On-Demand: Financial Services Year-End Tax Planning--Part III
December 15, 2020
In Part III of our webcast series, we discussed the most recent developments in U.S. inbound and outbound taxation and reporting.
Jay Bakst:We set out to put together a presentation focusing only on what is most relevant to the fund industry. We wanted to cover not just the most important factual developments, but also we wanted to take it to the next level, giving you observations and planning ideas. We put together a slide deck, which we think will be helpful for you to use for those of you who want to refer back to it as a learning tool at their own convenience.
At the same time, it contained so much because there is so much to talk about that we felt that we would all benefit from an executive summary in the simple format of factual information or updates, as well as our observations on those. And you can see that I'm over here. That's exactly what we did. So we have done, this is the first 13 slides. We have barely over an hour to deliver this update. And of course it will not be possible to cover all of the slides in detail.
What we will set out to do though, is to touch on the most important points on a high level while making sure to share with you our insights and comments. I should also mention before we start that for the section on ECI, I will be presenting directly from the highlights slides, not from the detailed slides. So now let us turn two. Okay.
So let's start talking about the international changes to the partnership forms. In July, 2020, the IRS released a draft with instructions of new schedule to partnership level and K-3 partner level. Now this will first be part of the K-1 reporting to investors for tax reporting year 2021. We're more than a year away, yet this will impact the reporting landscape in section monumental way that it makes sense to start understanding and thinking now about what the impact will be.
So the historical methodology for reporting foreign related tax information to partners and funds can be summarized in two words. It's been the Wild West. Not only is there no IRS prescribed standard format for presenting the information but worse yet, there's no formal detailed list of what information is required in the first place. This leaves partnerships and their tax preparers in the position of deciding what they want to provide in whatever format and whatever they don't want to go into, they just say, please consult your tax advisor as if the tax advisors would know, would have the information.
The partner and the tax preparers on the other hand are often left scratching their heads, trying to understand the disclosures and following up with all sorts of clarifications, emails flying back and forth. And then it is the IRS who has no consistent form of information reporting to use in the event of an audit. So the IRS set out to change that and they put together, I'm just going to show you what we hear briefly. This is there are nine parts we're going to focus.
We think the ones that are most relevant for the fund industry are parts five, six, and nine. We're going to touch upon even those not going into too much detail. And what is the impact going to be? This is going to go a long way in ensuring that everybody has the necessary information to prepare their own tax returns and cut down as I said, on all the back and forth. Now for some partnerships, the current version of the draft forms and instructions will simply provide a standardized format for reporting the same information that you've been reporting until now. For others, it will force them to consider and report more than they have until now and this will be an additional burden.
And yet, for other partnerships, these K-2, K-3 forms may place an unnecessary burden on them altogether requiring them to disclose information that will not be relevant to their partners in the first place, which sort of highlights the challenge that the IRS faces in striking the balance and choosing which information to require. We're going to talk more about this later. And we have inserted in the various sections that we're going to speak about in detail, certain samples of these forms. Okay, now I'm going to turn it over to Ayelet.
Ayelet Duskis:All right. So, hi everyone. Before we can start talking about the PFIC regulations, the final regulations was actually just came out December 4th, about 10 days ago. We have to understand some of the basics of PFICs. An entity is considered a PFIC, a passive foreign investment company, if at least 75% of its gross income or 50% of its assets are passive or are held to produce passive income.
When we're looking at a foreign corporation, what we do is we tasked the foreign corporation to see if the entity meets either one of those tests and is there for a PFIC. In a tiered structure, we generally consolidate at the highest level and perform the testing on a consolidated basis. The general rule has always been to include any entity and a subsidiary that held 25% or more in the consolidation.
In the past, what we've always done is we've looked at how much each corporation is held by the other. And as long as the bottom corporation is held, at least 25% or more by the corporation on top of it, it was included in the consolidation. In the final regulations, the IRS came out and said, "You guys are looking at it wrong. You need to start on the top. You need to look at Foreign Corp 1, and you need to see how much that entity holds in the subsidiaries."
You cannot include any entity in the consolidation for the purposes of PFIC testing, unless it has held 25% or more by all of the entities that you're performing the testing on. In this situation, Foreign Corp 1 and can include Foreign Corp 2 and 3 in its consolidation, but it does not hold more than 25% of Foreign Corp 4 and it cannot include Corp 4 in the consolidation on PFIC testing.
On the other hand, Foreign Corp 3 when we're looking at that and then to see if it can be a PFIC, we can include Foreign Corp 4. If Foreign Corp 4 is the only active entity in the structure, this will leave Corp 1 and 2 as PFICs verses 3 and 4, which can include the active income and assets. And they will remain not be PFICs.
Jay Bakst:And I'm going to just chime in right here-
Ayelet Duskis:When we're looking at-
Jay Bakst:Let me just chime in for a second over here. And if we just go back to here, the planning advice over here is very simple. Foreign Corp 1 and 2 would be PFICs, and they're not doing much anyway, just check the box on them to have them be disregarded. And therefore you won't be burdened with the PFIC ramifications and you will be able to get qualified dividend treatment on dividends that are flowing up the tier. Go ahead Ayelet.
Ayelet Duskis:The next question, when we're looking at tiered structures is what about partnerships? So when the IRS came out with the proposed regulations in July, 2019, they said, "We're going to treat partnerships the same way we treat corporations." And in partnership, that's held 25% or more by the corporations on top of it, you can include the corporation's share of the assets and income when doing the PFIC testing.
Many people complained about this and just came under a lot of criticism because partnerships are not taxed the way corporations are. Partnerships are flow-through entities. And in general, we have an aggregate theory of partnership taxation. So people found that it would only be fair to include your share of the income and assets of the partnership, regardless of how much percentage is owned in the partnership.
So the IRS came back on the final regulations and said, we'll give you two circumstances where you can include your share of the income and assets of the partnership when performing the PFIC testing. One is if you hold 25% or more in the partnership. And the other is that the test of Foreign Corporation satisfies what is called the active partner test.
The active partner test is mainly just means that the test of Foreign Corporation has to not be a PFIC. It has to be an active entity before taking into consideration the less than 25% partnership. The point is that the IRS doesn't want the partnership the less than 25% partnership to help the corporation out of PFIC status. I'm going to show you a few examples, which will help make this more clear.
