December 5, 2017 IRS issues proposed regulations on international rules under BBA partnership audit regime Treasury and the IRS have issued proposed regulations (REG-119337-17, the New Proposed Regulations) providing guidance on the application of certain international tax rules under the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015 (BBA). Partnerships subject to these rules are referenced herein as "BBA partnerships." The New Proposed Regulations address coordination of the BBA regime with the international tax provisions of the Code in two major areas. The first area is the withholding tax rules for payments to non-US persons and entities of Sections 1441-1446 (Chapter 3) and the Foreign Account Tax Compliance Act (FATCA) rules of Sections 1471-1474 (Chapter 4). The second is taxes eligible for the foreign tax credit (FTC), as well as creditable foreign tax expenditures (CFTEs) and items that affect a partner's ability to utilize FTCs. The preamble notes, but does not provide guidance on, other issues, such as indirect foreign tax credits under Sections 902 and 960, interaction of the BBA regime with taxation of foreign indirect US partners of direct partners that are foreign corporations, and coordination with the mutual agreement procedure under income tax treaties. The preamble states that the New Proposed Regulations are intended to supplement the proposed regulations (REG-136118-15)1 under the BBA partnership audit regime (herein referred to as "the June Proposed Regulations," to distinguish from the New Proposed Regulations), and that Treasury and the IRS intend to integrate the provisions when both are finalized. Specifically, these proposed regulations provide the following key provisions: 1. Rules to coordinate the interaction of the centralized partnership audit regime with audits or examinations under chapters 3 and 4 2. Rules applying the withholding and reporting requirements under chapters 3 and 4 to a partnership that makes a Section 6226 election to "push" liability for any understatement out to the partners 3. Rules that require the separate reporting of items that could affect the computation of foreign tax credits at the partner level 4. Rules for computing the imputed underpayment with respect to an adjustment of CFTEs Background As part of the BBA, Congress enacted legislation that overhauls the manner in which partnerships are audited and how any resulting tax liability is assessed and collected. Before the BBA, a partnership audit generally was conducted in accordance with Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which did not provide any statutory mechanism for collecting tax at the entity level. Rather, the IRS generally was required to seek payment of underpaid tax directly from those who were partners in the partnership during the year of audit. The BBA brought in a new regime to allow for assessment and collection of tax at the partnership level under centralized audit procedures, along with a number of other changes to the partnership audit process. These new rules are generally effective for most partnerships for tax years starting after December 31, 2017. On June 13, 2017, Treasury and the IRS released the June Proposed Regulations, which provide additional guidance on the applicable procedures, the determination of the amount of taxes, interest and penalties owed, and other consequences of an adjustment to a partnership tax return. Among other provisions, the June Proposed Regulations include procedures for opting out of the new regime, designating a partnership representative, filing administrative adjustment requests, and determining amounts owed by a partnership or its partners from adjustments following partnership exam. For a detailed discussion, see Tax Alerts 2017-0168 and 2017-1002. Chapters 3 and 4 of subtitle A of the Code A partnership that receives a payment of US-source income that is allocable to a partner that is a foreign person may have withholding requirements under chapters 3 or 4 of subtitle A of the Code. The key provisions of Chapter 3 (Sections 1441 — 1446) are Sections 1441, 1442, 1445 and 1446. Sections 1441 and 1442 generally require withholding at a rate of 30% on US-source passive fixed or determinable, annual or periodic income paid to nonresident aliens and foreign corporations. Section 1445 imposes withholding at a rate of 15% of the amount realized on dispositions by a foreign person of a US real property interest. Section 1446 requires withholding on the amount of a partnership's "effectively connected" taxable income allocable to foreign partners. Chapter 4 (Sections 1471 — 1474) generally requires US and non-US withholding agents, including "foreign financial institutions" (FFIs), to identify who their payees are and the FATCA status of those payees. For FATCA purposes, US withholding agents must withhold tax on certain payments to FFIs that do not agree to report certain information to the US regarding their US accounts and on certain payments to certain "non-financial foreign entities" (NFFEs) that do not provide information regarding their substantial US owners to withholding agents. Coordination of centralized partnership audit regime and chapters 3 and 4 The June Proposed Regulations did not include withholding liability within the centralized partnership audit regime, because a withholding liability under chapters 3 or 4 is not a tax imposed under chapter 1 and, therefore, does not fall within the scope of the regime. The IRS will continue to examine a partnership's compliance with its obligations under chapters 3 and 4 in a separate proceeding outside of the centralized partnership audit regime. The New Proposed Regulations include rules to coordinate the interaction of the centralized partnership audit regime with audits or examinations under chapters 3 and 4. If an audit under Chapter 3/Chapter 4 happened first, and tax were collected as a result of an adjustment, the issues resulting in that adjustment (or portion