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Company Comments on Application of Passthrough Payment Rules to Flow-Through Entities

OCT. 13, 2011

Company Comments on Application of Passthrough Payment Rules to Flow-Through Entities

DATED OCT. 13, 2011
DOCUMENT ATTRIBUTES

 

October 13, 2011

 

 

Ms. Manal Corwin

 

Deputy Assistant Secretary for International Tax Matters

 

U.S. Department of the Treasury

 

1500 Pennsylvania Avenue, N.W.

 

Washington, D.C. 20220

 

 

Ms. Danielle Nishida

 

Attorney Advisor

 

Office of the Chief Counsel (International)

 

Internal Revenue Service

 

1111 Constitution Avenue, N.W.

 

Washington, D.C. 20224

 

 

Mr. John Sweeney

 

Senior Technical Reviewer

 

Office of Associate Chief Counsel (International)

 

Internal Revenue Service

 

1111 Constitution Avenue, N.W.

 

Washington, D.C. 20224

 

 

Mr. Jesse Eggert

 

Attorney Advisor

 

Office of International Tax Counsel

 

U.S. Department of the Treasury

 

1500 Pennsylvania Avenue, N.W.

 

Washington, D.C. 20220

 

 

Mr. Michael Danilack

 

Deputy Commissioner (International)

 

Large Business & International Division

 

Internal Revenue Service

 

1111 Constitution Avenue, N.W.

 

Washington, D.C. 20224

 

 

Mr. Michael Plowgian

 

Attorney Advisor

 

Office of International Tax Counsel

 

U.S. Department of the Treasury

 

1500 Pennsylvania Avenue, N.W.

 

Washington, D.C. 20220

 

 

Ladies and Gentlemen:

 

 

Northern Trust Corporation ("Northern Trust") welcomes the opportunity to submit comments regarding certain issues to be addressed in the regulations that are being developed to implement the Foreign Account Tax Compliance Act ("FATCA") provisions set forth in Section 501 of the Hiring Incentives to Restore Employment Act (the "HIRE Act"). Northern Trust is a leading provider of investment management, asset and fund administration, banking solutions and fiduciary services for corporations, institutions and individuals worldwide. Northern Trust's Global Fund Services business unit is a full service provider of fund solutions to investment manager and fund company clients around the world. FATCA will have a significant impact on Northern Trust and our clients, in particular our fund clients.

FATCA requires participating foreign financial institutions ("PFFIs") to deduct and withhold a tax of 30 percent on any "passthru payment" made to a recalcitrant account holder or another FFI that is not a participating FFI.1 Code Section 1471(d)(7) defines "passthru payment" as "any withholdable payment or other payment to the extent attributable to a withholdable payment." Notice 2011-34 provides preliminary guidance regarding the definition of the term "passthru payment" and proposes an approach under which the amount of a payment to be treated as "attributable to a withholdable payment" would be determined based on the calculation of a PFFI's "passthru payment percentage" ("PPP"), which in turn is based on the ratio of the PFFI's "U.S. Assets" to total assets. The Notice further provides that an FFF's "U.S. Assets" will include some portion of any interest in another FFI (Lower Tier FFI) as determined by that FFF's PPP.

Notice 2011-34 specifically requested comments regarding the application of the passthru payment approach outlined in the Notice to partnerships and other flow-through entities, including the following:

  • the use of the PPP with respect to domestic and foreign partnerships and other flow-through entities;

  • whether it is appropriate to permit a U.S. financial institution ("USFI") that is a partnership or other flow-through entity under U.S. tax principles to calculate and make available a PPP that may be used by other PFFIs in determining their own PPPs; and

  • how a partnership or other flow-through entity may determine whether a payment it makes to an interest holder is a withholdable payment or a passthru payment.2

 

Summary of Recommendations

While we believe that many aspects of the passthru payment approach outlined in Notice 2011-34 are problematic, many issues have been addressed at length by other comment letters. This letter is focused solely on application of the proposed passthru payment rules to partnerships and other flow-through entities.

