership information must also be placed in the hands of U.S. partners, so they can substantiate the amounts themselves in the event of an IRS audit.
There may, however, be a different view of the relevant statute and regulations. The return filing requirement is caused by the partnership having U.S. source income, whereas the U.S. source nature of the income is created only at the partner level. If the source rule could be applied as a residence test at the partnership level, or the partnership could be considered as having no source for its income, then a foreign investment partnership would not have U.S. source capital gains. However, based on informal discussions with IRS personnel, the IRS is not expected to concur with this view.
A U.S. partner wishing to make a partnership election (e.g., a Section 754 election to step up inside asset basis) will need to have a statement of election filed with a U.S. partnership income tax return (form 1065) even if a return is not required. No amount need to be entered in that form, however, it must be signed by all partners or an authorized partner.
Failure to file a required U.S. partnership income tax return for a foreign partnership whose books and records are maintained outside the U.S., or who has a nonresident tax matters partner, could cause denial to all partners (including U.S. partners) of partnership deductions, losses and credits. Proposed regulations provide a 60-day period for filing a partnership income tax return following the mailing date of an IRS notice proposing disallowance of the items listed above. Under the proposed regulation, if the return is not filed by the end of the 60-day period, the IRS can disallow such items to a partner. Even then, the IRS has discretion whether to issue a notice reflecting such disallowance. Furthermore, if the partner can establish to the IRS’s satisfaction that the losses and/or credits are proper, and that the partner made a good faith effort to have the partnership file the required return, then the IRS may allow the losses and/or credits in whole or in part.
In addition, subject to a reasonable cause exception, a penalty can be assessed against a non-filing or late filing partnership, at $50 per month per partner, for up to five months.
U.S. Partners in Foreign Partnerships
The Tax Relief Act of 1997 imposed a three-prong reporting regime for U.S. partners in foreign partnerships but left it up to regulations for implementation. Two of these reporting requirements, which are applicable to controlled foreign partnerships and the acquisition or disposition of a 10% interest in a foreign partnership, are first effective for 2000, with reporting first required in 2001, pursuant to regulations issued in late December 1999. Thus, there are currently no reporting requirements applicable to these matters. The other prong became effective January 1998 and relates to transfers to foreign partnerships.
Transfering Money or Property to Foreign Partnerships
Reporting is required on form 8865 with the U.S. person’s U.S. income tax return for the year of transfer if any U.S. person (including a U.S. entity) contributes money or other property to a foreign partnership in exchange for a partnership interest and immediately after the transfer, such U.S. person (directly or indirectly) owns at least a 10% interest in either the capital or the profits of the partnership or the value of the transfers by such U.S. person to the foreign partnership during the 12-month period ending on the date of the transfer exceeds $100, 000.
If a U.S. partnership makes a reportable transfer, it should do the reporting. However, if it fails to do so, each U.S. partner whose proportionate share of the transfer (or its proportionate interest in the foreign partnership) is of sufficient size is required to do its own reporting. No reporting is required if a foreign partnership contributes property to another foreign partnership.
If a U.S. person was required to report a transfer of appreciated property to a foreign partnership, and the foreign partnership subsequently (during any year, current or future) disposes of the property while the U.S. person remains a direct or indirect partner (other than in a tax-free transaction, which defers this reporting), that U.S. person must report the disposition on form 8865. Subject to a defense of reasonable cause, the penalties for failure to comply with these reporting requirements are 10% of the value of contributed property, with a maximum penalty of $100,000 (unless the failure was due to intentional disregard of the rules), and recognition as a taxable gain any appreciation on the contributed property. Noncompliance includes the failure to report at the proper time and in the proper manner or the provision of false or inaccurate information.
Stephen J. Epstein is a Tax Partner at Richard A. Eisner & Company, LLP, an accounting and consulting firm in New York City. Epstein specializes in issues concerning venture capital and mergers and acquisitions.