In this first example, we have a test of Foreign Corporation, which we're going to assume has no income or assets of its own. It holds two foreign subsidiaries, and one of the foreign subsidiaries has 10% in a foreign partnership. Both foreign subsidiaries have 100% active income. There's no passive income in this structure at all.
Therefore, TFC would not qualify as a PFIC. It would pass the active partner test, and it would be able to include its share of the income and assets of the foreign partnership when doing the PFIC testing. This is as opposed to this next example, where Foreign Corporation 1 is a passive entity and has only passive income and passive assets. In this case, Foreign Corporation 1 has 1,100 assets whereas Foreign Corporation 2 only has 900. This makes there be more than 50% passive assets and TFC fails the active partnership test.
What happens here is, is that this 10% share of the foreign partnership is going to be treated as a passive asset on the books of the test of Foreign Corporation and the tests of Foreign Corporation will be a PFIC. It exactly the point here is that there's this structure, these tested Foreign Corporations of PFIC without regard to the foreign partnership and the IRS does not want the foreign partnership to help the tested Foreign Corporation come out of PFIC status. So it will not allow it to include its share in the PFIC testing.
Jay Bakst:So let's just think for a moment about, from a structuring perspective, what this might mean. That means that if you form a Foreign Corporation to hold exclusively a less than 25% partnership interest in an operating business, if that Foreign Corporation has the most minute amount of cash in an interest bearing account, that will likely make that Foreign Corporation without regard to what's beneath it into a PFIC.
And therefore, the partnership interest itself will be passive making the whole entire Foreign Corporation into a PFIC, which poses a dilemma, quite frankly, because you don't want to be able to check, you don't want to have to check the box on that to make it flow through. You don't want to have the operating income of the partnership flowing through up to the fund investors. So this is something to be aware of. Go ahead.
Ayelet Duskis:All right. Another item that we look at when we're doing PFIC testing is how do we measure the assets? Do we measure the assets by vote or value? Historically, CFCs, controlled foreign corporations that are not publicly held are measured based on their adjusted basis versus their value.
What happened is, is that downward attribution, which we'll talk about a little bit later on tonight's discussion came out and all of a sudden we had many, many new CFCs. Could we use the value when passing the CFCs for PFIC status or did we have to now treat them as CFCs and use only adjusted basis? The final regulations came out and said for purposes of PFIC testing, you disregard the downward attribution and you can treat the entity as any other entity that is not a CFC and use the value of the assets when performing the PFIC testing.
Jay Bakst:This is highly favorable by the way, because many companies, particularly the ones that are backed by VCs and they rely on the value of their non-passive intangible assets to get out of PFIC status. And those intangible assets typically have very little and no material tax basis. So this is a very welcome development in the new regulations.
Ayelet Duskis:The last item that we're going to talk about regarding how we're doing our PFIC testing is cash. Historically, cash has always been treated as a passive asset when doing a PFIC testing. If you look at cash in a very superficial light, it's sitting in the bank and it's earning interest, therefore it would be a passive asset, but everybody who runs a business knows you can't run a business without working capital.
In the preamble to the proposed regulations, which also, and that just came out on December 4th of this month, the IRS said that they recognize that an operating company needs cash in order to operate and function. Therefore, they are going to allow certain circumstances. They're going to allow the cash to be treated as an active asset. Both the following criteria have to be met.
The cash has to be sitting in a non-interest bearing account and it cannot exceed more than 90 day’s worth of the company's cash needs, meaning whatever your expenses would be for 90 days or whatever the expected expenses of the corporation are going to be for 90 days, you cannot have more cash than that sitting in this non-interest bearing account and continue to treat the cash as a non-passive asset.
Jay Bakst:So it's really questionable if you think about this, it sounds like the IRS gave you something, but it's really questionable if this limit exception gave you anything because they require the cash to be in a non-interest bearing account. So if it's in a non-interest bearing account, then what authority would there be to treat it as a passive asset in the first place, even if it's held for more than 90 days, right?
I mean, presumably you're holding all the cash that you're holding is either for your working capital or you're holding it to invest. And here's the key to invest in future operations of your business, which you're also non-passive. So I don't really think that IRS gave you anything, at the same time, this really highlights the dilemma that the IRS has because to treat cash that's sitting in an interest bearing account as non-passive might require a statutory fix because the rules are clear that this would be an asset that's held to produce passive income. The IRS has asked for comments on this, let's see where it goes.
Ayelet Duskis:We're going to take a look at what the K-2 is going to look like. This is mainly based on how our footnotes have been looking, obviously, in our own way to the partners when we provide a tax return with PFICs, the name, the address, anything that the partner is going to need in order to make any elections or file any forms that they need on their personal tax return.
I know it's rather small, but I want to call your attention to this box all the way on the side. It says, check this box that the PFIC meets the income task or the asset task section 1297(a) for the tax year. This basically means check the box. If the entity is PFIC or passes one of those tests that we talked about before the 50% assets or the 75% gross receipts, wouldn't we only be including entities here that are already PFICs. Why would we need to check this box?
So the IRS is saying that any entity that was a former PFIC, unless you have 100% growth at the end of the year is not a peak that you would want to continue to include it on this list. And you're not able to just get rid of the PFIC stat. You're not able to take it off this list, which means we're going to be including items to our partners that are not necessarily PFICs anymore.
And as you can see, this is the second part of that Schedule K-2. And it just continues to include all the information that our partners are going to need to make whatever elections or pick up any income that they need to pick out on their personal tax return.
Jay Bakst:And then again, this just comes back to what I said before about the current Wild West, where you just reported whatever you felt like reporting. And sometimes it was very unclear whether this company continues to be a PFIC, and you took a certain position quote unquote. If you did not disclose it as such, you didn't say specifically that it was not a PFIC. And the point right now is that if this is correct, if the current draft of the Schedule K-3 goes through, this will force partnerships and their tax preparers to take definitive positions as to whether a portfolio company continues to be a PFIC when in the past it has been.
Thank you, Ayelet. Okay, moving right along. So ECI, section 864 CA, which is effective November 27th 2017, final regs were issued in September 21st, 2020, they were effective with retroactive effect to 12/26/18. In a nutshell, foreign person who disposes of an interest in a partnership that is engaged in a U.S. trader business, realizes ECI on the gain and passes U.S. tax on it. This is what we call the substantive tax. There's also withholding regime. We'll talk about that later.
