Prop. Regs Address Foreign Issues Relating to Centralized Partnership Audit Regime

(Parker Tax Publishing December 2017)

The IRS issued proposed regulations which provide rules addressing how certain international tax rules operate in the context of the centralized partnership audit regime. The proposed regulations include rules relating to the withholding of tax on foreign persons, the withholding of tax to enforce reporting on certain foreign accounts, and the treatment of creditable foreign expenditures of a partnership. REG-119337-17 (11/30/17).

Background

In the Bipartisan Budget Act of 2015 (BBA), which was enacted into law on November 2, 2015, the current rules governing partnership audits were repealed, effective for tax years beginning after 2017. Under Section 1101 of the BBA, the current rules governing partnership audits are replaced with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. On June 14, 2017, in notice of proposed rulemaking (NPRM) REG-136118-15, the IRS issued the first set of proposed regulations relating to the centralized partnership audit regime. On November 30, the IRS issued a second set of proposed regulations, which provide rules addressing how certain international rules operate in the context of the centralized partnership audit regime.

The proposed regulations address (1) provisions relating to Chapter 3 (Withholding of Tax on Nonresident Aliens and Foreign Corporations) and Chapter 4 (Taxes to Enforce Reporting on Certain Foreign Accounts) of subtitle A of the Code; (2) provisions relating to creditable foreign tax expenditures and foreign tax credits; (3) provisions relating to treaties and reductions to the rate of tax on foreign persons; and (4) provisions relating to certain foreign corporations.

Proposed Rules Relating to Chapters 3 and 4

In the preamble to the June 14 proposed regulations, the IRS explained that taxes that are not covered by the centralized partnership audit regime include taxes imposed by Chapters 3 and 4. Accordingly, the IRS said that it will continue to examine a partnership's compliance with its obligations under Chapters 3 and 4 in a proceeding outside of the centralized partnership audit regime.

To demonstrate the rules regarding the scope of the centralized partnership audit regime and the examination of the partnership's obligations under Chapters 3 and 4 outside of the centralized partnership audit regime, the November 30 proposed regulations provide examples that illustrate what occurs when (1) a partnership fails to withhold at the correct rate on an item of income allocable to a foreign partner, and (2) a partnership fails to report an item of income and, therefore, also fails to withhold on the additional income allocable to a foreign partner.

Example 1 under Prop. Reg. 301.6221(a)-1(f) clarifies that a partnership's withholding tax liability for failure to withhold at the correct rate on an item of income that the partnership received and properly reported on its partnership return may be adjusted by the IRS under the procedures applicable to an examination under Chapter 3 or Chapter 4, and that the procedures under the centralized partnership audit regime do not apply to the adjustment. The same result would occur on a partnership's failure to withhold at the correct rate under Code Sec. 1441 on a payment made to an unrelated foreign person, or upon a partnership's failure to withhold as a transferee of a U.S. real property interest at the correct rate under Code Sec. 1445.

Example 2 under Prop. Reg. 301.6221(a)-1(f) presents a case in which the partnership has failed to report on its partnership return an item of income that it received for which it would have had a withholding obligation under Chapters 3 and 4, and the failure to report the item is discovered in an examination of the partnership's compliance with its obligations under Chapters 3 and 4. Because an adjustment to increase the partnership's income would be an adjustment to an item of income of the partnership, it would be subject to the centralized partnership audit regime.

Under Code Sec. 6226, a partnership may elect to "push out" adjustments to its reviewed year partners rather than paying an imputed underpayment determined under Code Sec. 6225.The November 30 proposed regulations provide rules that apply withholding and reporting requirements under Chapters 3 and 4 to a partnership that makes a Code Sec. 6226 election with respect to a reviewed year partner that would have been subject to withholding in the reviewed year, and rules that apply to the reviewed year partner when taking these adjustments into account. Under Prop. Reg. Sec. 301.6227 - 2(b)(4), these same rules apply when a partnership elects to have its reviewed year partners take into account adjustments requested in an administrative adjustment request (AAR).

Prop. Reg. Sec. 301.6226 - 2(h)(3)(i) requires a partnership that makes a Code Sec. 6226 election to pay the amount of tax required to be withheld under Chapters 3 and 4 on any adjustment allocable to a reviewed year partner that would have been subject to withholding in the reviewed year. The partnership must pay the withholding tax (in the manner prescribed by the IRS in forms, instructions, and other guidance) on or before the due date for furnishing the Code Sec. 6226 statement that reports the adjusted item.

Proposed Rules Relating to the Foreign Tax Credit

A partnership is not eligible to claim an FTC under Code Sec. 901 (or a deduction for foreign taxes under Code Sec. 164). Instead, under Code Secs. 702(a)(6), 706(a), and Code Sec. 901(b)(5), each partner takes into account its distributive share of the creditable foreign taxes paid or accrued by the partnership in the partner's tax year with or within which the partnership's tax year ends. Under Code Sec. 702(a)(6), this amount, known as a creditable foreign tax expenditure (CFTE) is accounted for as a separately stated item. Under current rules, the partnership is not required to maintain records or report to the IRS whether its partners claimed credits or deductions with respect to their CFTEs or the extent to which any such credits are subject to a partner's FTC limitation.