As a general matter. Northern Trust believes that the following principles should apply in the determining the passthru payment rules applicable to funds that are partnerships and other flow-through entities:

 

1. The approach should be consistent with FATCA statutory language and the underlying intent of FATCA.

2. Application of the FATCA rules should follow Chapter 3 principles only where doing so would ease the burdens of FATCA compliance, and not where doing so would create complexities unnecessary to meet the goals of FATCA.

3. The passthru payment rules should be as simple as possible to apply so that they do not introduce opportunities for error or create unnecessary burdens that may provide disincentives for FFIs to become PFFIs.

4. The passthru payment rules should be applied consistently for investment funds that are PFFIs or USFIs to ensure a level playing field among funds and equal treatment of investors.

 

Accordingly, Northern Trust recommends that Treasury and IRS consider the following:

 

1. All investment funds that are "foreign financial institutions" pursuant to Code Section 1471(d)(5)(C), and that are PFFIs, including PFFIs that are partnerships or other flow-through entities, should calculate a PPP for purposes of calculating any FATCA withholding to be applied to recalcitrant investors, and should also make such PPP available to other PFFIs for use in calculating their own PPPs.

2. U.S.-domiciled investment funds that are partnerships or other flow-through entities should also be permitted to calculate a PPP for these purposes.

3. All funds that are partnerships or other flow-through entities, should apply FATCA withholding to payments the fund makes to its recalcitrant investors based on its own PPP at the time such payments are made, and should not be required to trace and allocate income and gross proceeds received by the fund to each of its investors.

4. The approach to defining assets includable for purposes of calculating the PPP of a PFFI fund should remain as simple and straightforward as possible, and the calculation of the PPP should, therefore, be limited to assets includible on the balance sheet of the fund prepared in accordance with accounting and regulatory requirements that govern preparation of the fund's financial statements. Furthermore, PFFIs that do not prepare financial statements on a quarterly basis should be permitted to use best available information to calculate the ratio of U.S. assets to total assets as of their quarterly testing dates, or alternatively, should be permitted to calculate their PPPs using less frequent testing dates in accordance with their financial statement filing schedule.

 

Discussion

The calculation of the PPP serves two purposes for financial institutions that are funds. First, the PPP is used by investors of the fund that are themselves PFFIs in determining their own PPPs. Second, the PPP is used in calculating the portion of each payment a fund makes to its recalcitrant investors that will be subject to FATCA withholding.

The primary advantage of the PPP approach is that it eliminates the complexities that would have resulted if payments had been required to be traced through multiple tiers of FFIs in fund of funds structures. Notice 2011-34 acknowledged that such a tracing approach would present complications and requested comments regarding the use of a PPP by foreign and domestic partnerships and other flow-through entities. We believe that an FFI that is a partnership or other flow-through entity should calculate a PPP in the same way that other FFI funds do. If payments were required to be traced through FFI funds that are partnerships or other flow-through entities, the benefits of the PPP approach would be lost. A tracing requirement would increase complexity, risk of error and compliance costs, which in turn provide disincentives for FFIs to become PFFIs.

We also believe that it is appropriate to permit a USFI fund that is a partnership or other flow-through entity to calculate and make available a PPP for use by its investors that are PFFIs. Fund of funds structures often include both FFIs and USFIs, some of which are partnerships, and others of which are not, and they should be treated consistently. The PPP concept should be applied consistently regardless of where a fund is domiciled and regardless of whether it is a flow-through entity. This would create a level playing field in a very competitive market.

The PPP is also used in calculating the portion of each payment a fund makes to its recalcitrant investors that will be treated as subject to FATCA withholding. We believe that a PFFI fund that is also a partnership or other flow-through entity should apply FATCA withholding to payments it makes to its recalcitrant investors based on its own PPP at the time such payment is made in the same manner that a PFFI fund that is not a partnership would. It also should not be required to trace and allocate income and gross proceeds it receives to each of its investors.