thereof) would be disregarded for purposes of any subsequent audit under the BBA rules. If the centralized audit under the BBA rules happened first, the partnership paid an imputed underpayment under Section 6225, and the partnership adjustment included an adjustment to an amount subject to withholding under Chapter 3 or Chapter 4, then the partnership generally would be considered to have satisfied any withholding tax liability associated with the adjustment in the event of a subsequent audit covering chapters 3 and 4. However, any interest, additions to tax or penalties for failure to withhold could be assessed and collected as part of a subsequent audit under chapters 3 and 4. Under the New Proposed Regulations, this same rule would apply when the partnership filed an administrative adjustment request (AAR)2 and paid the imputed underpayment. The New Proposed Regulations illustrate these points with examples addressing what occurs when: (1) a partnership fails to withhold at the correct rate on an item of income allocable to a foreign partner, and (2) a partnership fails to report an item of income and, therefore, also fails to withhold on the additional income allocable to a foreign partner. This is consistent with the general rule that, if tax under Chapter 3/Chapter 4 is not withheld from a payment to a non-US person, but the non-US person pays the tax due, the payment discharges the withholding agent from liability for the tax not withheld, but not from liability for interest, additions to tax and penalties for failure to withhold. Section 6226 elections and requirement to withhold and report under chapters 3 and 4 Under Section 6226 and the June Proposed Regulations, a partnership may elect to "push out" adjustments to its reviewed year partners rather than paying the imputed underpayment at the partnership level. To be valid, this election must comply with all the regulatory requirements for such an election and the partnership must provide notice to the partners and IRS. The June Proposed Regulations make it clear that the partnership is no longer liable for any imputed underpayment once a valid "push out" election is made. The New Proposed Regulations include rules that apply the withholding and reporting requirements under chapters 3 and 4 to a partnership that makes a Section 6226 election. For the Section 6226 election to be valid, the New Proposed Regulations would require the partnership to pay the withholding tax (in the manner prescribed by the IRS in forms, instructions or other guidance) on or before the due date for furnishing the Section 6226 statement that reports the adjusted item. The New Proposed Regulations clarify that this includes a requirement that the partnership file the appropriate withholding tax returns required by chapters 3 and 4 (Forms 1042 or Form 8804), including any associated information returns (Forms 1042-S or Form 8805) for the tax year that includes the date on which the partnership furnishes the Section 6226 statement. These same rules apply when a partnership files an AAR and elects to have its reviewed year partners take into account adjustments requested in the AAR. In short, liability for withholding tax under chapters 3 and 4 may not be "pushed out." Under the New Proposed Regulations, a partnership that is required to pay withholding tax under the regulations could reduce the amount of that tax to the extent that the reviewed year partner provided valid documentation to establish that it is entitled to a reduced rate of tax under chapters 3 and 4. The partnership, however, would not be allowed to reduce the amount of withholding tax due on effectively connected income under Section 1446 based on partner-level items as provided in Treas. Reg. Section 1.1446-6 because of administrability issues. In other words, certificates of partner-level items on Form 8804-C are not taken into account. The New Proposed Regulations would also require a reviewed year partner that is subject to withholding under the proposed regulations and receives a Section 6226 statement from the partnership to file a return for the reporting year to report its additional reporting year tax and its share of penalties, additions to tax, additional amounts and interest. This is notwithstanding the exception under Section 6012 that relieves a taxpayer that does not have any effectively connected income from the obligation to file a return if the taxpayer's US tax liability is fully satisfied through withholding. A partner claiming a withholding tax credit paid by the partnership must substantiate the credit with the appropriate information return (Form 1042-S or Form 8805). The preamble to the New Proposed Regulations states that the IRS is considering ways to alleviate the filing obligations in the proposed regulations for foreign persons when a partnership pushes out its adjustments and does not request the IRS to determine a specific imputed underpayment for adjustments subject to withholding. Specifically, it is considering, and requests comments on, whether to allow a partnership to elect to pay the share of penalties, additions to tax, additional amounts and interest attributable to a partner that would have been subject to withholding in the reviewed year. The IRS also requests comments on the application of chapters 3 and 4 to Section 6226 for partners that are foreign flow-through entities. US foreign tax credits In general, taxpayers may elect to claim an FTC under Section 901 for income, war profits and excess profits taxes paid or accrued during the tax year to any foreign country. Sections 902 and 960 allow certain corporate taxpayers to be deemed to have paid foreign taxes that are paid or accrued by foreign subsidiaries from which they receive a dividend or that generate subpart F income subject to current tax, respectively. A partnership is not eligible to claim an FTC under Section 901 (or a deduction for foreign taxes under Section 164). Instead, each partner takes into account its