On May 13, 2005, the IRS issued final and temporary regs (TD 9200, 2005-23 IRB 1158) regarding a US partnership’s obligation to withhold tax under Code section 1446 on effectively connected income allocable to a foreign partner, applicable to partnership taxable years beginning after May 18, 2005 (or beginning after December 31, 2004 if the partnership so elects). The new regs finalize regulations proposed on September 3, 2003 and are intended to simplify the withholding.

Generally, a foreign person engaged in a US trade or business is subject to US tax on effectively connected income. A US partnership with effectively connected taxable income (ECTI) that is allocable to a foreign partner under section 704 (relating to a partner’s distributive share of partnership income) must pay a withholding tax at the highest tax rate applicable to such a foreign partner: 35 percent for both corporations and individuals. The tax paid on its behalf by the partnership is generally creditable by the foreign partner.

The new regs include guidance on (1) the determination of the domestic or foreign status of partners, (2) tiered partnership structures, (3) the calculation of the withholding tax, and (4) the application of interest, penalties, and additions to the tax on a withholding agent’s failure to comply.

A partnership must only withhold on a foreign partner’s ECTI share and therefore must determine whether the partner is US or foreign. Prior to the new regs, the process to certify foreign status was not consistent with the withholding rules applicable to foreign persons for passive income under sections 1441 and 1442. Under the final regs, a US partnership may accept any form that constitutes acceptable documentation of US or foreign status for the purposes of section 1441, including forms W-9, W-8BEN, W-8IMY, W-8ECI, and W-8EXP, and any substitute therefor that is consistent with the section 1441 regulations. However, two notable differences exist: for section 1446, a US grantor trust with a foreign grantor is treated as a foreign partner, not a US partner, and a foreign simple trust is treated as an entity, not a flowthrough entity. Thus, a US grantor trust and a foreign simple trust may need to provide different documentation for section 1446 and sections 1441 and 1442.

The final regs generally require a partnership to look through any of its partners that is a foreign partnership if that foreign partnership has provided appropriate documentation, such as form W-8IMY, and documentation establishing the status of its partners. If an upper-tier foreign partnership provides a form W-9 on behalf of one of its (US) partners to a lower-tier US partnership but fails to adequately document the status of its other partners, the lower-tier partnership must look through the upper-tier partnership to the extent of the US partner’s interest and not withhold section 1446 tax on that partner’s allocable share.

The final regs also provide guidance in calculating the section 1446 tax. In determining the highest rate of applicable tax, the regs allow a US partnership to consider the relevant type of income or gain allocable to a foreign partner. Thus, a partnership may apply a reduced 15 percent rate of tax to effectively connect income consisting of long-term capital gain allocable to a non-corporate partner, but only if the partner has adequately documented its status to the partnership.

In addition, the temporary regs generally allow a US partnership to consider a foreign partner’s deductions and losses that are reasonably expected to be available to reduce the partner’s US income tax liability on its allocable share of US business income or gain from the partnership in the taxable year. The new temporary regs allow certain foreign partners to certify that they have deductions and losses to reduce their tax liability on their allocable share of the partnership’s effectively connected income. However, the partnership may be liable for the tax if the partner’s certification proves incorrect.

The final regs also clarify the rules relating to the imposition of additional tax, interest, and penalties for a partnership’s underpayment of a section 1446 instalment tax under sections 6655, 6601, and 6651. A partnership is now responsible for additions to tax, interest, and penalties on its failure to make instalments even when it is deemed to have paid all section 1446 tax due as of the close of its taxable year with respect to a foreign partner who fully paid its US income tax.

The new regs offer welcome guidance for many Canadian investors in US partnerships and limited liability companies. Canadian individual partners may now benefit from the lower capital gain rate (15 percent) when the section 1446 tax is computed. Further over-withholding relief is gained because Canadian partners may take into account certain deductions and losses outside the partnership to reduce the required withholding.