The tracing of each income and gross proceeds payment received by a PFFI partnership through to its partners would not be feasible. While many partnerships, particularly U.S. partnerships, have relatively sophisticated partnership accounting systems, such systems are designed to allocate income, gains and losses over a specified period; they are not capable of tracing and allocating individual payments. Even the most sophisticated systems do not have the capability to directly trace and link a withholdable payment received by the fund to an individual investor. As a result, PFFI funds that are partnerships have many of the same tracing challenges that other PFFI funds have and should be treated the same for simplicity and consistency. To avoid the complexities associated with tracing, all funds that are partnerships or other flow-through entities, should apply FATCA withholding using their PPP. Moreover, the withholding should be applied at the time the partnership makes any payment to a recalcitrant investor, including a payment related to the distribution of partnership gains and profits or a payment in redemption of partnership interests. To avoid abuses, withholding would also need to be required from redemptions that are not paid in cash (i.e. in-kind redemptions). We recognize that such a rule differs from the approach taken under Chapter 3 (discussed further below), and would present an opportunity for recalcitrant investors to defer FATCA taxes to future years. However, the alternative creates complexities that provide disincentives to FATCA compliance.

The success of FATCA depends in large part on the ability of PFFIs at all levels to comply with the passthru payment withholding requirements. Many PFFIs (even partnerships and other flow-through entities) that do not have direct U.S. investors, but may have investors that are NPFFIs, utilize systems that do not have tracing capabilities, making a tracing approach for such funds not feasible. For the PPP approach to work in practice and not create disincentive for FFIs to become PFFIs, it must be based on clear rules and calculations that are simple to apply.

Even though guidance is currently pending regarding what types of entities may use the PPP, it is evident that the Treasury and IRS intend to utilize the application of PPP to passthru payments due to reasons stated above.

Finally, it remains unclear what assets will be included in the calculation of the PPP. Notice 2011-34 states that "An asset will also include off-balance sheet transactions or positions to the extent provided in future guidance." The lack of clarity may be rectified with one of two solutions. The first possible solution is for the Treasury and IRS to publish a listing of off-balance sheet transactions and positions that must be adjusted on the reporting entity's financial statements in order to determine its own PPP. This option not only requires continual maintenance by the Treasury and IRS about which the reporting entity will have to stay educated, but more importantly, it imposes a requirement on the reporting entity to maintain a second set of records which could be a disincentive to becoming a PFFI. Unlike the first possible solution, which is burdensome to all parties involved, an alternative solution would be for the reporting entity to rely on its audited financial statements or best available information as provided to investors that have been prepared in accordance with its own local filing regulatory requirements. This second option not only reduces the risk of calculating the PPP incorrectly, but by eliminating the burden of maintaining a second set of financial statements, it increases the likelihood that an FFI will choose to become a PFFI. For these reasons, we believe that PFFIs (and USFIs) that are funds should be permitted to calculate the PPP based on their own local laws using the best available information that is provided to investors.

In support of our recommendations 1 through 3 above, we offer the following examples as an illustration of the various approaches that may be taken in applying the passthru payment percentage to partnerships and other flow-through entities.

EXAMPLE 1 -- Application of Passthru Payment Withholding to Foreign Corporate Fund

The Fund

Fund A is an FFI that is treated as a foreign corporation for purposes of Chapter 3 of the Code.

The Custodian

The Custodian of Fund A is a PFFI that holds all of Fund A's investment assets in a custodial account.

Assets of the Fund

Fund A's investment assets are as follows:

  • $20 interest in Fund W (a NPFFI (treated as a foreign corporation) with PPP=0%)

  • $30 interest in Fund X (a PFFI (treated as a foreign corporation) with PPP=50%)

  • $10 interest in Company Y (a NFFE (treated as a foreign corporation))

  • $40 interest in Company Z, a U.S. corporation

 

Fund A's PPP is 55% [($20x0%)+($30x50%)+($10x0%)+($40x100%)].3

Investors of the Fund

Fund A has four investors: Investor #1 is a U.S. individual, Investor #2 is a foreign corporation and a PFFI, Investor #3 is a nonwithholding foreign partnership and a PFFI, and Investor #4 is a foreign corporation and a NPFFI.