As the IRS pointed out in the preamble to the November 30 proposed regulations, neither the statutory text of the centralized partnership audit regime nor the explanation of that text prepared by the staff of the Joint Committee on Taxation explicitly addresses any coordination with the foreign tax credit (FTC) rules. The IRS noted that nothing in the BBA indicates that the new procedures should increase the incidence of double taxation or alter the pre-existing restrictions, limitations, or obligations affecting a taxpayer's right to claim (or retain) an FTC. The IRS also found it unlikely that the enactment of the new centralized partnership audit regime was meant to change significant and well-established FTC rules without any explicit reference to those rules in the statutory text. As a result, the IRS concluded that, to the maximum extent possible, the long-standing FTC rules should be preserved while implementing the broader purpose of the centralized partnership audit regime.

Accordingly, the tax effects of an adjustment to the CFTEs reported by a partnership cannot be determined solely by examining the return and other records of the partnership. Similarly, the partnership lacks the necessary information to determine those tax effects in connection with an AAR.

Prop. Reg. 301.6225-1(a)(2) (June 14 NPRM) provides that for purposes of determining the imputed underpayment of a partnership, all applicable preferences, restrictions, limitations, and conventions will be taken into account to disallow netting of adjustments as if the adjusted item was originally taken into account in the manner most beneficial to the partners. Similarly, Prop. Reg. 301.6225-1(d)(1) (June 14 NPRM) provides that items within each grouping are divided into subgroups, for netting purposes, based on preferences, limitations, restrictions, and conventions, such as source, character, holding period, or restrictions under the Code applicable to such items.

Prop. Reg. Sec. 301.6225-1(d)(2)(iv)(A)(1) provides that the creditable expenditure grouping includes all adjustments to CFTEs. Prop. Reg. Sec. 301.6225-1(d)(2)(iv)(A)(2) further provides that adjustments to CFTEs are included in subgroupings based on the category of income to which the CFTEs relate in accordance with Code Sec. 904(d) and the regulations thereunder and in order to account for different allocations of CFTEs between partners. Prop. Reg. Sec. 301.6225-1(d)(2)(iv)(A)(3) provides rules used in computing the imputed underpayment when there are one or more adjustments to CFTEs. Specifically, Prop. Reg. Sec. 301.6225-1(d)(2)(iv)(A)(3) provides that a net reduction to CFTEs in any subgrouping is treated as a decrease to credits in the credits grouping and therefore increases the imputed underpayment (and safe harbor amount) on a dollar-for-dollar basis. A net increase to CFTEs in any subgrouping is an adjustment that does not result in an imputed underpayment and is therefore taken into account in the adjustment year in accordance with Prop. Reg. Sec. 301.6225-3 (June 14 NPRM).

Observation: According to the IRS, these CFTE subgrouping rules serve several goals. First, subgrouping prevents netting of CFTEs between partners, or between separate categories with respect to the same partner, a restriction which is necessary to preserve the application of the category-by-category limitation required under Code Sec. 904 and related regulations. Second, by subgrouping based on the sharing ratio of the partners in the reviewed year, adjustments that would be allocable to one partner cannot be netted against adjustments to CFTEs that would be allocable to another partner. This is intended to provide greater consistency with the requirement that CFTEs be allocated in accordance with the partners' interests in the partnership under Code Sec. 704 and the regulations thereunder. Subgrouping based on the category and allocation of the adjustment between the partners is necessary, the IRS said, to avoid a net reduction in the U.S. tax collected as the result of adjustments to CFTEs for which no credit would have been allowed to the partner if the CFTEs had been correctly reported in the reviewed year.

Proposed Rules Relating to Treaty-Related Issues

In the June 14 proposed regulations, the IRS provided seven enumerated types of modifications that it will consider if requested by a partnership. In the preamble to the June 14 proposed regulations, the IRS requested comments on modifications that could be considered appropriate where a partner is a foreign person and thus may be subject to gross basis taxation under Code Sec. 871(a) or Code Sec. 881(a), or where a partnership, partner, or indirect partner is entitled to a reduced rate of tax under the Code or as a resident of a country that has in effect an income tax treaty with the United States.

According to the IRS, it is still considering additional modifications to address circumstances where a partnership, partner, or indirect partner is a foreign person, and which potential modifications, such as modifications for portfolio interest and U.S. source capital gains, may already be addressed by one of the seven types of modifications included in the June 14 proposed regulations.

The IRS is continuing to request comments on what specific types of modifications available to partners or partnerships that are foreign persons (including partners that are foreign persons described under Code Sec. 501(c)) should be included in Prop. Reg. Sec. 301.6225-2(d) (June 14 NPRM). Pursuant to income tax treaties in effect between the United States and other jurisdictions, the IRS said it intends to allow access to mutual agreement procedures (MAP), when and where appropriate, for a partnership, partner, or indirect partner that is subject to the centralized partnership audit regime. However, the IRS said it is continuing to study this issue and requests comments on how to coordinate MAP with the centralized partnership audit regime.

Proposed Rules Relating to Foreign Corporations

In the preamble to the June 14 proposed regulations, the IRS said it intended to issue regulations to address situations where a partnership pushes out an adjustment under Code Sec. 6226 to a direct partner in the partnership that is a foreign entity, such as a trust or corporation, that may not be liable for U.S. federal income tax with respect to one or more adjustments, but an owner of the direct partner is, or could be, liable for tax with respect to that amount. According to the IRS, it is continuing to study this issue and is requesting comments both on how the reporting obligations concerning foreign entities should be modified to ensure that statements issued under Code Sec. 6226 are reflected on the returns of the U.S. owners of these entities, and more generally, on how to incorporate rules governing foreign corporations into the centralized partnership audit regime.

For a discussion of the centralized partnership audit regime rules, see Parker Tax ¶28,700.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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