Now, how much ECI is realized from the sale of the partnership interest? The starting point is the whole thing, but this gain or loss is limited by the amount of ECI gain or loss that would be allocated to the foreign partner on a deemed sale of the partnership's assets. Let's jump right into an example and see how this works.
Okay. I'm sorry, I can't point, but you'll see over here, we're dealing with a situation where FP, a foreign partner sells 50% interest in ABC Partnership for 95,000 basis of 100,000 realizes a loss of $5,000 in the disposition of the partnership interest. We have over here three boxes. The upper left-hand corner, we have ABCs assets and we're categorizing them by U.S. business capital asset, U.S. business ordinary asset, foreign business capital asset, foreign ordinary asset.
And we have just the basis for a market value. That's the upper left hand box. The right upper hand box is what's called a three-step process that is going to calculate, first of all, what the gain or loss on a deemed sale of these assets are at the partnership level and then allocate it to the partner. And then all the way in the bottom of this slide, we have the actual calculation of how you determine how much of the gain or loss from the sale of the partnership interest is ECI and in what capital ordinary.
And trust me, if you think that it's just as simple as looking through and determining what the ECI would be on a deemed sale, that's not that way. It's almost a little bit the opposite. Let's go through the example, okay. So over here, starting with under the column that says, step one, okay? Before we even talk about ECI, let's talk about it on the partnership level, okay?
What is the amount of the capital gain or loss on the sale of these assets? It's the $30,000 from the U.S. asset. And then if we go down two, it is the $20,000 loss from the foreign capital asset, those two net to a capital gain of 10,000, 50% of which is 5,000. We take that 5,000 and we put it in the bottom left hand corner where we're calculating, what's called FP outside gain or loss. This is the regular calculation of the gain or loss on the sale of the partnership interest. We've got $5,000.
Next, we're going to do the same thing for the ordinary assets. We're going to go back up to the column step one. And on the second row, we have the U.S. business inventory, $20,000 gain from that. And we skip over one to the foreign business inventory. We have a $40,000 loss on that. Those two net to a $20,000 loss, 50% of which is going to be a $10,000 ordinary loss. And that number goes down to the bottom left hand corner, ordinary assets, $10,000.
So before we talk about any ECI, our partner has a $5,000 loss on the disposition of the partnership interest. $5,000 is going to be capital gain, and 10,000 is going to be an ordinary loss netting 25,000, okay? Now let's look through and ask ourselves if these deemed assets would be sold, how much would be ECI? We're only going to take into account the top two assets, right? Because those are the only ones that are U.S.
So we have on the top $30,000 capital gain from the asset, 15,000 is going to be allocable to the foreign partner. We take that 15,000 of U.S. capital gain, and we put it down on the top row of the middle column on the bottom of the screen. And we did the same thing for the U.S. business inventory. That's an ordinary asset. And we say $20,000 would be realized by the partnership on that U.S. asset. And $10,000 would be allocable to the foreign partner. And we take that $10,000 and we put it in the bottom middle column on the bottom of the screen.
So now what do we have over here? We have focusing now on the bottom of the screen, we have the first column to the left is going to be on the entire partnership, $5,000 capital gain, a $10,000 ordinary loss. This is the starting point for what is ECI; the amount of this ECI is going to be limited to the amount that would be ECI on a look through basis.
Well, what would be ECI on a look through basis if these assets were to sold? We would have a $15,000 capital ECI gain and a $10,000 ordinary gain. Let's take it one by one. These ECI amounts, they're not the amounts that you're ultimately going to pick up as ECI from the sale of the partnership interests. These are the limitations, okay?
Now let's take the capital assets, since 15,000 is more than 5,000, the limitation does not come into play at all. And therefore we wind up with the same $5,000 of capital gain is going to be treated as ECI. Now we come to the ordinary asset, okay? At the partnership level, without ECI, it's going to be just a $10,000 loss.
That $10,000 loss now, how much of that is going to be ECI? Well, if you look through the answer is zero because there's no ECI loss, remember we're talking about a loss and we have a $10,000 gain. So the answer is zero of that ordinary asset loss is going to be treated as ECI.
So then in total now, what do we have? We have a partnership interest that's sold at a $5,000 loss and of that $5,000 loss, how much is ECI $5,000 capital gain? The result is really not intuitive at all. And the point that I want to keep on stressing is it is not as simple as just looking through and saying, that's your ECI. It's not a complex set of rules of what you offset against what, and this illustrates it.
Okay. Now through our detail, what's considered to be a U.S. asset at all, got a detailed rules and the general rule is the basic presumption is that an asset is attributed to a partnership's U.S. office or fixed place of business, but there are limitations on that rule. There's a special rules for inventory, intangibles, depreciable personal property that allow you to allocate it a little bit differently in certain circumstances.
And in general, an asset that has not been used in a U.S. trade business and has not produced ECF for the last 10 years is not treated as a U.S. asset at all. Okay. Now the foreign partner and the U.S. partnership also whether it has a direct or indirect foreign partner, that's transfers the partnership interest must formally notify the partnership within 30 days with specific information on the transferer and the transferee.
And then the partnership in turn must provide a statement to the transferring partner of all of this information that we just went through, how much is there effectively connected item, ordinary capital. And this statement is for as do though with the K-1. So that could be a full year later. It can be more than a full year later, okay?
Now let's just make one point over here. This required statement can be very time-consuming to calculate and prepare. It requires an analysis of a sale that didn't actually occur at a time that could be in the middle of the year. This is not otherwise part of the normal K-1 process. So what do we have to take out from here that it's prudent for a GP to clarify who will be bearing the cost of doing this analysis and prepare the required statement as part of the process of approving the transfer.
And just realize that the partnership may be pressured to provide this statement at the time of the transfer to avoid withholding. Be prepared for that. We're going to speak more about that soon. Okay. Now let's talk about the withholding regime, okay? So having nothing to do very little to do with the amount of substantive tax that will be wanting to being paid, section 1446(f) requires the transferee or the buyer of the partnership to withhold 10% of the amount realized that is a defined term. 10% of the amount realized includes the partnership liabilities, okay?