Payments

Custodian collects the following payments made to Fund A:

  • $100 Dividend from Fund W

  • $100 Dividend from Fund X

  • $100 Dividend from Company Y

  • $100 Dividend from Company Z

 

Application of Chapter 3 Withholding and Reporting (without application of FATCA)

Under Chapter 3 rules currently in effect before the effective date of FATCA provisions: Custodian must treat Fund A as the payee. Fund A would provide a Form W-8BEN and Custodian would be required to withhold on the $100 U.S. sourced dividend payment from Company Z at a rate determined by the treaty claims made by Fund A on its Form W-8BEN. Chapter 3 withholding would take place at the fund level. Dividends collected from Fund W, Fund X and Company Y would be treated as foreign sourced, and, therefore, not be subject to Chapter 3 withholding. Custodian would be required to report the U.S. income paid to Fund A on Form 1042-S, and if Custodian is a Qualified Intermediary, such reporting would be part of a consolidated rate pool reporting.

Application of FATCA to Payments to Fund A

If Fund A is a PFFI, FATCA withholding would not apply to payments to Fund A, and Custodian would apply Chapter 3 withholding as described above.

If Fund A is a NPFFI, custodian would apply FATCA withholding at the fund level. Due to the fact that Custodian is a PFFI, Custodian would be obligated to apply FATCA withholding to the passthru payments it collects for Fund A, and passthru payments include any "withholdable payment or other payment attributable to a withholdable payment." The dividend from Company Z is a U.S. sourced payment, and, therefore, a "withholdable payment." Dividends from Fund W, Fund X and Company Y are not U.S. sourced dividends, and are, therefore, not "withholdable payments." However, pursuant to Notice 2011-34, Custodian would be required to treat payments from other FFIs (Fund W and Fund X) as passthru payments in an amount equal to the amount of the payment multiplied by the passthru payment percentage of the issuer FFI. As a result, if Fund A is a NPFFI, Fund A would suffer FATCA withholding in the amount of $45 [((100% of the $100 withholdable payment from Company Z) X 30%) = $30) + (0% of the $100 dividend from Fund W) + ((50% of the $100 dividend from Fund X) X 30%) = $15)].

Application of FATCA to Fund A's Investors

Code section 1471(b)(1)(D) requires a PFFI to deduct and withhold a tax equal to 30% of any passthru payment made to a recalcitrant account holder or NPFFI, and passthru payment includes any "withholdable payment or other payment attributable to a withholdable payment." If Fund A is a PFFI and paid a dividend of $100 to Investor #4, FATCA withholding would apply in this example because Investor #4 is a NPFFI. Dividends paid by Fund A to its investors would be treated under existing tax principles as foreign sourced, and, therefore, no part of the payment to Investor #4 would be a "withholdable payment." However, following the PPP approach outlined in Notice 2011-34, Fund A would apply its PPP (55% as stated above) to determine the amount of the payment attributable to a withholdable payment, and Fund A would withhold $16.50 [(55% X $100 X 30%)= $16.50)] on its payment to Investor #4. Due to the fact that Fund A is a PFFI, FATCA does not apply at the fund level where it would impact all investors, and only the non-compliant Investor #4 suffers FATCA withholding. In addition, as noted above, Fund A would have suffered Chapter 3 withholding at the fund level on any U.S. sourced FDAP income it received. As a result, Investor #4's investment will have been subject to withholding under Chapter 3 at the fund level along with all those of other investors; in addition, Investor #4 will be subject to FATCA withholding at the investor level under Chapter 4.

EXAMPLE 2 -- Application of Passthru Payment Withholding to Foreign Partnership

The facts of Example 2 are the same as Example 1 above, except the fund (Fund B) is treated as a nonwithholding foreign partnership for purposes of Chapter 3 of the Code. In addition, Fund B's four investors share partnership profits, gains and losses in the following proportions:4 Investor #1 -- 25%, Investor #2 -- 25%, Investor #3 -- 15%, and Investor #4 -- 35%.

Application of Chapter 3 Withholding and Reporting (without application of FATCA)

