When non-US persons invest in US assets, the investment structure should be considered well in advance. In many instances, foreign investors using US-based entities for investment are blissfully unaware of the pitfalls with regard to the structure chosen.
This blog post will generally examine use of a US partnership as the investment vehicle for the foreign investor, with an emphasis on the withholding rules.
Withholding of Tax
If the US partnership has taxable income that is considered effectively connected with the conduct of a trade or business within the United States (“effectively connected income”, or “ECI”) that is allocable to a foreign partner, the US tax law mandates that the partnership report and pay a withholding tax under IRC Section 1446 to the US Internal Revenue Service (IRS). Under the tax rules, a foreign partner includes a nonresident alien individual, a foreign corporation, foreign partnership, foreign trust, foreign estate, and any other person that is not a US person.
The withholding rules are very strict. The partnership must pay the withholding tax regardless of the amount of the foreign partners’ ultimate US tax liability. Thus, it could be that the foreign partner will actually owe no US tax, but the partnership must nonetheless withhold and pay over to the IRS. The affected foreign partner must file a tax return with the IRS and claim a refund. Furthermore, the withholding rules apply regardless of whether the partnership makes any actual partnership distributions during its tax year.
The rate of withholding will depend on the status of the partner and the type of income earned by the partnership. Withholding is imposed at the highest tax rate of 39.6% for noncorporate foreign partners; a 20% rate is imposed for individual long-term capital gain, and at a 35% rate for foreign corporate partners. Overwithholding is a very common result due to the high withholding rates.
Revenue Procedure 92-66, and Treasury Regulation section 1.1446-3 set forth the time and manner for the partnership to pay the withholding tax, as well as the general reporting obligations with respect to the tax. Refer to Form 8804, Annual Return for Partnership Withholding Tax (Section 1446), Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax, and Form 8813, Partnership Withholding Tax Payment Voucher (Section 1446), for further guidance on reporting and paying the IRC section 1446 withholding tax. A partnership that fails to comply with IRC section 1446 reporting and withholding requirements may be subject to penalties and interest.
US TIN is Very Important – Claiming a Refund for Overwithheld Tax
In order for a foreign partner to claim a refund of overwithheld tax, a valid Taxpayer Identification Number (TIN) is required. In order to claim the refund, a foreign partner must file an income tax return (Form 1040NR, Form 1120F, etc.) with a valid TIN. Even if a foreign partner does not have a TIN, the partnership must still pay the withholding tax for that foreign partner. Thus, the partner can lose out on a tax refund if he lacks a TIN.
An individual’s taxpayer identification number is the individual’s social security number (SSN) or individual taxpayer identification number (ITIN). An ITIN will always begin with a 9, and the middle two digits will be in the range of 70 to 80. It is also possible that a partner’s TIN could be its US employer identification number (EIN).
Foreign partners will annually be provided a Form 8805, “Foreign Partner’s Information Statement of Section 1446 Withholding Tax”, by the partnership. Form 8805 will show the amount of ECI and the total tax credit allocable to the foreign partner for the partnership’s tax year. The foreign partner must attach Form 8805 to their US income tax returns to claim a credit for their share of the IRC section 1446 tax withheld by the partnership. To insure proper crediting of the withholding tax when reporting to the IRS, a partnership must provide a TIN for each foreign partner. The partnership should notify any of its foreign partners without a valid TIN of the necessity of obtaining a US taxpayer identification number.
Individual Foreign Partner May Need to Renew US ITIN
As mentioned, an individual’s taxpayer identification number is the individual’s SSN or ITIN. ITINs that have not been used on a federal tax return at least once in the last three years are no longer valid for use on a tax return as of Jan. 1, 2017. Additionally, all ITINs issued before 2013 with middle digits of 78 and 79 (Example: (9XX-78-XXXX) have also expired. If an individual foreign partner has a 2016 filing requirement and the ITIN has expired, IRS recommends submitting the ITIN renewal application along with the federal income return to prevent delays. Using an expired ITIN on a US tax return will be processed and treated as timely filed, but it will be processed without any exemptions and/or credits claimed and the refund will be delayed.
The following ITINs expired on January 1, 2017:
- ITINs with middle digits of 78 and 79 (e.g. 9NN-78-NNNN). The IRS sent Letter 5821 to taxpayers with those expiring ITINs.
- ITINs that have not been used on a tax return for Tax Year 2013, Tax Year 2014, or Tax Year 2015
A foreign partner will need to renew the ITIN if the partner will be filing a tax return or claim for refund using the expired ITIN. The IRS has compiled a detailed set of FAQs on expired ITINs and how to go about renewing them.
Other Possible Relief from Overwithholding – Form 8804-C
Foreign partners may obtain relief from overwithholding by annually submitting a Form 8804-C, Certificate of Partner-Level Items to Reduce Section 1446 Withholding to the partnership. The partnership may reduce the foreign partner’s share of the partnership’s gross effectively connected income by certain partner level deductions and losses if the foreign partner certifies these losses on the Form 8804-C. (see also Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, for additional information). In order for the foreign partner to obtain relief for the entire year, the partner must submit the Form to the partnership each year before the first quarterly withholding undertaken by the partnership. The partnership can reasonably rely on the deductions and losses claimed on Form 8804-C until it has actual knowledge or reason to know that the certificate is inaccurate. The partnership can also reject the information if it suspects inaccuracies.
US LLC’s Often Taxed as Partnerships
A US Limited Liability Company (LLC) is a type of corporate entity formed under State law. For US tax purposes, however, the LLC is “looked through” and the corporate entity is completely disregarded; it is treated as a “pass-through” entity. Accordingly a US LLC is characterized as a “sole proprietorship” if it has a single member, or a “partnership” if it has more than one member. So, a foreign investor has to bear this in mind when joining an LLC since the same tax consequences can occur as discussed above for partnerships. But of course, there will always be nuances – such as when a Canadian corporation becomes a member of a US LLC.
Foreign investors must be particularly careful when investing through US LLCs, since their use can result in significant home-country tax problems. Such problems can arise if the home country treats the LLC as other than a pass-through entity. For example, a Canadian investor in a US LLC may be treated by Canada as if he has invested in a “corporation” rather than a pass-through entity. This can result in the investor being subject to both US and Canadian taxes without the use of fully offsetting foreign tax credits, resulting in higher taxes than if he had made the investment through a US partnership. Every foreign investor should carefully check the home country characterization and understand the tax consequences prior to the investment.
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