Now let's make one point over here. The partnership itself may be the transferee for example, a distribution next to basis or redemption, okay? And it's very important to note that the partnership, the requirement to withhold this requirement for the partnership to withhold where it is the transferee, it should not be confused with the partnerships requirement to withhold where there's another transferee who failed to withhold. That's what we call backstop withholding and that is different. That backstop withholding is first effective for transfers 1122 or later.
We're now talking about with the partnership with the partnership is the transfer itself. Now, how does the partnership know if this is a distribution excess basis. It generally may rely on a partner's representation, but if it knows our reason that this is not the case, then it may not rely on it.
So I'm just wanting to throw it out over there. We all know the recent requirements for a partnership to report negative tax capital of a partner, which granted is only inside tax capital. But in the process of looking at that, the partnership might have a reason to question the accuracy of a partner's assertion that this distribution is not an excess of basis. Just something to point out and think about.
Okay, so what are the rules over here? The IRS came out with notice 2018 that's 29 of April of 2018. And they provided certain temporary procedures for non PTP interests. We're going to get to what the differences are. In the IRS issued final regs in October of 2020, they are generally applicable to transfers that will occur on or after January 29th, 2021.
So therefore, until that date, we can still rely on the IRS notice 2018 date 29. If the transferee or the buyer fails to withhold, the partnership has to withhold that we spoke about that before that withholding is from the distributions to the transferee backstop withholding again, first applies 1122.
Okay. So now the final regs give us a little bit of a break and they say that if somebody should have withhold and they did fail to withhold, if you can establish to the IRS that the transferee had no gain subject to tax and the transfer, then you're off the hook, okay? It's not clear what the IRS would require in order to establish this. Maybe something similar to an IRS Form 4669 for failure to withhold FICA taxes.
In light of this uncertainty, it's really should only be considered as a last resort, but you should definitely not rely on this to not withhold in the first place, okay? So there are six exceptions to the requirement to withhold, and we're going to take them one by one pointing out what's practical, what's not, okay?
The transferor or the partnership must withhold if they receive this certification as of what's called the determination date, which means up to 60 days before the transfer, but there are alternate dates available if you're a minority partner. Now there is a notification process. This is important. There's a notification process between the transferor, transferee and the partnership to check the validity of the certifications.
Let's start with the beginning. The basis is the transferor is presumed to be foreign unless proper documentation is provided, which brings us to exception number one, that if the transferor, the seller provides a valid W-9 or certification that they're not a foreign person that meets certain requirements, then you can not withhold.
What's very important to note is that this W-9 can not be provided. There's no such thing as a retroactive W-9. Unlike a W-8, which under certain circumstances may be retroactive. So the takeaway over here is it's imperative to make sure that even in cases where you know, quote unquote that the transferor is U.S., make sure that you get the documentation at the time of the transfer.
Exception number two, if this transfer the settler provides certification that the transfer will not result in any gain. Now what's the hitch over here that this includes ordinary income in the section 751 the transfer before they even have a loss, a capital loss, or an overall loss in the partnership interest, but you could have a section 751 gain on hot assets, inventory, unrealized, receivables, okay?
If this is the case, if the transferor, the seller wants to provide that certification, they have to attach to their certification to the buyer. They have to attach the certification from the partnership saying that there's no 751 gain also. A partnership that's a transferee acting in the capacity of a transferee may rely on its books and records, but they must meet certain formal requirements regarding identifying the information that is relied upon on the books and records within 30 days of the transfer, okay?
What's the takeaway over here? That it's going to be difficult I think in most cases to obtain this assurance from the partnership, if it has had assets that there is going to be no gain on these hot assets. And also, secondly, again, we tend to think of yeah, books and records we know, and that's it. It's not as simple as that. You really have to follow the formal identification rules contemporaneously. You have to know what information specifically you're relying on your books and records to rely on no withholding.
Moving right along, exception number three, if the partnership now not the transfer, but the partnership itself provides certification that on the deemed asset sale, the transferor distributive share of the net ECI from the partnership would be less than 10% of the total gain from the partnership or that the partnership was not engaged in U.S. traded business at all.
This last thing was added to the finding regulations and it's probably the most practical. If that's your situation, when you know that everything's foreign, know you're a trader business. It should be relatively easy to obtain this certification. But when this is not the case where CSM is not, it's probably going to be impractical to get the partnership to focus on the detailed calculations that are necessary to make the certification more than 10%, less than 10% where are you getting to the numbers from?
Can it be made on time at all to avoid withholding? Very, very unlikely. Now be aware, this is something that I've already in practice, be aware of partnership certifications that are drafted by the buyer or the seller council, not by the partnership council, but the buyer, the seller council that go beyond stating the facts, okay? For example, explicitly stating, and therefore no withholding is required.
Although this is probably true. Would this be tantamount to the partnership providing tax advice to the partners under penalties of perjury analyst? Because that's what the certification has to be, right? And here's the point, the regulations require only to state the facts less than 10%, whatever the facts are. There's no requirement that the certification say, and therefore, you have the following consequence. You don't have to be told, be aware of that.
And finally, as I noticed before the notice 2018-29 provided for threshold less than 25% more favorable, if you can get the transferred that's done within the next six weeks, you can still rely on that. Exception number four, and here is something we really need to focus because I think it's a little bit misleading.
Exception number four is with the transferor the body provides through certification that the transferor was a partner for the last three years, right to the transfer. And in each of those three years, the partner's share of gross CCI as reported on Schedule K-1. Remember those words, gross CCIs reported that Schedule K-1 was less than 10% of the partner share of gross income and less than a million dollars. And then all of this ECI was properly reported and tax was paid on the partner's return.
The proposed regulations had a standard of less than 25%. And it also spoke about net ECI, not gross. And it also spoke about as being reported on Form 8805 and Schedule K-1. And that led to problems because for several reasons, there could be situations where there was a loss let's say, and there was no 8805 that was issued. So the IRS changed this in response to those comments.
And this sounds like a very positive development, there's just one problem over here. Would somebody please tell me where pretail are the amounts of gross income and specifically gross ECI required it to be reported on a K-1 between 2017 to 2019. Don't tell me lot 16, because it's not that's foreign source and it's certainly not ECI. And it's true that for corporate partners Schedule K-1 28 requires these disclosures, but certainly not for all partners. And I'm not sure that that goes back three years.