Under Chapter 3 rules currently in effect before the effective date of FATCA provisions: Custodian may not treat Fund B as the payee, rather the partners of Fund B (Investor #1, #2 and #4) as well as the partners of Investor #3 (unknown) are the payees for purposes of withholding and reporting under Chapter 3 and Chapter 61.5 Fund B would provide a Form W-8IMY and Withholding Statement to Custodian along with tax documentation for Investors #1, #2, #3 and #4. Since Investor #3 is a nonwithholding foreign partnership, it would also provide a Form W-8IMY and Withholding Statement. Custodian would be required to withhold on the $100 U.S. sourced dividend collected from Company Z at the time such payment is collected because the dividend is U.S. sourced FDAP income subject to withholding under Chapter 3. Custodian would use information provided in the Withholding Statement of Fund B to allocate that payment to the Investors of Fund B, and would reduce Chapter 3 withholding in accordance with treaty claims certified on the tax documentation provided by such investors. The Withholding Statement of Fund B must be provided prior to each payment and allocate each payment, by income type, to each payee for whom documentation has been provided. However, under Treas. Reg. § 1.1441-1(e)(3)(iv)(D), allocation information may be provided after the payment date if the withholding agent agrees to the use of alternative procedures. Such procedures would allow Fund B to provide allocation information to Custodian no later than February 14 following the calendar year of the payment. This extension of time is often needed, especially by a fund of funds, because information required to calculate partner allocations may not be available at the time the partnership received income subject to Chapter 3 withholding. Such information may not even be available by the extension date; consequently, estimates may be used.

In contrast to this Example 2, Custodian in Example 1 above would not be required to look through Fund A (a foreign corporate fund) to its underlying investors, and Fund A would not disclose any information about its investors to Custodian.

Dividends collected from Fund W, Fund X and Company Y would be treated as foreign sourced, and, therefore, not subject to Chapter 3 withholding. Custodian would be required to report the U.S. sourced income allocated to Investors #2 and #4 on Forms 1042-S, and all income regardless of source allocable to Investor #1 on a Form 1099. U.S. sourced FDAP income allocable to #3 would be presumed paid to a foreign payee, and would be reported on Form 1042-S to "unknown recipient." Custodian would also apply withholding at the investor level.

Application of FATCA to Payments to Fund B

A key question in the application of FATCA to flow-through entities is whether a withholding agent making a payment to an FFI fund that is a partnership or other flow-through entity treats the FFI or its partners as the payee. If the FFI partnership is treated as the payee for FATCA purposes, this would differ from Chapter 3 treatment described above. However, we believe that treating the FFI partnership as the payee for FATCA is consistent with the FATCA statute and better serves the goals of FATCA for the reasons stated below.

The statute requires a PFFI to apply FATCA withholding to any passthru payment made to a NPFFI. The statutory language does not distinguish between NPFFIs that are flow-through entities and those that are not. Further, if Fund B in this example were a NPFFI and the rules followed Chapter 3 principles, which treat the fund as transparent and require Custodian to look through Fund B and treat its partners as the payees, Fund B would suffer no FATCA withholding. As a result, Fund B would suffer no adverse consequences from its decision not to become a participating FFI. In contrast, if Fund A (the corporate fund in Example 1 above) chose not to become a participating FFI, it would suffer FATCA withholding at the fund level.

If Custodian treated Investor #4 as the payee and was only obligated to withhold FATCA tax on the portion of the passthru payment paid to Fund B that was allocable to Investor #4 (35%), the resulting FATCA penalty would be $15.75 ($45X35%). This is inconsistent and lacking in fairness when compared to Example 1 above, where if Fund A were a NPFFI, FATCA withholding would equal $45. We do not believe this result is consistent with the statute. Furthermore, Fund B would have little incentive to enter into an FFI Agreement if FATCA withholding was applied in this manner. We therefore recommend that PFFI funds that are partnerships or other flow-though entities should be treated the same as other PFFI funds (i.e., as the payees) for FATCA purposes.

Application of FATCA to Fund B's Investors

In this Example 2, Custodian would have no FATCA withholding responsibility with respect to income collected and paid to Fund B so long as Fund B is a PFFI. However, if Fund B is a PFFI, and Investor #4 is a NPFFI, Fund B is obligated to withhold 30% of any passthru payment that Fund B makes to Investor #4. We considered three options for how such withholding might be applied in practice as follows:

 

