E&Y Suggests Modifying Guidance on Withholding Foreign Partnership or Trust Agreements

[1] The following is respectfully submitted in response to Notice 2002-41's invitation to submit comments regarding the draft "withholding foreign partnership" ("WHP") agreement set forth in the Notice. This letter also submits, at the end, a few comments on the "withholding foreign trust" ("WHT") agreement, although this letter does not contain comprehensive comments on the WHT proposal, and we reserve the right to make future submissions at a later date.

Background

[2] The new withholding tax regulations that came into effect in the beginning of 2002¹ have posed substantial problems for non-U.S. investment funds that are properly classified as partnerships for U.S. federal income tax purposes.

[3] Under these rules, the base rule is that a non-U.S. partnership is regarded as transparent for U.S. withholding tax purposes. The partnership must collect U.S. tax certifications from each partner (Form W-9 from U.S. partners, and the appropriate variant of Form W-8 or, in some cases, documentary evidence from foreign partners). The partnership must then transmit this information, together with (a) the partnership's own tax certification on Form W-8IMY and (b) a schedule showing how the income is to be allocated among the partners, to its payors. The payors must then perform information reporting and withholding as if they were paying the underlying partners directly.²

[4] This procedure creates the following issues, among others, for investment funds that are properly classified as non-U.S. partnerships.

[5] Relations with payors. A partnership typically would only have a single account with each of its brokers, custodians, banks, and other financial institutions. Under the base rule set forth above, a person making a payment to what it has historically treated as a single customer -- the partnership -- now must act as if it were paying all of the underlying partners, which might be numerous. In other words, if a partnership has 100 partners, then a person making a payment to the partnership must perform partner-level withholding and information reporting as if it were paying all 100 partners directly. It is burdensome for a partnership to assemble this information and transmit it to its payors, and even more burdensome for its payors to process this information. This information also would have to be updated every time a partner was admitted or withdrew, which might be every month in many funds we see.

[6] Allocations. The allocations of an investment partnership are often complex, and may be impossible to determine in the middle of the year. First, it is not at all uncommon for the manager of an investment partnership to be a general partner, and to receive his compensation by way of a special allocation of partnership profits. Thus, such a general partner may have an allocation of profits that is disproportionate to his capital account. Second, the formula for such a general partner's share of profits is often complex. The manager of an investment partnership's often receives allocation on an incentive basis. The manager might receive, for each year, a set percentage (say, 20%) of the partnership's profits for the year in excess of a specified benchmark. If the general partner is the manager and his share of partnership income is computed on this basis, the general partner's share of partnership income (or any item thereof) may be impossible to compute until the end of the year, when total income for the year can be determined. Third, as with any partnership, an investment partnership has some (although not unlimited) flexibility to change partnership allocations retroactively up to the date the return for the year is due.³ For all of these reasons, it may be impossible to determine any particular partner's share of any particular item of partnership income until after the books for the year are closed.

[7] Investor privacy. The premise behind the QI rules is non-U.S. investors may be permitted to invest in U.S. securities without disclosure, provided that sufficient steps are taken to ensure that U.S. investors do not hide behind non-U.S. custodians, and benefits under U.S. tax treaties are restricted to those who are entitled to them. Historically, this has been important in attracting non-U.S. investors into the U.S. market, since the preference of certain non-U.S. investors for privacy is a fact of life that Congress has long recognized.⁴

[8] Investor certifications. In most cases, persons receiving payments from U.S. payors are required to provide either Form W-9 or the appropriate version of Form W-8 in order to avoid withholding. Non-U.S. investors who appropriately would file one of the W-8 forms are often very reluctant to sign anything that appears to, be an official U.S. tax form (or substitute therefore). QIs are allowed to use IRS-approved "know your customer" ("KYC") documentation instead of W-8s for non-U.S. customers, and all payors are allowed, for certain purposes, to use documentary evidence for payments made outside the United States to offshore accounts and sales effected at an office outside the United States.⁵ How the latter rules apply in the case of a foreign partnership is not clear.

Notice 2002-41

[9] Notice 2002-41, as it stands, goes far to address many of these issues, and the IRS is to be commended for the effort that, clearly, has gone into thinking through the issues. If a partnership can qualify as a WHP, it can give a single W-8IMY to its payors (to the extent it is permitted to act as a WHP with respect to all of its partners, a point which we shall address later). If no distributions are made during a year, Section 3.02 permits withholding to be done in the following year (giving time to close the partnership's books), up to the date a Schedule K-1 for the year would be required to be sent. If a WHP makes the pooled reporting election in accordance with Section 6.03, Form 1042-S will not be filed with respect to each non- U.S. partner, but only on a pooled basis.