distributive share of the creditable foreign taxes paid or accrued by the partnership in the partner's tax year with or within which the partnership's tax year ends. This amount of such taxes paid, i.e., the amounts that would be CFTEs under the New Proposed Regulations, is accounted for as a separately stated item by the partnership. Partners can only claim FTCs against tax on net foreign-source income. In addition, taxes imposed on net foreign-source "passive" income may not be credited against US tax on net foreign-source "general basket income" and vice versa. Thus, an adjustment of any item — even one with no obvious connection to foreign income or taxes — at the partnership level has the potential to affect a partner's ability to use foreign tax credits. In addition, the source of certain types of income, such as gain from sale of inventory property, is determined at the partner level, and partners must apportion their own interest and research and development expenses between domestic-source income and foreign-source income. Adjustments affecting the category or amount of CFTEs of a BBA partnership The New Proposed Regulations expand upon a concept in the June Proposed Regulations. For purposes of calculating an imputed underpayment, the June Proposed Regulations provided that all partnership adjustments are to be grouped pursuant to different defined groupings enumerated in the regulations, and then further grouped into subgroupings based on "preferences, limitations, restrictions, and conventions." This concept allows the netting of adjustments within each grouping or subgrouping, but disallows netting of adjustments between different groups or subgroups at the partnership level. For example, the June Proposed Regulations provided that adjustments to ordinary income and loss items are grouped together, separately from capital gain and loss items. Only net positive adjustments in each grouping or subgrouping are taken into account when calculating the total netted partnership adjustment. The June Proposed Regulations left a placeholder for a "Creditable expenditure grouping." The New Proposed Regulations provide that the creditable expenditure grouping includes all partnership adjustments that can affect creditable foreign taxes or the ability to use them under the limitations previously described. The New Proposed Regulations provide subgroupings for: (1) items related to types of income that must be tracked in separate categories, such as general basket versus passive basket, and (2) items affecting computations made at the partner level, such as research and development expenses and interest expense. For example, change to interest expense could not be netted against changes to bottom-line income at the partnership level, and would have to be passed through in a separate subgrouping. Interest expense would have to be passed through separately to enable partners to make their own interest allocation computations. Also, increases to items that affect domestic-source income could not be netted against decreases to items that affect foreign-source income. On the other hand, an increase in interest expense related to one activity could be netted against a decrease in interest expense from another activity, and need not be passed through separately. This is because the partner's computations on how interest expense affects the ability to claim foreign tax credits start with the partner's "overall" interest expense and ignore which activity was related to any item of interest expense. The New Proposed Regulations also include rules for computing imputed underpayments. If the amount of CFTEs were decreased on audit, the item would be treated as if the partners had underpaid their US tax by that amount, and, as a result, the New Proposed Regulations would increase the imputed underpayment by the amount of the CFTE reduction. Conversely, if the amount of CFTEs were increased on audit, the proposed regulations would treat the item as if the FTC limitation would prevent use of the increased credit and, therefore, would not reduce the imputed underpayment. In other words, a downward adjustment of CFTEs would result in an underpayment of tax based on the assumption that all partners fully utilized such CFTEs in the past, but an upward adjustment of CFTEs would not automatically result in an overpayment of tax based on the assumption that the partners would be unable to utilize the newly available CFTEs. Section 6225 would generally allow the partnership to incorporate specific partners' facts when determining the imputed underpayment, which should help mitigate such consequences to some degree. The Preamble acknowledges that, given the potential significance of certain items of expense that may be subgrouped under the rules, imputed underpayments may be created that exceed the tax that would have been owed had all items been treated correctly in the reviewed year. (For example, an increase in domestic-source income and a corresponding decrease in foreign-source income would not in fact affect a partner that had deducted foreign taxes rather than claiming a credit, but the computation of the imputed underpayment assumes that all partners elected to claim foreign tax credits and were able to utilize them in full.) Treasury and the IRS request comments regarding whether such distortions could be reduced when computing the imputed underpayment before the modification process, while remaining consistent with the purpose of the source and allocation and apportionment rules under Sections 861 and 865, as well as the application of the FTC limitation under Section 904. Treasury and the IRS also request comments on the grouping and subgrouping of items of income, gain, loss or deduction based on source and separate category. Application of Section 905(c) to changes to creditable foreign tax expenditures Section 905(c) generally requires a taxpayer to notify the IRS in the event of certain changes to creditable foreign taxes, such as a