Option 1. Fund B indicates on its Withholding Statement that it is electing to be withheld upon and that Investor #4 is subject to FATCA withholding. Custodian would apply FATCA withholding in lieu of Chapter 3 withholding to Investor #4's allocable share (35%) of each withholdable payment (the dividend from Company Z) and would also apply FATCA withholding to payments from W, X, and Y based on their passthru payment percentages. As a result, Investor #4 would suffer Chapter 4 withholding in the amount of $15.75 [(35% of $100 dividend from Fund W x its PPP of 0% x 30% FATCA rate=$0) + (35% of $100 dividend from Fund X x its PPP of 50% x 30% FATCA rate = $5.25) +(35% of $100 dividend from Fund W x its PPP of 0% x 30% FATCA rate = $0) + (35% of $100 dividend from Company Z x 30% FATCA rate = $10.50)]

Option 2. If Fund B is a PFFI, Custodian applies no FATCA withholding and instead treats each of Fund B's investors as the payees under Chapter 3 and applies Chapter 3 withholding to each investor (including Investor #4) according to the allocation information and documentation passed on by Fund B. Fund B then applies FATCA withholding when it makes payments to non-compliant Investor #4. As a result, if Investor #4 is not resident in a country that has an income tax treaty with the U.S. investor #4 would suffer Chapter 3 withholding in the amount of $10.50 [(35% of $100 dividend from Company Z x 30% Chapter 3 rate = $10.50]. Investor #4 would also suffer Chapter 4 withholding at the time it receives any payment from Fund B, in accordance with Fund B's PPP. So, as an example, if Fund B pays a distribution to Investor #4 of $254, Investor #4 would suffer Chapter 4 withholding of $41.91 [($254 x PPP of 55% x 30% FATCA rate = $41.91)].

Option 3. If Fund B is a PFFI, as in option 2 above, Custodian applies no FATCA withholding and instead treats each of Fund B's investors as the payees under Chapter 3 and applies Chapter 3 withholding to each investor (including Investor #4) according to the allocation information and documentation passed on by Fund B. Fund B then applies FATCA withholding on the earlier of the date when it makes payments to Investor #4, or if income is not distributed during the year, on a later date by which income is required to be allocated. As a result, the Chapter 3 withholding amount would be the same as in option 2 above. However, as discussed further below, Chapter 4 withholding could not be calculated until well after the close of Fund B's fiscal year.

 

Of the three options considered, we believe that the Option 2 is consistent with the intent of FATCA while presenting the least onerous set of implementation challenges. However, in the event that Treasury and IRS reject Option 2, Option 3 would be preferable to Option 1.

Under Option 1 above, the FATCA withholding obligation would shift from Fund B to Custodian, effectively resulting in imposition of a mandatory election-to-be-withheld upon, and Fund B would have to provide allocation information with respect to each payment collected by Custodian. Partnerships do not allocate each individual payment the partnership receives to each partner at the time the partnership receives the payment. Chapter 3 recognizes this by allowing nonqualified intermediaries, partnerships, and other flow-through entities to use an alternative procedure for allocation of U.S. sourced FDAP subject to Chapter 3 withholding. The alternative procedure allows limited time after the end of the calendar year to make adjustments to allocations. Unlike the over-simplified facts of this illustrative Example 2, partnerships generally allocate profits and gains and losses for a period of time based on complex formulas in their partnership agreements that utilize factors which may not be known until after the close of the annual reporting period. As a result, Fund B would not be able to provide accurate allocation information to Custodian at the time payments are made to Fund B. Furthermore, it would not be possible for Custodian to calculate Investor #4's allocable share of gross proceeds from the sale of every U.S. security sold in Fund B's custodial account. Partnerships often allocate capital gains and losses differently than FDAP, and they do not allocate gross proceeds. As a result, we do not believe that Option 1 is feasible.

Under Option 2, the complexities of partnership allocations are not an issue because FATCA withholding would apply to the amounts paid to Investor #4 at the time Fund B makes such payments, whether such payments are income distributions or redemptions of partnership interests. This is the most straight-forward of the three options considered. In addition, the result is consistent with Example 1 above where the PFFI is not a partnership. Where a fund is a PFFI, withholding agents making payments to the fund should apply Chapter 3 withholding without reference to FATCA, whether the fund is a corporation or a partnership; and payments from PFFI funds to their investors should also be treated the same under FATCA, whether the fund is a corporation or a partnership.