Now let's ask ourselves the question. So you have the K-1, you don't have the information, would a statement from the partnership obtained now, years later, referring back to the part of K-1, would that constitute the regulatory requirements as reported on Schedule K-1 with enough comfort level for the transferee not to withhold. Remember the transferee is ultimately going to be on the hook for this, okay? I really questioned this.
Now, we're going to see also later that the draft Schedule K-3 does require reporting gross and net gross ECI, but it'll be four or five years before partners will have a three prior year history of such reporting. So in light of all of this, I think it's highly questionable unless the IRS comes up with further guidance saying that you can go back to the partnership. I think it's highly questionable about practical useful this exception will be in the short term. Again, you can still rely on the notice for our list of 25% threshold of net ECI for transfers over the next six weeks.
The next exception is simply if the transferor provides a certification that's not required to recognize. And again, because it's under a non-recognition provision, for example, the transferor just transfers it to a partnership and they have to certify this and they have to briefly explain the relevant law and facts relating to the certification. Find that should be easy enough to do if that's your situation.
And the final exception is that the transferor, the buyer provides a certification making a valid treaty claim. That sounds reasonable, except that it will really be the case that treaty benefits can be claimed if it's ECI, because if you think about it, most treaties require that there be no permanent establishment in order to not be taxed on business profits.
And if you have ECI, what do you probably have a permanent establishment. So therefore the takeaway is be any claim for treaty benefits, any exemption, any certification for claim treaty benefits, scrutinize that carefully. It's probably not accurate.
Moving right along. So if an exception to withholding does not apply, then you have to withhold 10% of the amount realized which includes the partnership of share of liabilities. How are you supposed to know that? You may rely on the certification of either the transferor or the partnership. There are certain requirements that apply to each of these certifications. You can look at them in this slide.
If the transferee now is unable to determine the amount realized because it does not have actual knowledge and of the liabilities and it didn't receive the required certification, the entire sales proceeds must generally be withheld, okay? So therefore, this is a very serious thing. It's critical to take the necessary steps to properly document and communicate the amount of liabilities.
If not, the seller will have to wait until it falls into his tax return and receives a refund to receive any of the sales proceeds or alternatively, if the transferee just withholds 10% on the amount of cash that's going out, without regard to the shared partnership liabilities, which has not been properly certified to it, then the transferee remains on the hook to the sales proceeds that he pays to the transferor, unless it ultimately will be able to prove to the IRS that there was no tax and that gets back to something that you don't want to rely on.
Moving right along. So if the transferor now is a foreign partnership, okay? Whose partners are not all foreign, for example you set up a foreign partnership to go into an offshore entity, but you have all U.S. investors or you have very small percentage of foreign investors, right? What you can do is provide a withholding statement to the buyer to say, this percentage alone is allocable to a foreign person, and therefore withhold only on this partner and this is what's called a modified realized amount.
This seems to be relatively practical to do. We're not over here getting into any calculation of the ECI gain or look through anything like that, we are just saying of the total amounts realized, withhold on this percentage. It seems to be fairly easy to do, to take advantage of if that's your situation.
Now, there might be a situation where transferee is unable to provide one of the certifications to provide a complete exemption, but it might be able to provide a certification of maximum tax liability. Very complicated. You can go through the steps, you have to get a certification from the partnership about the demand of deemed ordinary capital gain from deemed sale of the partnership assets along with the detailed computations.
It's possible that you can get it, but it generally seems to be very difficult and impractical if obtaining it when you have no ECI or less than 10% is difficult. It's going to be that much more difficult if you only partially exempt. So I don't want to see this as being very prevalent. Now, the amount of withholding also is limited to the entire amount of cash and the fair market value of the property received without regard to liabilities.
What does this mean? This means in this situation where the partnership liabilities are very, very large compared with the sales proceeds. Then you don't have to kick in cash in order to meet your 10% of the amount realized. Because if you think about it, if you have a very large amount of liabilities, when added to the relatively small amount of the proceeds, 10% of that might exceed the proceeds. So this is a back step to make sure that you don't get into that situation.
When would you have this situation? Very simply, if the partnership borrowed a lot of money against highly appreciated assets, distributed the proceeds of that borrowing and basically squeezing on most of the equity, but leaving the partners with the liability. That's when you might have it. Maybe it applies more to real estate. We're not going to go there. Important to know.
Now the transferee, what happens? Okay, so you have all of these certifications. The transferee now must certify to the partnership, the extent to which it withheld within 10 days of the transfer. Certification must include any certifications to the transferee that it relied upon. And anything else that in determining what to be told and either a copy of the Form 8288-A which was filed with the IRS shortly withholding, or the amount withholding.
Okay. So there's a formal notification process to the partnership, and then the partnership reviews this and decides if it's satisfied with it. And if it's not, then it has to withhold 10% and if that is, it's discretion, okay? So if the certification from the transferee to the partnership is not provided, or if it establishes only a partial satisfaction of the amount required to be of the amount realized, or the partnership determines that it will not rely on it, then it withholds and it withholds at 10% from future distributions. Very important.
The preamble to the final regulations, note that the IRS decided to require not to require, the client to require, I should say the partnerships withhold unless it has affirmative reason to know. So what does that mean? That means that the partnership does not have to prove to anybody why it's not relying on it. It's not required to rely on anything that the buyer has done, okay?
As with all other withholding partnerships, withholding agent is king. Therefore, my suggestion would be that it would appear prudent for the transferee, the buyer of the partnership interest to incorporate into its due diligence process. Obtaining affirmative assurance from the partnership that it will not withhold on future distributions as a result of the transfer of the interest.
Here's my documentation. Now tell me, please, before I do this deal, are you planning on withholding from me? I think that's a very, very important point. Okay. So now a partnership, let's talk about this backstop withholding. A partnership that is required to withhold not as a transferee must withhold the full amount of each distribution until it makes up the full amount that has not been withheld plus interest. Very, very important to know, plus interest.