Comments on Notice 2002-41

[10] The above having been said, the WHP procedure as set forth in Notice 2002-41 will not, as it stands, be workable for many widely-held non-U.S. investment funds that are structured as partnerships for U.S. tax purposes. The following issues, and suggested solutions, are respectfully submitted with a view to making the WHP regime more useful for such investment funds.

Issues

[11] Passthrough partners. Under Section 4.07, a WHP would not be permitted to act as such with respect to partners that were nominees, other intermediaries, partnerships (other than other withholding foreign partnerships), and simple and grantor trusts (other than "withholding foreign trusts") (collectively, "passthrough partners"). Instead, the WHP would have to collect the appropriate documentation from such a passthrough partner and forward it to its payors. Thus, a person paying a WHP that had passthrough partners would be acting in two capacities. To the extent the WHP's income was not allocable to passthrough partners, the payor would pay WHP on a gross basis, with the WHP attending to withholding. To the extent the WHP's income was allocable to passthrough partners, the payor would ignore the WHP's role as a WHP, and withhold and report as if it were paying such partners (and the persons behind them) directly.

[12] Notice 2002-41 states that the purpose of this rule is to spare WHPs the burdens of complying with, and undergoing an audit for compliance with, the complex documentation and presumption rules that would apply to such indirect partners. In many cases, this may well be a fair comment. One might imagine, for example, a family investment partnership comprising a few siblings, their spouses and children that is enthusiastic about investing in U.S. securities. Such a small, closely-knit group could easily comply with the full documentation requirements and restructure its affairs if necessary in order to avoid passthrough partners, thus avoiding the need to apply presumptions, and might shy away from the WHP regime if the audit requirements were complex.

[13] We are concerned that this rule would greatly lessen the practical utility of the WHP procedure. If a WHP has partners that are passthrough partners, and so cannot act as a WHP with respect to all of them, this opens up the problems, discussed above, of payors having to treat a partnership as multiple customers for withholding tax purposes, and having to give allocations information to a payor when allocations shift during the year and may not be determinable until the year has closed. This has the potential to create major operational and systems problems. We submit the following example:

[15] Failure to obtain documentation. Section 9.04 provides that a WHP agreement will automatically terminate if a WHP does not obtain Form W-9 or the relevant version of Form W-8BEN from all of its partners, although there is an extended cure period. With all due respect, this rule is impractical. The thought behind it is understandable enough: if one assumes the small family partnership, as discussed above, where the partners are closely-knit and on good terms, it is better to provide very strong incentives to get all the relevant documentation than to provide complicated rules for what happens when this is not the case. Even on these terms, this rule is open to question.

[16] Consider the general partner of a small foreign partnership who does not read English as his native language and does not have the resources to have U.S. tax experts supervise all operations[.] The U.S. entity classification rules are not at all intuitive for foreign persons. Suppose, for example, that a trust is a partner in that partnership. Deciding whether a trust is a complex trust (which is not a passthrough partner) or a simple or grantor trust (which is) can require a complex analysis by a trained U.S. tax practitioner, especially if the settlor or any of the beneficiaries are U.S. persons. Such a general partner might not even recognize that there was an issue that required analysis.

[17] The possibility of inadvertent error by a well-meaning general partner who is sincerely trying to comply with his obligations to the IRS, but who does not appreciate all of the subtle nuances of U.S. tax law, is too high to make disqualification the general baseline penalty. Furthermore, as to the cure period, persons who were cooperative friends at the beginning of the venture, and only too pleased to supply any missing documents, might not be so at the end, leaving a general partner who is now trying to correct a good-faith error in a difficult position.

[18] Documentary evidence. There is no provision for non-U.S. partners⁶ of WHPs to use anything other than official W-8 series forms (or authorized substitutes) to document their status as non-U.S. persons. As noted above, this can be problematic for unsophisticated investors who are not accustomed to signing U.S. tax forms.

[19] Mid-year distributions. Suppose that, in the middle of a tax year, a WHP earns income that is subject to different withholding rates for different partners. Suppose that the allocations cannot be settled before year end. Suppose the WHP makes a distribution before year end. It is not at all clear what the general partner is to do.

