U.S. Partnerships With Foreign Partners: A Look at Withholding and Reporting Obligations
U.S. partnerships with foreign partners are subject to very complex tax laws. The main source of that complexity stems from additional withholding and reporting obligations imposed on the partnership.
There are four types of withholding obligations that may be imposed on U.S. partnerships with foreign partners:
- Withholding on FDAP (Fixed, Determinable, Annual, and Periodic) Income
FDAP income is defined as all income except gains derived from the sale of real or personal property, items of income excluded from gross income, or items of income effectively connected with a U.S. trade or business. Accordingly, FDAP income includes compensation for services, dividends, interest, rents, royalties, etc. Withholding on FDAP income is known as Chapter 3 withholding and the rate is 30 percent of the gross income being distributed unless reduced or eliminated by an income tax treaty.
- Withholding on ECI (Effectively Connected Income)
ECI is all income from sources within the U.S. connected with the conduct of a trade or business. A U.S. partnership must withhold upon a foreign partner’s distributive share of ECI at the recipient’s highest marginal tax rate.
- Withholding Related to FATCA (Foreign Account Tax Compliance Act)
FATCA requires foreign financial institutions and certain other foreign non-financial entities to provide information about U.S. account holders. The penalty for failure to disclose this information is a 30 percent withholding rate on withholdable payments. This withholding is known as Chapter 4 withholding and is not available to be refunded. The obligation to withhold is imposed on the payer unless the payer has documentation from the recipient claiming an exemption from FATCA withholding. The appropriate documentation is a Form W-8 to document a foreign person’s status and potential exemptions.
- Withholding Related to FIRPTA (Foreign Investment in Real Property Tax Act of 1980)
FIRPTA is triggered when a foreign person disposes of an interest in U.S. real property. The buyer must withhold 15 percent of the foreign seller’s gross proceeds less liabilities assumed by the buyer realized in connection with the sale.
As referenced above, income tax treaties between the U.S. and foreign countries can have a significant impact on the required withholding. Currently, the U.S. has income tax treaties with more than 60 countries. Almost every tax treaty addresses the withholding rate on FDAP income distributed to residents of the treaty nations. Treaties generally address each item of income separately and provide separate rates for interest, dividends, royalties, etc. Additionally, many tax treaties include a “business profits” clause, which may have an impact on the requirement to withhold upon a foreign partner’s share of ECI (although this is much more limited than reduced withholding on FDAP income). Generally, the business profits clause references the requirement to have a permanent establishment in the U.S. in order for payments of ECI to be taxable in the U.S. The analysis of whether an entity has a permanent establishment in the U.S. is complex and requires an in-depth analysis of the relevant facts and circumstances.
There are various forms that U.S. partnerships with foreign partners may need to file or receive in order to comply with U.S. tax laws.
- Form W-7 – Form W-7 is used by a foreign person to apply for an Individual Taxpayer Identification Number (ITIN). ITINs can only be assigned to taxpayers that are not eligible to receive a Social Security Number. An identification number is required on most U.S. tax filings.
- Form W-8 – The W-8 series of forms are used to report to withholding agents the treaty and FATCA status of foreign people that are receiving U.S. source income. This form is required if the foreign person wants to claim an exemption from FATCA withholding or take advantage of any reduced tax rates provided in an income tax treaty.
- Form 8804, 8805, and 8813 – These forms are filed by the partnership to report and pay the withholding tax liability associated with a foreign partner’s distributive share of ECI.
- Form 8804 – This form is filed by the partnership to report the partnership’s total withholding liability.
- Form 8805 – This form is filed by the partnership for each individual foreign partner to report that partner’s share of ECI and withholding. A copy of this form must be provided to each foreign partner to attach to their U.S. tax return in order to claim any withholding credits.
- Form 8813 – This form is used to remit payment of the withholding collected by the partnership.
- Form 1042 – The 1042 series (including Form 1042, 1042-T and 1042-S) must be filed by the withholding agent to report non-ECI withholding. Generally, this would be withholding related to FDAP income under Chapter 3 or FATCA withholding under Chapter 4.
- Form 1042 – This form is filed by the partnership to report the withholding agent’s gross withholding liability.
- Form 1042-T – This form is filed by the partnership as a summary and transmittal return that aggregates all the information on Forms 1042-S.
- Form 1042-S – This form is filed by the partnership for each recipient of U.S. source income subject to withholding under Chapters 3 or 4.
- Form 8833 – Form 8833 is used to report a treaty based position taken on a tax return. A separate Form 8833 must be attached to the tax return for each treaty based position taken on that return.
In conclusion, U.S. partnerships that have foreign partners face significant complexity and reporting requirements. It is important to make sure that all required forms are filed and payments are remitted as the ultimate liability for the withholding rests with the withholding agent (the U.S. partnership). If you have any questions, please contact a KSM advisor.
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