Jay Bakst:Okay. Let's move right along. Not withhold the requirement. Okay. Discussed this already. And now we're going to move over to the FATCA 1042-S area. Okay. I'm sorry, it's going to take a minute, why is this not? Here we go. Okay, fine. So now we're going to talk about Form 1042-S, okay? So a partnership that earns U.S. source FDAP, typically let's use these example of dividends, okay? If it pays it to a foreign person, a foreign partner, it's got to withhold. What happens if it doesn't pay it out, okay?
But it receives U.S. source FDAP in year one. It doesn't distribute it until year two or it doesn't at all, okay? So the rule is that the withholding tax is we made it to the IRS upon the earlier of the distribution of such income in year two, or when the year one K-1 is issued in year two. Historically, the IRS required that this U.S. source FDAP, that was subjected to withholding in year two be reported on a year two Form 1042-S.
Notwithstanding the fact that this income was allocated to the foreign person on a year one K-1. This is what we call the lag method. This caused a mismatch and was problematic for some foreign partners. So in December of 2018, the IRS issued proposed regulations that eliminated this lag method of reporting. Now, very important to note, we're going to talk a little bit about this, but the proposed regulations are optional until they're finalized.
Recent comments and formal comments by the IRS, as well as the draft instructions to 2021 Form 1042-S suggest that the proposed regulations are not expected to be finalized with this upcoming Form 1042-S filing season. And then in the meantime, the lag method can still be used.
Now let's speak about what the proposed regulations, if you choose to adapt them call for, okay? So now again, the partnership earns interest in dividends in year one, doesn't allocate it until year two. The withholding tax is being deposited in year two. The time of that withholding remains unchanged. I cannot stress this more. The time of the withholding of deposits, the IRS in year two remains unchanged.
What does change is that now this income and withholding is going to be reported on a year one Form 1042-S. And therefore, number one, it needs to be designated as a year one deposit when making the deposit. Number two, we have this little bit of a quirky rule that if they're withholding tax deposit is done after March 15th of year two, then the year one Form 1042-S relating to such income and withholding is going to be due September 15th of year two not March 15th.
And the partnership must check back 7c on Form 1042-S to indicate that it qualifies for this later due date. If on the other hand, the withholding tax deposit is done in year two, prior to March 15th, then that year one Form 1042-S is still due on March 15th of year two. Okay.
Very important. The IRS clarified that this elimination of the lag method if you choose to apply it, it applies also for income allocated in year two and account of year one, where there was no withholding tax that was required. For example, this portfolio interest exception to find tax exempt a treaty reduction. This is a very, very important development because otherwise it would have been a nightmare.
Okay. So what are the ramifications of this? The most important thing I think, besides deciding whether you want to early adopt or not, is that if the partnership does not distribute the income before 3/15, you really need to focus on when you issue your K-1s.
Either provide your K-1s prior to 3/15 in enough time to allow you to prepare and file Forms for 1042-S or if you're not going to be able to do that and sometimes it's very, very close to lay the K-1 delivery to at least 3/16 or in order that you should not run a foul of having to file your year one Form 1042-S by 3/15. Alternatively, you can request a 30 day extension.
Okay. So let's talk about under the new rules once as presently drafted and once you adopt them, the partnership may be required to file up to three Forms 1042-S for the same type of payment made to the same partner in one year. How was that? One to Form 1042-S for distributions of income that are actually made during the year. You leave Box 7c blank. That has a March 15th deadline.
The next one is if the partnership distributes the income to the foreign partner in year two, but prior to March 15th, okay? That's you have to issue a separate 1042-S for that, and the Box 7c has to be checked. And then finally, there's a third one that if you don't distribute the money by March 15th, then the September 15th deadline applies, and you also have to check Box 7c. So that's a very important point to note that this is going to add an additional burden if you have these types of situations.
Moving right along. On Schedule K-2, K-3, just want to point that one thing very briefly over here, and that is you see over here that you have to separate your U.S. source FDAP from your foreign source, ECI from non ECI by line items, which we never had before. We alluded to this before.
One important thing that I think is very important to notice rental real estate gross rents from U.S. real estate is FDAP subject to 30% withholding on gross. Even if it's from your sources, unless the foreign partner makes it elected to treat it as ECI. If it does that, then it has to, of course, inform the partnership that it did that so that it knows not to withhold 30% of the gross, but a full 37% or 21% on the net.
The instructions over here say that if the partner has made this election at the partnership level on Schedule K-2, you're still going to report it, the rents as U.S. source FDAP and Schedule 3, though, if the partner has made the election, you've got to report it to that partner as U.S. source ECI, which then we accustomed to allocating the amounts on Schedule K to all of our partners over here, it would be allocated in different manner. I thought that that was very interesting to note.
Jay Bakst:Okay. No surprises there. Okay, very interesting. The IRS has partnered with Fairfax Software to develop a software tool that would aid the Form 1042-S filers in validating the data prior to e-file submission. The purpose of the software is to catch errors that should be detectable in the face of the form. And the IRS expects to use this software to send out notices. There's going to be no cost for using the tool and it's expected to be available later in 2021.
The IRS intends to send out notices to advertise its availability to withholding agents. And you can read over here on the slides of certain things, what the software does and does not do, how it works, et cetera, et cetera. And we're going to skip now to next thing. Okay. That's good. Responsible officer's certification. Let me just tell this to you in less than 30 seconds, okay?
Your FATCA online message board, even if you're a model one FFI is going to say, you must go in and certify. And the deadline to certify is today. For Model 1 countries that have no branches outside Model 1 jurisdictions, it's not really required, but the system requires you to go in and to just tell them that. You can read through the slides as to what you might do afterwards to make sure that this doesn't happen again. You have to just change your registration.
It's not a big deal. Just please make sure to do it because otherwise your GIIN could theoretically be revoked if you don't tell them that you're not required to do it and you don't do it.
Missing GIINs for U.S. accounts, okay? The pressure is up, okay? FF1s in Model 1 jurisdictions have to report the U.S. reportable account to the local country and then report them to the U.S., and the issue arises when the IRS receives this report of U.S. accounts without TINs.
Now, sometimes the reason for this is because the person is not really U.S., but since they're not properly documented as a foreign person, then the default was required to treat it as U.S. reportable account. This is a big problem for the IRS. The question is whether IRS is going to force foreign financial institutions to close down such undocumented accounts, okay?
