Guest Article: New IRS Regulations Impact Foreign Partnerships, Capital Transfers –

During 1999, the IRS issued three regulations detailing the required reporting by U.S. persons with respect to foreign partnerships and one regulation governing U.S. income tax return filing requirements for foreign partnerships. This article discusses the final regulations published on December 28, 1999 concerning (1) the acquisition or disposition of a 10 percent interest in a foreign partnership and (2) interests of U.S. persons in controlled foreign partnerships (“CFPs”). This article also discusses amendments to earlier regulations which reduce certain of the reporting burdens for transfers to foreign partnerships.

These regulations detail the reporting rules applicable to “U.S. persons,” i.e., U.S. citizens or residents, U.S. corporations, partnerships, estates or trusts. Form 8865 must be attached to a timely-filed U.S. income tax return for the tax year that includes, as relevant, (a) the reportable event, or (b) the year-end of the CFP.

The regulations discussed herein exempt state and local government retirement plans from the requirement to report (unless Form 8865 instructions re-introduce this requirement), and the IRS has asked for comments on whether there should also be an exemption for other tax-exempt entities. However, a U.S. partnership is itself subject to reporting regardless of whether its partners consist of entities exempt from reporting.

In a key departure from the proposed regulation, and unlike the reporting rules for transfers of money or other property to foreign partnerships, the covered acquisitions and dispositions are reportable only if they occur on or after January 1, 2000. In another easing from the proposed regulation, only direct acquisitions and dispositions by U.S. persons are reportable. (Indirect transactions through foreign entities and acquisition or disposition of interests in intermediate foreign entities which themselves own interests in foreign partnerships are not covered transactions and do not require reporting under this regulation.) Furthermore, and as originally proposed, certain overlap reporting has been addressed and eliminated. If a transaction is reportable and has been reported under the rules for transfers of money or other property to foreign partnerships, no duplicate reporting is required under the 10 percent acquisition or disposition rule.

Reportable Events

A “reportable event” is: (1) an acquisition, by any means, of at least a 10 percent interest (or a lesser acquisition which first brings the ownership to at least 10 percent) in the profits, capital, losses or deductions of a foreign partnership, (2) a disposition of at least a 10 percent interest (or a lesser disposition which brings the remaining ownership down to less than 10 percent) in a foreign partnership, or (3) any change in a U.S. person’s proportionate interest in a foreign partnership which meets the 10 percent test described in (1) or (2). The definition of a reportable event is very broad and covers nonrecognition transfers, transfers by gift, and transfers at death, as well as additional 10 percent acquisitions and dispositions subsequent to the initial one. However, it includes only direct acquisitions and dispositions of interests in a foreign partnership by a U.S. person. This differs from the CFP reporting rules, where an indirect interest must also be reported. Changes in proportionate interests referred to in (3) could include the redemption of another partner’s interest by the partnership, which increases the U.S. partner’s percentage interest. It could also include a change resulting solely from operation of the original terms of the partnership agreement, e.g., the typical flip of the general partner’s (“GP’s”) share of profits from its capital percentage to add the 20 percent carry after the relevant benchmark has been achieved.

When reporting is required, it must include a description of indirect ownership, in addition to the direct ownership which caused the filing to be made. It also includes information on other partnerships and disregarded entities (U.S. as well as foreign) which are at least 10 percent owned by the foreign partnership. The fair market value of the interest acquired or disposed of must also be disclosed.

A U.S. person who fails to report is subject to a penalty of $10,000. If such failure continues for more than 90 days after receipt of notice of failure to comply, then an additional $10,000 penalty is imposed for each 30-day period, or fraction thereof, subject to a maximum of $50,000. A taxpayer may assert reasonable cause as a defense against these penalties. If a transaction is reportable as a transfer, and also as an acquisition of an interest, failure to report could cause imposition of penalties for both failures. Generally, the penalties for failure to report transfers to foreign partnerships are far more severe than those described here (and are described in our December 1999 Tax Alert). Furthermore, the statute of limitations would remain open indefinitely with respect to unreported transactions.

Effective for the calendar year 2000, a reporting system for at least 10 percent U.S. owners of CFPs has been created, which is similar to the long-standing system applicable for controlled foreign corporations (“CFCs”). There are, however, significant differences between both the CFP and CFC definitions and the reporting details for each system.