subsequent increase or decrease to the current-year foreign tax liability. Treasury and the IRS request comments on whether the administrative adjustment request (AAR) process could also be used to satisfy the requirements of Section 905(c) for changes in CFTEs paid or incurred by the partnership. Foreign taxes deemed paid under Sections 902 and 960 The New Proposed Regulations do not address the treatment of FTCs allowed for deemed paid foreign taxes under Sections 902 and 960. Treasury and the IRS request comments on whether it would be appropriate to require a partnership, as opposed to the individual partners, to maintain and report the information necessary to compute deemed paid foreign taxes with respect to foreign corporations in which the partnership owns shares, so that the IRS can audit foreign tax credits under Sections 902 and 960 entirely at the partnership level. Alternatively, it requests comments on any approach whereby the IRS could effectively adjust credits for deemed paid foreign taxes at either the partnership level or at the partner level, without creating unreasonable distortions or undue burdens on taxpayers or tax administration. Treaty issues The June Proposed Regulations listed seven types of modifications of imputed underpayments that the IRS will consider if requested by the partnership. The preamble to the New Proposed Regulations states that the IRS is still considering additional modifications to address circumstances in which a partnership, partner or indirect partner is a foreign person that may be subject to either gross basis taxation under Sections 871(a) or 881(a) or entitled to a reduced tax rate under the Internal Revenue Code or an income tax treaty. Accordingly, Treasury and the IRS request comments on what specific types of modifications available to partners or partnerships that are foreign persons should be included in addition to the seven types previously listed in the June Proposed Regulations. In addition, Treasury and the IRS, in the June Proposed Regulations, requested comments on how the mutual agreement procedure (MAP) used under tax treaties to mitigate double taxation could be coordinated with the centralized partnership audit regime. The preamble to the New Proposed Regulations also states that the IRS intends to allow access to MAP as appropriate. CFC/PFIC issues If a direct partner in a partnership is a foreign corporation that is a controlled foreign corporation (CFC) or passive foreign investment company (PFIC), an adjustment to the income, etc., of the partner might not affect the partner's US tax liability but might affect the US tax liability of US owners of the foreign corporation. The preamble to the June Proposed Regulations stated that Treasury and the IRS intend to issue regulations addressing when a partnership pushes out an adjustment under Section 6226 to a direct partner in the partnership that is a foreign entity that may not be liable for US federal income tax on one or more adjustments, but an owner of the direct partner is or could be liable for tax on that amount. While the government continues to consider this issue, the preamble to the New Proposed Regulations requests comments both on how the reporting obligations concerning foreign entities should be modified to ensure that statements issued under Section 6226 are reflected on the returns of the US owners of these entities, and more generally, on how to incorporate rules governing foreign corporations into the centralized partnership audit regime. Implications Although the complexities of the June Proposed Regulations and the New Proposed Regulations are challenging, the Government apparently felt this complexity was necessary to ensure that partners are taxed as if they earned the underlying items directly. While the specific guidance provided by these regulations provided some clarity on the appropriate coordination between the centralized partnership audit regime and various international tax rules, they leave many major issues: — There is no full coordination between Chapter 3/Chapter 4 withholding tax audits and the BBA centralized partnership audit regimes. — As the IRS admits, computing imputed underpayments based on the assumption that each partner elected to claim foreign tax credits and utilized them in full will result in some partners being overtaxed. — Several issues, such as indirect foreign tax credits under Sections 902/960 and coordination with the mutual agreement procedure under income tax treaties, have not been addressed. There can be no guarantee that addressing these issues will not create yet further complications. Outside of the New Proposed Regulations, the IRS is still also actively working on finalizing the general BBA guidance provided in the June Proposed Regulations, as well as regulations addressing administrative and judicial review rules, regulations addressing push-out elections by tiered structures, and regulations addressing adjustments to bases and capital accounts and the tax and book basis of partnership property. It is expected that some of these projects will be issued by the end of 2017. With the January 1, 2018, effective date for the BBA regime rapidly approaching, partnerships should continue to consider the effect of the BBA regime, whether and how to respond to the Government's requests for comments on specific issues in the proposed guidance, and how to address certain issues with their partners (e.g., modifications to legal documents and terms surrounding a future potential assessment of tax). ———————————————
——————————————— 1 A previous substantially identical set of proposed regulations was released on January 18, 2017, but was withdrawn before publication due to a regulatory freeze ordered by the incoming Presidential administration. 2 Filing an AAR for a partnership is the counterpart to filing an amended return for an individual, corporation, etc. | |||||||||||||||||||||||||||||||||
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