[20] Location of withholding burden. A WHP must act as the withholding agent, and thus must deal with the complications of making federal tax deposits and filing Form 1042-S. The requirement to make federal tax deposits can be a burden for someone who does not have a U.S. bank account and U.S. banking relationships, since making a federal tax deposit by coupon requires that one have a relationship with a U.S. bank that has a Treasury trust & loan account, and the EFTPS procedures are far too complex for, say, a small partnership with a non-English-speaking general partner.

Suggested Solutions

[21] Passthrough partners. The IRS can reasonably insist that if all of the documentation from indirect partners is not to flow through to the U.S. payor, someone must agree with the IRS to perform the necessary withholding and reporting duties, to have its performance reviewed, and to face the consequences if it fails to fulfill its contractual duties. But if the WHP has contractually agreed to do this, it should be allowed, if it wishes, to take on the responsibility for all of its partners, both direct and indirect. The WHP agreement ought to allow for two alternatives. In the base case, as with Notice 2002-41, the WHP would not be allowed to act as such for its passthrough partners. But if the WHP made what might be called the "passthrough partner election," it would be permitted to have all kinds of passthrough partners, but would in return be required to comply with, and submit to audit of its compliance with, all of the rules relating to presumptions and documentation of indirect partners. This would allow the small family partnerships of the world to operate under simple rules and audits, while giving investment partnerships the flexibility to service all of their partners.

[22] Failure to obtain documentation. First, even for small partnerships, there ought to be a materiality threshold before applying the draconian sanction of revoking a WHP's status. Section 11.04(F) of the Model QI Agreement, Rev. Proc. 2000-12, provides that flaws in obtaining documentation from a QI's direct customers constitute an event of default under the Agreement only if such flaws relate to "a significant number of direct account holders." Thus, although a QI is liable for its failures to withhold, it will not lose its status for an insignificant number of failure to obtain documentation. The same standard should apply here.

[23] Second, a WHP that elects to have passthrough partners and comply with the necessary rules should be dealt with the same way as QIs: it should be permitted to apply presumptions where documentation has not been obtained, and it should not be subject to disqualification for minor mistakes.

[24] Documentary evidence. We have two sets of proposals.

[25] First, any U.S. payor is permitted to use documentary evidence to document the status of a foreign person for payments made outside the United States to an offshore account or sales effected at an office outside the United States. There does not appear to be any rule restricting the use of documentary evidence to payors subject to KYC or similar rules. We suggest that a WHP that does not have a place of business in the United States should be permitted to use documentary evidence for all payments, except, possibly for partners that are known to the general partner to have an address in the United States, or who have their income sent to a bank account in the United States. If documentary evidence can be conceded to U.S. payors -- even payors who are not subject to KYC rules -- where there are sufficient indicia of non-U.S. status, we perceive no reason why the same may not be done so here.

[26] Second, Notice 2002-41 requested comments on whether the IRS ought to incorporate documentation provisions similar to the provisions in the QI agreement in the case of certain foreign partnerships that are required by local law to comply with KYC rules for obtaining documentation confirming the identity of partners, beneficiaries, or owners (or the interests in which are generally held through institutions that are subject to KYC rules); and either (i) the offer and sale of interests in which are subject to securities regulation in that jurisdiction; or (ii) the interests in which are publicly traded on an established securities exchange or continuously offered and sold to the general public (and the partnership is not classified as a corporation pursuant to section 7704). We have not been asked to submit examples of a particular country's KYC rules for your consideration, but we would raise two observations.

[27] First, if an interest in a partnership is held through an account at a QI, the WHP should be able to accept the QI's Form W- 8IMY certifying to its status as such without further enquiry. In other words, even if (contrary to the above suggestions) the IRS sees fit to maintain the restriction on interests held by passthrough partners, this should not apply to interests held through a QI. A QI has entered into an agreement to police who its customers are. If this is good enough for payments directly to the QI, it ought to be good enough for payments to a partnership where a partner holds its interest through a QI.

