Prop. Regs. on Partnership Withholding on Foreign Partners

On Sept. 2, 2003, the Treasury issued proposed regulations (REG-108524-00) on a partnerships obligation to withhold and pay tax under Sec. 1446 on effectively connected taxable income (ECTI) allocable to its foreign partners. Until these regulations are finalized, partnerships subject to Sec. 1446 must continue to comply with Rev. Proc. 89-31, as modified, until the partnerships first tax year starting after the date the final regulations are issued.

The proposed regulations only affect partnerships engaged in a trade or business in the U.S. that have one or more foreign partners. Procedurally, they are similar to guidance issued in Rev. Procs. 89-31 and 92-66.

Background

Sec. 1446 originally required both domestic and foreign partnerships with any income, gain or loss effectively connected with the conduct of a U.S. trade or business to withhold a 20% tax on any amount distributed to a foreign partner. Congress revised Sec. 1446 in 1988 by imposing a withholding tax (Sec. 1446 tax) on the ECTI allocable to a partnerships foreign partners, whether or not distributed. This change placed new importance on the determination of a partners allocable share of the partnerships income. These proposed regulations incorporate this statutory change from distribution-based to allocation-based withholding.

Subchapter K Analysis

A partners allocable (or distributable) share of a partnerships income is determined under Sec. 704(b). In general, a partners allocable share of the partnerships tax items is based on that partners interest in the partnership, unless the partnership agreement contains a different allocation that has substantial economic effect.

A partnership agreement may allocate particular items of gross income or deduction, or may allocate net income or loss (bottom-line allocations). Bottom-line allocations are deemed to consist of a pro-rata piece of every partnership tax item. In addition, a partnership allocation that includes a preferred return is usually made out of bottom-line income. Thus, for example, in a year in which a partnership earns income sufficient to cover only the preferred return, that return carries with it all of the partnerships ECTI for the year. Whether or not allocations are made out of net income or items of gross income or deduction, partnerships with foreign partners and ECTI should re-examine the nature of their Sec. 704(b) allocations to ensure compliance with Sec. 1446 withholding requirements in light of the proposed regulations.

From Barksdale Penick, Washington, DC