Centralized Partnership Audit Regime: International Regulations

As the 2018 implementation of the centralized partnership audit regime passed under §1101 of the Bipartisan Budget Act (BBA) of 2015 is fast approaching, the Internal Revenue Service (IRS) is releasing a myriad of regulations to provide a framework for compliance by taxpayers. This new audit regime generally applies any tax burden or penalty arising from an audit adjustment to the partnership itself instead of flowing the adjustments through to the individual partners as under prior law. It is important to note that the centralized regime allows partnerships with 100 or fewer partners to opt out of the rules as long as their partners consist only of individuals, corporations, and estates. The provisions of §1101 of the BBA were outlined in our article entitled “IRS Issues First Partnership Audit Regulations Under New Regime” which is available through the following link: http://kurtzcpa.com/irs-partnership-audit-regulations/

In June of 2017 the IRS released regulations regarding the scope of the new regime, the ability of “eligible partnerships” to opt out, the appointment of a partnership representative, the handling of imputed underpayments, the ability to “push out” penalties and underpayments to partners holding an interest at the time the underpayment occurred, consistent treatment of returns by partnerships and their partners, and administrative adjustment requests. See our article on these regulations entitled “IRS Partnership Audit Regulations Reissued” through the following link: http://kurtzcpa.com/irs-partnership-audit-regulations-reissued/

On November 30, the IRS published proposed regulations addressing the international aspects of the centralized partnership audit regime. Specifically, the regulations coordinate audit regime with a partnership’s requirement to withhold tax on U.S.-source income allocable to foreign partners. The proposed regulations also provide guidance with respect to the treatment of foreign tax credits (FTCs). The remainder of this article will discuss each of these aspects in turn.

Coordination of Audit Regime with Withholding Taxes on Payments to Foreign Partners

Internal Revenue Code (IRC) §1446 generally requires a partnership to withhold on taxable income attributable (“effectively connected” in the language of the IRC) to the partnership’s U.S. trade or business activities to the extent allocable to foreign partners. The partnership must withhold at the highest marginal tax rate applicable to that type of partner (e.g., 39.6% in the case of an individual). In addition, a partnership must withhold tax at a 30% rate on certain U.S.-source income not effectively connected to trade or business activities allocable to foreign partners such as dividend or interest income. Furthermore, IRC §1445 imposes withholding at a 15% rate on the amount realized by a foreign persons on the disposition of a U.S. real property interest. For example, if a partnership purchases a building located in the U.S. from a foreign person it must withhold 15% of the sales proceeds. A partnership’s requirement to withhold may be reduced or eliminated by the applicable tax treaty.

Under IRC §§ 1471 through 1474, a U.S. withholding agents (in this case, the partnership) must withhold tax on certain payments to “foreign financial institutions” that do not agree to report certain information regarding their U.S. accounts and payments to “non-financial foreign entities.”

The withholding taxes outlined above do not fall within the scope of the centralized BBA partnership income tax audit regime. This means the IRS would conduct a separate audit in order to ensure a partnership complies with the withholding rules. The proposed regulations coordinate the potential two separate audits. As such, the proposed regulations specifically state that if a withholding audit precedes an audit under the BBA rules, and a tax was collected as a result of that withholding audit, the BBA audit will bypass any withholding-related issues. Similarly, if a BBA audit precedes a withholding audit the BBA audit will disregard underpayment issues specifically associated with the withholding audit.

Foreign Tax Credits (FTCs)

A partnership will compute its imputed underpayment by multiplying the net audit adjustment to taxable income by the highest federal individual income tax rate while also taking into account its credits. However, partnerships as pass-through entities cannot directly claim FTCs. As a result, the newly proposed regulations create a category known as credible foreign tax expenditures (CFTEs) to incorporate FTCs into the calculation of the imputed underpayment.

The proposed regulations create a creditable expenditure grouping representing all partnership adjustments potentially offset by FTCs. If the audit results in an imputed decrease in the CFTE the partners are assumed to have fully utilized their FTCs resulting in an increased imputed underpayment. On the other hand, if the audit increases the CFTEs the partners will be assumed to not be able to fully utilize the newly available FTCs and an overpayment may not result. This negative result for taxpayers can be mitigated to a certain extent as IRC §6225 would allow the partnership to incorporate specific partners’ facts when determining the imputed underpayment.

In addition, the proposed regulations request comments on how to handle various other international tax issues arising from the centralized partnership audit regime. These issues range from coordinating the new regime with tax treaties (specifically, the mutual agreement procedure) to how to incorporate rules governing foreign corporations to whether a partnership can elect to pay the share of penalties, additions to tax, additional amounts and interest attributable to a partner that would have been subject to withholding in the reviewed year.

For more information about these proposed regulations and the centralized partnership audit regime please contact a tax professional.

About The Author

Daniel Quintana

Daniel Quintana of Kurtz & Company, P.C. in Dallas Texas. https://www.linkedin.com/in/drquintana