[28] Second, we note that historically, the United States has been more lax than other countries about requiring non-bank financial organizations to follow KYC rules. We understand that they are quite common, in fact. Furthermore, as discussed above, there may be an expansion of U.S.-related requirements due to the USA Patriot Act. KYC rules for non-bank financial institutions worldwide are a complex area that may be in flux. We question whether all possible issues can be dealt with now, in the context of finalizing the model WHP agreement. We suggest that the final agreement build in flexibility to deal with future events. It should provide that non-U.S. partners may be documented with (a) W-8 series forms, (b) documentary evidence, as discussed above, and (c) such other documentation as the IRS may prescribe in the future, either for a particular WHP via a private letter ruling, or for all WHP's, or a defined class thereof, by public guidance such as a Revenue Procedure. This last point will allow the IRS a simple way to address future developments, and allow WHPs to ask for flexibility on specific points.

[29] Mid-year distributions. If a WHP makes a distribution in mid-year, before allocations are settled, one solution would be to require the WHP to withhold at the highest possible rate, and then make an adjustment using either the set-off procedure or the reimbursement procedure. This would protect the IRS's legitimate interests, but would create a cash-flow problem for investors, and also requires that allocations for each year be settled by March 15 of the following year (rather than the April 15 return date), because these procedures must be claimed on a timely- filed Form 1042-S. Thus, we also suggest that if a partnership has income from a prior year, it should be allowed, solely for withholding tax purposes, to designate a distribution as having been paid out of income earned in previous years (to the extent of such undistributed income), so that withholding for the current year's income can be deferred to April 15 of the subsequent year when allocations are settled.

[30] Location of withholding burden. We would suggest allowing a WHP to agree with its U.S. payor to have the U.S. payor assume the withholding responsibilities, if the payor is willing. Thus, the regime would be parallel to the QI regime, where either the U.S. payor or the QI is permitted to assume withholding responsibilities. Admittedly, this will only be attractive in simple situations, e.g., where all partners in the partnership have a properly-documented claim to benefits under the same income tax treaty. But such simple situations might be precisely the ones where the general partner might find it difficult to attend to the mechanics of withholding, deposits and reporting itself.

Withholding Foreign Trusts

[31] Although this letter primarily relates to Withholding Foreign Partnerships, we, we would like to address the impact of the requirement that a Withholding Foreign Trust obtain documentation from 100% of its beneficiaries. Many of the trusts that would apply for WHP status relate to employee plans. Often, the plan participants terminate their employment or retire from the employer sponsoring the plan. Yet, the now former employee still has a vested interest in the plan and will receive income. The process of obtaining a new Form W- 8BEN every full third calendar year will be difficult and may result in circumstances where the former employee does not return the renewal certification timely, if at all. It is recommended that rather than terminate the WHT agreement for lack of 100% documentation, the IRS consider allowing the WHT to continue as such as long as it (i) uses efforts customary in its local country for acting upon return mail/inactive accounts and (ii) imposes 30% withholding on any reportable amounts earned (or backup withholding, if greater, if the most recent information available to it contains indicia of U.S. status). The QI regime recognizes that 100% documentation may not always occur and has provisions in the Default section for a substantial number of undocumented customers. We recognize that the WHT could apply to be a certifying acceptance agent to obtain TINs for the plan participants but we have been told that the receipt of a passport or similar KYC document and the occurrence of a face-to-face meeting with each participant is not customary and unlikely to happen.

²Treas. Reg. § 1.1441-5(c).

³Section 761(c) provides that the partnership agreement for any taxable year includes any modifications duly made up to the original due date (without extensions) for filing the partnership's tax return for the year, i.e., in general, up to April 15 of the following year for a calendar-year partnership.

⁴The fact that Congress specifically permits bearer bonds to qualify for the "portfolio interest" exception from U.S. withholding tax, provided that sufficient precautions are taken to keep such bonds out of U.S. hands, Section 871(h)(2)(A), indicates that Congress historically accepted this state of affairs. Admittedly, it is not at all clear what the fallout of the September 11 tragedy and the effect of future guidance under the USA Patriot Act of 2001, P.L. 107-56, may have on the ability of foreign investors to invest in the United States with privacy. The USA Patriot Act is a shadow looming over the entire withholding tax area, and the QI and WHP rules should be modified as necessary to work in harmony with the USA Patriot Act's know your customer rules, once they have been settled. In the absence of further guidance under the USA Patriot Act, we cannot comment further on this issue at this time.

⁵Treas. Reg. §§ 1.1441-1(e)(1)(ii)(A)(2), 1.6049-5(c)(1).

⁶We are not requesting that anything other than Form W- 9 or authorized substitute be acceptable for U.S. partners.