So we have some guidance previously, and until for reporting years through 2019, which is really ending right now, You don't really have to worry about it. Going forward, you're really supposed to get it. And what the IRS has said that for going forward with reporting is 2020. Afterwards, the IRS is going to start generating error notices. If you have a missing TIN, if you have a TIN with nine A's or O's or some other identifiable pattern, and the error notice will say, you have to respond to us in 120 days to correct the issue.
If they don't do that, then the U.S. will consider the facts and circumstances to consider if there's significant non-compliance into the IGA. If it determines that it will not be automatic, if it determined that there is, and the IRS would notify the exchange partner country, who will have 18 days to address it after which under the IGA, the FFI could have its GIIN invalidated by the IRS, which is the ultimate weapon.
And now let's talk about foreign TINs, okay? So it's been several years now that you had to obtain and report foreign TINs, unless you had a reasonable explanation for not having one, or you were not required to have one. For W-8 Forms that were signed prior to 12/31/17, if the FTIN was missing, you could obtain it outside of the form. It didn't have to be on the form.
Now, considering the fact that any W-8 Form that was signed during 2017 will expire by the end of this year, you have to get new forms and by now every withholding agent should have a valid W-8 on file with the FTIN.
Let's go on. CRS Cayman reporting, okay? So the DITC Cayman released a new CRS compliance form. It's important people know about this, okay? This required form should not be confused with CRS reporting or reportable accounts. On the contrary, this new form, annual form is more focused on the accounts that the Cayman Financial Institution did not report as well as other matters.
The first annual deadline for this file was supposed to be by the end of 2020, it was extended because of COVID until March 31st, 2021. Noting, the most important thing to note over here, I think, is that Cayman reporting FIS, which is virtually all funds will need to file this form, even if they had no reportable accounts to report on the CRS. And therefore, they didn't have to submit, and they report them to CRS, right?
For example, if you had a Cayman Financial Institution with only U.S. partners, U.S. has not signed up to CRS. Therefore would have been no U.S. reportable accounts, but these Cayman FIs will have to submit the support annually regardless.
Another update in Cayman. On November 9th, barely a month ago, the Cayman Islands finally went live with their new portal. This no portal is supposed to replace the old AEOI Portal. And users should have received an activation email, firstname.lastname@example.org with instructions of how to update themselves and to get logged out to the new portal. And supposedly that email link is only valid for two weeks.
The problem that we are aware of is that many, many primary points of contact have not received this email. And therefore, what do you do if you don't receive the email? It's very trying circumstances. So we have over here in the slides on slide 76, over here, some suggestions from a local law firm down there as to what steps you might take, if you do not receive the email. Okay. At this point, I'm going to turn it over to Ayelet who's going to talk to us about CFC and Downward Attributions in Form 5471. Go ahead, Ayelet.
Ayelet Duskis:Awesome. This is my favorite topic. All right. If we're looking over here, we're looking at the Schedule K-2 of what we're going to provide to our partners regarding any CFCs, how about foreign corporation? It's really, again, anything that the partner is going to need in order to either follow their own forms or pick out any of their applicable share out of the income that they need to pick up.
What's interesting to notice that from the instructions to the Form Schedule K-2, you have to include all CFC information, regardless of if none of our partners are 10% or more partners in our partnership. Meaning even if nobody from the perspective of the partnership is a U.S. shareholder, we need to include this information for the partners.
What you'll see on the Schedule page three, and the instructions of the Schedule page three is that the IRS is telling the partners that they are the ones that need to make the determination if they are a U.S. shareholder, and if any of this information is applicable to them and if they need to pick up any of this income. Meaning that we're going to have a little bit of an additional reporting requirement and the partners are then going to decide how they handle that information.
Jay Bakst:Okay. So if we just take a step back, if I may chime in over here, this is really a huge cause of concern. When I first saw this, I couldn't believe it. Let's just think about all of the Cayman partnerships, fund partnerships that are invested in CFCs. And these CFCs are only CFCs let's just say because of that one attribution or otherwise, but there are no 10% U.S. share.
Well, let's see, is generally say we don't have to worry about it. Well, if you read the instructions carefully, I know it doesn't make sense. And I agree it doesn't make sense, but if you read the instructions carefully, there seemed to say that you have to provide Subpart F information, guilty information in order to calculate this without regard to whether they really are a 10% shareholder, not in the CFC.
And I can understand a little bit where the IRS is coming from precisely, because there are very complex rules about ownership attribution, downward attribution, which we're going to speak about immediately. The partnership might not be in a position to determine which one of his partners is a 10% shareholder in the CFC.
And therefore, it was easy for the IRS to just say, you know what? Let's not go down that slippery slope. You just give them the information. If they don't need it, they won't use it. But where does that leave the partnerships in a very, very burdensome position. So I'm hoping that the IRS will come up with further guidance to provide some relief on this point, if only to perhaps get a certification from the partners saying we don't need this information. Let's continue, Ayelet go ahead.
Ayelet Duskis:All right. So I'm going to talk a little bit about the background of downward attribution. The Tax Cuts and Jobs Acts drastically changed the way we look at ownership attribution rules under Section 958(b). The Tax Cuts and Jobs Act repealed Section 958(b)(4) which prevented a U.S. person from being attributed stock owned by a foreign person.
I'm going to show you pictures and examples, because I think that's going to make a lot more sense, and I would dice for me. So if we look at this first picture over here, we have a foreign parent, which owns both in U.S. Sub and a foreign Sub. There are no U.S. economic owners of any of the foreign entities.
The U.S. Sub has attributed, it says if the U.S. Sub is the one that owns the stock in the foreign subsidiary, and the foreign subsidiary becomes what is called a foreign controlled CFC. The U.S. Sub is what is it called a related constructive U.S. shareholder. They will need to file a Form 5471 and we'll see, later on that, it's been a complete Form 5471.
In this next picture, everything stayed the same, except for that now we have a U.S. economic owner at the top. The foreign Sub is still what's called a foreign controlled CFC, but since there's a U.S. partnership, which is a 10% or more shareholder, that U.S. partnership is also going to need to file a Form 5471. It will also be a modified Form 5471, but it will be 5471 nonetheless.
This next image is really interesting because this isn't where attribution is happening on the shareholder level. It's not happening on the subsidiary level. U.S. PE fund LPF only owns 9% of Foreign Corp, but it does not qualify as a U.S. Shareholder because it owns less than 10% in the Foreign Corp below it.
