On April 12, 2007, the IRS issued final regulations that address withholding on interest earned by a partnership and allocable to the partnership’s foreign investors (TD 9323). Regs. Sec. 1.871-14(a) provides that, as a general rule, no tax shall be imposed under Secs. 871(a)(1)(A), 871(a)(1)(C), 881(a)(1), or 881(a)(3) on any portfolio interest (as defined in Secs. 871(h)(2) and 881(c)(2)) received by a foreign person.
A private equity leveraged buyout fund is typically organized as a large limited partnership with a diverse, widely held limited partner investor base and one general partner (usually itself organized as a limited partnership). The limited partner base in a typical fund often includes a significant number of foreign investors. Prior to the issuance of these final regulations, it was unclear if U.S. withholding taxes were due in certain instances. At issue was the definition of “portfolio interest” when the interest is paid to a partnership with foreign partners (i.e., the typical fund).
Portfolio interest is not subject to U.S. withholding taxes. Interest that is not portfolio interest is subject to U.S. withholding by the fund on behalf of certain foreign investors. In addition to numerous other requirements (e.g., the debt must be in “registered form,” interest must not be contingent, etc.) for interest to be classified as portfolio interest, the recipient cannot own more than 10% of the obligor (Sec. 871(h)(3)). Prior to the issuance of these final regulations, it was unclear whether this ownership test was applied at the partnership level (i.e., the fund) or at the individual partner level. In many instances, a fund will clearly own an interest in the obligor in excess of 10%. However, because the fund is widely held by a diverse limited-partner investor base, it might also clearly be the case that no one investor (including any one foreign investor) owns 10% or more of the fund itself. These final regulations make it clear that the 10%-ownership test is to be applied at the individual partner level.
Specifically, final Regs. Sec. 1.87114(g) provides that, for purposes of Sec. 871(h), the term “portfolio interest” does not include any interest received by a 10% shareholder. The term “10% shareholder” means, in the case of an obligation issued by a partnership, any person who owns 10% or more of the capital or profits interest in such partnership. Regs. Sec. 1.871-14(g)(3)(i) contains a partner-level test providing that whether interest paid to a partnership and included in the distributive share of a partner that is a nonresident alien individual or foreign corporation is received by a 10% shareholder is determined by applying the rules of Regs. Sec. 1.871-14(g) only at the partner level.
Regs. Sec. 1.871-14(g) applies to interest paid after April 12, 2007. However, for fund managers who previously interpreted the 10%-ownership test at the fund level prior to these final regulations, a refund opportunity might be present for the fund’s foreign investors who own less than 10% of the fund. Regs. Sec. 1.871-14(i)(1) provides that taxpayers may choose to apply the rules of Regs. Sec. 1.871-14(g) to interest paid in any tax year not closed by the statute of limitation as of April 12, 2007, provided they do so consistently for all such years. Note, however, that a fund generally cannot itself claim refunds on behalf of its foreign investors; instead, the foreign investor must file for the refund using tax information provided by the fund. Unfortunately, filing a U.S. tax return can often be a source of tension for a fund’s foreign investors.
Alternatively, a fund manager might consider FSA 1998-314 and NSAR 010996. These two IRS Chief Counsel releases conclude that partnership withholding taxes on income allocated to foreign persons are “partnership items” to be determined at the partnership level under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and hence are subject to the uniform partnership audit proceedings prescribed by Secs. 6221–6233. Thus, it might be possible for the fund itself to file a refund claim under TEFRA Administrative Adjustment Request procedures and secure refunds on behalf of its foreign investors without the foreign investors themselves filing their own U.S. tax returns.
Frank J. O'Connell, Jr., CPA, Esq, Crowe Chizek, Oak Brook, IL.
Unless otherwise noted, contributors are independent members of Crowe Chizek.
If you would like additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.