Firm Notes Disconnect in Reporting and Crediting of Partnership Tax Withheld

We are writing to bring to your attention what appears to be a disconnect between the rules in the regulations and instructions for Form 1042 relating to the year for reporting tax withheld under Chapter 3 by U.S. partnerships (and by extension a non-U.S. partnership that is a withholding foreign partnership) and domestic trusts (other than grantor trusts) and the statutory and regulatory rules relating to the crediting of the withheld taxes against the tax due from the recipient of the income.

By way of background, the non-U.S. partners of a U.S. partnership ("USP") must take into account their distributive shares of the USP's non-effectively connected U.S. source fixed, determinable, annual or periodical income ("U.S. FDAP") received by the partnership during the partnership's U.S. tax year (the "Receipt Year") and, absent an exemption or reduced rate of tax afforded by the Code (e.g., IRC section 892(a)(1)) or a tax treaty (cf. IRC section 894(a)), are liable for U.S. tax thereon at a 30% rate. IRC sections 871(a) and 881(a); cf. IRC section 702(b). Absent receipt of an appropriate form¹ that would authorize a partnership not to withhold tax on a non-U.S. partner's distributive share of U.S. FDAP, the USP would be required to deduct and withhold tax in respect thereof at the rates prescribed by IRC sections 1441 or 1442. The tax withheld at source in respect of a non-U.S. partner's distributive share shall be allowed as a credit against the tax imposed on such partner. IRC sections 33 and 1462; Treas. Reg. sections 1.1462-1(a) and (b) and 1.1464-1(a).

The tax required to be withheld in respect of a non-U.S. partner's distributive share of U.S. FDAP is required to be paid by the USP in such year as its U.S. FDAP is distributed to such non-U.S. partner. See IRC sections 1441(a) and 1442(a) and Treas. Reg. sections 1.1441-1(b)(1) and 1.1441-5(b)(2)(i)(A). However, if the partnership does not distribute its income during the Receipt Year, a USP is not required to pay over the required tax withholding in respect of a non-U.S. partner's distributive share of its U.S. FDAP for the Receipt Year until the earlier of the due date for furnishing its Schedules K-1 for the Receipt Year to its partners or the date the Schedule K-1 for the Receipt Year is actually provided to the non-U.S. partner, either of which date necessarily falls during the year following the Receipt Year. See Treas. Reg. section 1.1441-5(b)(2)(i)(A).²

The disconnect arises because the regulations require the USP to report the tax withheld in respect of its U.S. FDAP received in the Receipt Year on its Form 1042 (and related Forms 1042-S) for the year in which the tax was required to be paid over, which in the circumstances indicated is in the year following the Receipt Year (see Treas. Reg. section 1.1461-1(b) and (c)), nor for the year in which the credit for the withheld tax to the recipient of the income would properly be allocable. In this connection, the USP must reflect the U.S. FDAP it received in the Receipt Year on its Form 1065 (and related K-1s) for the Receipt Year (see IRC sections 702(a), 703(a) and 706(a) and Treas. Reg. section 1.6031(a)-1(a)), the non-U.S. partner would have a tax liability for the Receipt Year in respect of its distributive share of the USP's U.S. FDAP realized in such Receipt Year and it would appear the non-U.S. partner would be entitled to a credit in the Receipt Year for the tax withheld allocable to its distributive share of the U.S. FDAP realized by USP in the Receipt Year. Cf. Treas. Reg. section 1.1462-l(b).

A non-U.S. partner entitled to claim a refund of the tax withheld in respect of its distributive share of U.S. FDAP (for example, because of a tax treaty exemption where it did not timely provide a W-8BEN claiming an exemption) must, in order to obtain such refund, file a claim for refund and attach thereto its Form 1042-S showing the tax withheld. See IRC section 1464; Treas. Reg. section 301.6402-2(a), Instructions for Form 1040NR, pg. 5 and Instructions for Form 1120-F, pg. 3. In the circumstances indicated, there would be no Form 1042-S filed for the Receipt Year showing a tax withheld in respect of the Receipt Year, but rather the tax withheld in respect of the Receipt Year would be reflected on a Form 1042 and Forms 1042-S for the year following the Receipt Year, which would not be submitted until the second year following the Receipt Year. This would make it difficult for the non-U.S. partner to file a refund claim for tax withheld in respect of Receipt Year income until after it received a Form 1042-S for the year following the Receipt Year. Moreover, if the non-U.S. partner did not have a distributive share of U.S. FDAP (or any other U.S. income) for the year following the Receipt Year, it would appear that the tax shown as withheld on the Form 1042-S for the year following the Receipt Year would automatically be in excess of the tax due for such year, thus giving rise to an automatic entitlement to a refund, without regard to the merits of the claim for treaty exemption.

We suggest that these problems could be avoided as follows:

² A similar rule obtains in the case of U.S. resident simple and complex trusts. See Treas. Reg. §§ 1.1441-5(b)(2)(ii) and (iii). In the case of a complex trust in which the income in question is not required to be distributed currently, both income inclusion and withholding are triggered by distribution, so that the mismatch discussed herein does not arise. In the case of a simple trust or to the extent income is required to be distributed currently in a complex trust, a similar mismatch to that arising in the partnership context might obtain.

³ Another approach that would also eliminate the disconnect would be to change the year of inclusion for non-effectively connected U.S. FDAP to the year in which tax withholding is required to be made in respect of such income, i.e., the year following the Receipt Year in the circumstances indicated. However, this alternative approach seems less desirable than the ones proposed in that it would appear to require a change in the statutory framework.