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The U.S. Withholding Tax on a Foreign Partner’s Share of Effectively Connected Taxable Income

The U.S. Withholding Tax on a Foreign Partner’s Share of Effectively Connected Taxable Income

By Anthony Diosdi

In recent years, there has been a significant increase in business activities between U.S. persons and persons from third countries. When U.S. persons and foreign persons enters into arrangements to conduct business activities in the United States, it is not uncommon for the arrangement to be general or limited partnership, a limited liability company, or some other informal arrangement, all of which may be classified as a partnership for U.S. income tax purposes.

A number of years ago, Congress was concerned that foreign persons generating profits from participating in any business arrangement that is classified as a partnership for U.S. income tax purposes were avoiding the payment of U.S. income tax. In an effort to close this potential loophole, Congress enacted legislation which in general requires that any partnership having U.S. “effectively connected taxable income” (“ECTI”) for any taxable year must withhold tax at such time and in such manner as prescribed by the regulations with respect to any portion of the partnership’s ECTI allocable to a foreign person. The tax to be withheld is determined by using the highest allocable to a foreign partner. The tax to be withheld is determined by using the highest rate of tax applicable to each foreign partner (i.e., 21 percent if the partner is a foreign corporation, and 37 percent if the partner is a U.S. income tax nonresident alien or foreign trust or foreign estate).

Generally, ECTI is the partnership’s taxable income that is effectively connected with the conduct of a U.S. trade or business with certain adjustments. Internal Revenue Code Section 1446 imposes a withholding obligation on the share of the partnership net income that is ECTI to a foreign partner. The result is that the partnership must withhold an amount equal to the product of the allocable share of such income attributable to the foreign partner and the maximum marginal tax rates specified in Sections 1 (for individuals) and 11 (for corporations), except that a lower rate may be applied for allocation of capital gains to a noncorporate foreign partner. See Reg. Section 1.1446-3(a)(2)(ii). Note that, unlike other situations in which withholding obligations apply when payments are made, the partnership is required to withhold the appropriate amount whether or not the foreign partner’s share of income is actually distributed. The tax so withheld will be treated as a distribution to the foreign partner to whom the withholding applies. See Treas. Reg. Section 1.1446-3(d)(2)(v).

As in the case of nonresident alien compensation income, the effect is the establishment of a withholding obligation that does not equal the income tax liability of the taxpayer. That liability may depend on other income, deductions and credits available to the taxpayer that are not reflected in the partnership calculations because they relate to other U.S. trades or businesses and the effective tax rate of the foreign partner. The foreign partner is required to file the appropriate income tax return in which the amount withheld by the partnership will be credited against any U.S. income tax liability.

The withholding tax summarized above is extremely important for U.S. and foreign persons who join together to carry out U.S. business or real estate activities through any business arrangement which can be classified as a partnership for U.S. income tax purposes. Failure to properly comply can result in significant tax liabilities plus penalties and interest. This article briefly outlines the more important aspects of the partnership withholding statute and any person participating in a partnership having one or more foreign partners and ECTI should consult a tax advisor with a strong background in international tax in order to comply with the appropriate rules and procedures.

Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.