What happens is, is that the 46% attribution from the Cayman LPG rolls through the Cayman GPC to Cayman GPB, which rolls back to U.S. PE LPF. All of a sudden this U.S. PE fund owns more than 10% in the Foreign Corp. The Foreign Corp then it becomes a CFC because it was just under 50% for that. And the U.S.PE fund has a 10% or more shareholder that needs to file a Form 5471.
In October of 2019, the IRS released Rev Proc 2019-40. Now, contrary to why we might've thought the Rev Proc wasn't to explain downward attribution, that's how downward attribution works. It was simply to provide relief for some of the very complicated areas that some of the issues that these new CFCs created.
In addition, at the same time, the IRS released proposed regulations, which were finalized on September 21st, 2020. These proposed regulations also did not clarify anything about downward attribution or change any rules about down attribution.
What they did was they looked at other laws that were affected by downward attribution and all these new CFCs that were created, and they made sure that the other laws and tensions remain intact, meaning that the consequences of any of these other laws was not changed because now we have these new CFCs.
And example of that is what we talked about before with PFICs that you can still use the value for the PFIC when doing the asset test if it's a foreign controlled CFC. Meaning nothing that changed in the CFC in the downward attribution itself. But we looked at some of the laws that were affected by the downward attribution. Jay.
Jay Bakst:Yeah. So I want to just put this all in perspective. We have all of these new unanticipated CFCs and all of this burden, and yes, the IRS tried to mitigate the burden, but perhaps the most significant aspect of the 2020 final and proposed regulations is as Ayelet mentioned before, nothing changed with regard to downward attribution in creating the CFCs, but in June, 2019, the IRS issued final duty regulations and propose a Subpart F regulations and unexpectedly, the IRS reversed its position for last 50 years. And they said that you're not supposed to pick up any of this income at the domestic partnership level, okay?
Now, if you think about this, I'm going to go out on the limb over here. And I'm going to say that in a very, very broad general way, most investors that are not flow-through entities themselves in private equity funds are not going to be owning 10% or more of these CFCs.
And therefore, for those investors, which is I would say the majority or the overwhelming majority, this greatly minimizes the unfavorable consequences of creating all these new CFCs, because now not only are these new CFCs Subpart F coming guilty, not going to be passed through to them, but even the CFCs that were not created by downward attribution, if the ultimate U.S. individual or corporation owns less than 10% through domestic partnership, they no longer will have to take this income into account.
So if you really shake it all down, what this really boils down to is that the, in once short sentence, okay? The result of downward attribution to fund with all of its new CFCs that it created is just one big major for the most part, one big major compliance burden. It's a very, very general statement, but it's important to keep in mind.
And that is why, by the way, that when we're considering what is important for funds, you see that we're not getting into any of the details of what Subpart F of income and what's guilty and what's a new rec say, you can treat for the under the look-through rules, you can treat something as a CFC for purpose of the loop, look-through rules, or you don't. It's mostly, mostly for the most part, not so relevant anymore. Very important point.
Ayelet Duskis:We're going to start talking about safe harbors that the leniencies or the things that the Rev Proc made a little easier for us. If we look here at the instructions to the Form 5471, the Rev Pro created two additional categories of 5471 filing. Unrelated Section 958(a) U.S. shareholder and related constructive U.S. shareholder. If the 5471 filer fits into either one of these categories, it's a modified Form 5471, which is including a lot less information, which is obviously helping with our burden of all these new CFCs.
Another very, very important relief that then Rev Proc provided was who you have to ask and how far you have to dig to find out if there are these foreign controlled CFCs up and down your structure. U.S. person is related to the foreign partnership, therefore U.S. must person must ask foreign partnership, what it owns underneath and if there are any foreign controlled CFCs.
U.S. person is not required to ask foreign person their personal information about who they own and what their structures look like. They're not related. And having a foreign person doesn't want to share any of this information with U.S. person anyways. So this really seems to make a lot of sense.
I'm going to take a look at the examples from the Rev Proc and I think it will clarify a lot of things for us. In this first example, we have a foreign corporation with both the U.S. Sub and a foreign Sub. There's also a U.S. economic owner on the top. The foreign corporation becomes what is known as a foreign controlled CFC. The U.S. Sub is what is called a related constructive U.S. shareholder.
That means that it doesn't actually have an economic interest in the foreign controlled CFC, but it is still a U.S. shareholder because of downward attribution and it is related. The U.S. parent on the top, the 10% U.S. owner on the top of the structure is what is called an unrelated 958(a) U.S. shareholder. Both U.S. one and U.S. two are eligible for filing the modified Form 5471, which means they don't have to file the complete 5471.
If we look at this next structure, everything's the same, except that now U.S. two owns a 1% interest in the foreign controlled CFC. What happens is, is that that U.S. two is now an economic owner of the foreign controlled CFC or a related 958(a) U.S. shareholder as the Rev Proc calls it and they are not eligible to file a modified Form 5471. U.S. one is still eligible to file that modified form, but U.S. two is not.
If we look at this next structure, we have a U.S. parent and a foreign parent that both own a foreign subsidiary. The Foreign Corp is also invested in a U.S. partnership. This goes back to our polling question. This U.S. partnership becomes what is known as an unrelated constructive U.S. shareholder. They theoretically have been attributed the shares in the foreign controlled CFC, but they have nothing to do with it.
There only is a 5% interest less than 50%. They're unrelated constructive U.S. shareholder. They denied and have a file of Form 5471. The U.S. Corp on the top is a 10% shareholder in this foreign controlled CFC and will have to file a Form 5471. And again, it'll be a modified Form 5471.
If we look at this last image, everything is the same, except for that when U.S. person ask the Foreign Corp, if they qualify under downward attribution of that as if they were a U.S. person or they had any U.S. investments, Foreign Corp answered that they did not or they did not have that information.
U.S. person is not going to be penalized under the Rev Proc for not treating the foreign corporation as a foreign controlled CFC. Even though the foreign corporation is a CFC. U.S. person doesn't file a 5471 or any of the other things that it should be doing, and it will be protected under the safe harbor because it did its due diligence when asking. Believe it or not, that is the end of our presentation.