Option 3 may be favored to prevent deferral of FATCA withholding because a partnership may not pay distributions during the life of the partnership. However, due to this timing difference between collection of payments by the custodian on behalf of the partnership in comparison to when the payments are allocated by the partnership to the partners, Option 3 would impose a fundamental challenge on the PFFI. Option 3 would require the PFFI partnership to maintain supplementary accounting records to track withholding taken from allocations so that duplicative withholding is not taken at the time of actual payment of distributions. While U.S. partnerships may be prepared for such record-keeping due to the similar Chapter 3 requirements applicable to a U.S. partnership's allocation of U.S. income to its non-U.S. partners under Treas. Reg. § 1.1441-5(b)(2)(i), a non-U.S. partnership would generally not have such capability. Many foreign partnerships have no direct U.S. investors. In addition, many foreign partnerships receive little or no U.S. sourced FDAP income subject to Chapter 3 withholding. As a result, many foreign partnerships have not developed sophisticated income classification and allocation systems. Forcing them to do so for FATCA withholding would require either very expensive system builds or costly error-prone manual operations; thereby creating a disincentive to becoming PFFI's. As stated above, U.S. partnerships maintain partnership accounting systems that allocate FDAP income and capital gains and losses to partners based on often complex formulas. Nonetheless, even the most sophisticated of these systems do not trace gross proceeds. Consequently, we do not believe that Option 3 is feasible.

Amount subject to withholding

In addition to the timing question posed above, computation of the withholding applicable to payments to Investor #4 also needs to be addressed for options 2 and 3. The question is whether Fund B would (1) be required to identify the withholdable payment portion of each payment it makes to Investor #4, or (2) apply its PPP to payments it makes to Investor #4. We believe that the approach described in (1) for FATCA withholding is problematic due to the issues with tracing described above (and currently not possible for gross proceeds), and, therefore, we recommend the approach described in (2).

EXAMPLE 3 -- Application of Passthru Payment Withholding to U.S. Partnership

The facts of Example 3 are the same as Example 1, except the Fund (Fund C) is a USFI that is treated as a domestic (U.S.) partnership.

Application of Chapter 3 and Chapter 61 Withholding and Reporting (without application of FATCA)

Under rules currently in effect before the effective date of FATCA provisions: Custodian would treat Fund C as the payee, and so long as Fund C provided a valid Form W-9, no withholding would apply to income collected and paid to Fund C.

As a U.S. partnership, Fund C is required to apply Chapter 3 withholding to any amount subject to withholding that is includable in the gross income of a partner that is a foreign person. Such withholding is required to be deducted from any distributions that include amounts subject to withholding (U.S. sourced FDAP) at the time distributions are paid. To the extent a foreign partner's share of income subject to withholding has not actually been distributed, Treas. Reg. § 1.1441-5(b)(2)(i) requires the partnership to withhold on the earlier of the date Schedules K-1 are actually provided or required to be provided to partners. In practice, even where a partner's distributive share of income during a given year is actually distributed, allocation information may be adjusted after year-end as information from underlying investment funds becomes available. As a result, U.S. partnerships are often required to estimate Chapter 3 withholding applicable to distributions during the year so that they can meet the deadline of depositing such withholding by March 15 of the following year; and they often make adjustments several months later when their annual financial statements and tax filings are finalized.

Application of FATCA to Payments to Fund C

Since Fund C is a USFI, FATCA withholding will not apply to payments to Fund C.

Application of FATCA to Fund C's Investors

Timing of Application of Withholding

The next questions raised are related to the timing of FATCA withholding to be applied by a USFI fund that is a partnership to payments it makes its investors that are NPFFIs. Fund C is obligated to withhold 30% of any withholdable payment that Fund C makes to Investor #4, a NPFFI.

We considered two options for applying FATCA withholding to Investor #4. The first option would follow principles of Chapter 3 and require FATCA withholding to be deducted from any distributions to Investor #4 at the time such distributions are paid; and to the extent a partner's share is not distributed, withholding would be required to be deducted when revenue is allocated. This option is problematic for the same reasons that Option 3 is problematic in Example 2 above. It would also require the partnership to maintain accounting records to track withholding taken at the time of allocations so that duplicative withholding is not taken at the time of payment. While U.S. partnership accounting systems may be able to be adapted to perform such accounting, we believe it would be unnecessarily burdensome, and would create an unlevel playing field between domestic and foreign partnerships.