Controlled Foreign Partnerships

A CFP is a foreign partnership for which, at any time during its year, more than 50 percent of the capital, profits, deductions or losses is attributable (directly or indirectly) to those U.S. partners to whom at least 10 percent of any of such items is attributable (directly or indirectly). In determining indirect ownership, an interest will be attributed from a nonresident alien under the family attribution rules only if the person to whom the interest is attributed owns a direct (or indirect through other attribution rules) interest in the foreign partnership. Furthermore, unlike the CFC rules, an interest owned by a corporation is attributed to all its shareholders, even if they own less than a five percent interest.

Two distinct reporting levels have been established. The most extensive reporting applies to a U.S. partner to which more than 50 percent of any of the above items is attributable. Those with 10 to 50 percent have no CFP reporting obligation when there exists a U.S. partner with more than 50 percent. When there is no controlling U.S. partner, then each 10 to 50 percent U.S. partner of a CFP must report, but with not nearly as extensive information as applies to a controlling partner.

Because of the attribution of ownership rules there can be more than one partner considered to be a more than 50 percent partner. In such case, if one partner who has a more than 50 percent interest in capital or profits meets the complete filing requirements, then any other more than 50 percent partner need file only very limited information. This will cover those entities higher up in a chain of U.S. entities, as long as the first U.S. owner of the CFP in the chain does complete reporting. Similar relief from duplicate reportings applies to a U.S. chain of 10 to 50 percent partners in a CFP, even when there is no controlling partner. Also, a common parent of a group of U.S. corporations filing a consolidated U.S. corporate income tax returns may file on behalf of all its subsidiaries included in that return.

Unlike CFCs, there is no voting power measurement for a CFP. Otherwise, the existence of a U.S. general partner in a foreign partnership would have resulted in automatic CFP treatment. However, when the GP’s profit percentage flips to introduce its carry, often 100 percent of net gains are allocated to such GP until it has received cumulative 20 percent allocations. During the period when the 100 percent allocation applies, the partnership will be a CFP even if there are no U.S. limited partners, and the GP will be required to do full reporting as a more than 50 percent partner. Similarly, any special allocation of a significant item can tilt the overall percentages for one of the relevant P&L items in such a way as to create a CFP. Those 10 to 50 percent partners required to file must report the following:

1. The amount of each of the P&L items allocable to the reporting partner;

2. a list of all U.S. and foreign partnerships in which the subject foreign partnership owns a direct interest (or an indirect interest of at least 10 percent);

3. information concerning any foreign disregarded entities owned by the foreign partnership; and

4. a summary of any transactions during the year between the foreign partnership and (a) the reporting partner and (b) any partnership or corporation controlled by the reporting partner.

More than 50 percent partners must report the above information and also the following:

1. Names, addresses and U.S. tax ID numbers (if any) of (a) each U.S. person owning at least a 10 percent direct interest and (b) each U.S. and foreign person whose interests are attributed to the reporting partner;

2. a list of transactions between the foreign partnership and each U.S. person owning at least a 10 percent direct interest;

3. the amounts of the partnership’s total income, gains, losses, deductions and credits; and

4. a statement of the amount of each item in 3 allocated to each U.S. person owning at least a 10 percent direct interest.

If the foreign partnership files a U.S. partnership income tax return, schedules from that return must be attached in lieu of completing the questions in Form 8865 asking for identical information. When one partner is filing on behalf of another, the other partner is relieved of its normal filing obligations only if the filing partner includes all information that the other partner would have been obligated to file (e.g., amounts allocated to the other partner).

Subject to a reasonable cause exception, a U.S. person failing to comply with the above reporting requirements will be subject to a $10,000 penalty (and loss of 10 percent of the U.S. person’s foreign tax credits from all sources) for each year of each foreign partnership for which the failure applies. Once the IRS mails a notice of failure to comply, the penalty will be increased by $10,000 for each 30 day period if such failure continues for more than 90 days after such notice, subject to a $50,000 maximum, and the percentage of disallowed foreign tax credit will also increase by five percent for each three-month period (with a maximum of the greater of $10,000 or the amount of the foreign partnership’s gross income, less the amount of the first penalty).

Money to Foreign Partnerships

Effective January 1, 2000, a transferor to a foreign partnership needs to report the names and addresses of only (a) direct 10 percent U.S. partners and (b) other U.S. and foreign direct partners related to the transferor. An exception to the listing of other partners continues to exist if the transfer being reported is solely of money and the transferor holds a less than 10 percent interest after the transfer. For 1998 and 1999, all other partners’ names and addresses must be reported.