The second option would require USFI partnership funds to continue to apply Chapter 3 withholding under current rules; and to apply FATCA withholding to all payments (in accordance with its PPP) to recalcitrant investors. We acknowledge that this may result in both Chapter 3 and Chapter 4 withholding being deducted from the same source of FDAP payments to recalcitrant investors. However, the alternative creates unnecessary complexity, and the result from option two is consistent with the application of FATCA withholding to recalcitrant investors of a corporate PFFI fund where Chapter 3 withholding applies at the fund level, and the fund in turn applies FATCA withholding at the investor level.

Amount subject to withholding

In addition to the timing question posed above, the computation of withholding applicable to payments to Investor #4 also needs to be addressed. The question is whether Fund C would (1) be required to identify the withholdable payment portion of each payment it makes to Investor #4, or (2) apply its PPP to all payments it makes to Investor #4. The first approach would treat the partnership like a custodian, requiring it to examine the issuers of each investment security it holds, determine which are U.S. (and therefore withholdable payments, including gross proceeds), and apply the PPP of each issuer for securities that are not U.S. Further, those payments, once sorted, would have to be allocated to investors.

We recognize that the statute requires USFIs to withhold only on withholdable payments, and not on passthru payments; and that as a result one may argue that the PPP concept should not apply to USFIs. Consequently, USFI partnership funds may prefer to have the option to determine the portion of payments to investors that are withholdable payments. However, this would require an ability to trace gross proceeds. After lengthy consideration, we have been unable to determine how tracing of gross proceeds could be feasible.

The second approach requires less tracking and is simpler to apply. More importantly, it results in consistent treatment of PFFIs and USFIs that are partnerships (or other flow-through entities). Therefore, we recommend the second approach rather than the first which is problematic (and currently not possible for gross proceeds).

Calculation of PPP by Investors in Fund C

There are three approaches that could be taken when a PFFI fund is determining its U.S. assets for the purpose of calculating its PPP, and the PFFI fund holds an interest in another fund that is a U.S. partnership or other flow-through entity like Fund C. First, the U.S. partnership interest could be treated the same as an interest in a domestic corporation (100% U.S.). This approach, while simple, would place funds that are U.S. partnerships on an unlevel playing field with respect to foreign partnership funds, as 100% of their distributions would be treated as U.S. sourced, and consequently 100% subject to FATCA withholding. Meanwhile, foreign partnerships could reduce the portion of their distributions subject to FATCA withholding in accordance with their PPPs. As a second option, the PFFI fund calculating its PPP could be required to look through the U.S. partnership to its underlying investments and trace income through layers until a foreign flow-through entity or a non-flow through entity was reached. This approach is problematic for an interest in a U.S. partnership for the same reasons it is problematic for an interest in a foreign partnership. As stated in Notice 2011-34, a tracing requirement would be difficult for FFIs to apply and for the IRS to administer. Consequently, the PPP approach was proposed to "more effectively accomplish the purpose of the passthru payment provisions of Chapter 4 and avoid complications presented by implementing a tracing approach." We believe such complications would be present for tracing through domestic partnerships just as they would for foreign partnerships. We, therefore, believe that a third approach is preferred under which a domestic partnership such as Fund C would be required to calculate a PPP for use by its investors in calculating their own PPPs.

Sincerely,

 

 

Lisa M. Chavez

 

Senior Legal Counsel

 

The Northern Trust Company

 

Chicago, IL

 

FOOTNOTES

 

 

1 Code Section 1471(b)(1)(D). A "participating" FFI ("PFFI") is an FFI that has entered into an agreement with the IRS pursuant to Code Section 1471(b)(1). A non-participating FFI ("NPFFI") is an FFI that has not entered into such an agreement.

2 IRS Notice 2011-34, Section II.B.4.

3 Calculation of the PPP has been simplified for illustrative purposes by presuming that proportion of US assets to total assets held on each of the last four quarterly testing dates has remained constant.

4 In practice, partnership allocations are much more complex than those presented in this simplified example and frequently change. Gains and losses also are often not allocated in the same manner as other income. This example has been simplified for illustrative purposes.

5 Treas. Reg. § 1.1441-5(c)(1)(i).

 

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