Attorney Comments on Proposed Regs on Foreign Partnership Withholding

This letter responds to the Department of Treasury's request for comments on proposed and temporary regulations published in the Federal Register on May 18, 2005,¹ published in conjunction with final regulations under Section 1446 of the Internal Revenue Code of 1986, as amended (the "Code"). Regulations were originally proposed under Section 1446 on September 3, 2003.²

I refer below to the May 18, 2005 final regulations as the "Final Regulations," and the proposed regulations at Prop. Reg. § 1.1446-6 and the May 18, 2005 temporary regulations at Temp. Reg. § 1.1446-6T collectively as the "Temporary Regulations." The Final Regulations and Temporary Regulations use the expression "1446 tax" to refer to the Section 1446 withholding tax and I have followed this usage in these comments.

My comments are the following:

1. Section 1446, if not unique, is quite unusual as a withholding tax. Withholding is a tax collection mechanism in which the law places on a third party withholding agent the responsibility to collect and pay over tax in situations where Congress has judged that this mechanism will improve the likelihood of tax being collected. In almost all cases, withholding taxes in Chapter 3 of the Code and elsewhere have two critical features:

a. First, the amount to be withheld is usually designed to approximate the amount of the tax that will be due and where that is not the case, the Code or Treasury regulations provide mechanisms for the amount to be reduced or quickly refunded.

b. Second, the withholding agent is only required to withhold on items of income of the foreign person within its "control, receipt, custody, disposal or payment", to use the expression found in Section 1441.

2. Section 1446, as implemented by the Final Regulations, has neither of these features and the Temporary Regulations provide only limited relief. Section 1446 more closely resembles a third party payment of an estimated tax than a withholding tax. The reason is that neither the payment to a foreign person nor the existence of assets in the partnership is a relevant factor for a tax payment obligation to be imposed on a managing partner or member of a partnership. If the partnership does have assets, the fact that the foreign partner has no claim on them and that they are attributable to other partners or to the creditors of the partnership is also irrelevant. All that is required is the existence of partnership income -- including phantom income -- and a foreign partner.

3. In cases involving significant current-year partner-level deductions, exclusions (such as cancellation of indebtedness (COD) income) and credits, the regulations can result in a significant economic burden for the withholding agent with no real means of redress. In many cases, the disallowance of deductions and credits interferes with the relationship of the partnership and its partners by compelling distributions to foreign partners in the form of tax payments on their behalf that bear little relation to the tax actually is owed. In the most egregious set of circumstances, the requirements of Section 1446 as implemented by the Final Regulations establish a transfer system under which property of the managing partner is used to fund the tax payment and a refund of tax is later issued to a foreign partner. The partnership may be unable to recover this amount from the foreign partner, especially if the foreign partner is insolvent. This cannot have been the purpose of Congress in enacting Section 1446. It is, however, what the Final Regulations provide for and although Section 1446(f) gives the Service the power to solve the problem, the Temporary Regulations offer no meaningful relief.

4. The problem with the approach taken by the Service in these regulations is that it has focused only on collecting tax from foreign partners and has not given adequate consideration to the withholding agents. I ask the Service to return to the tripartite balance that has characterized its approach to all other withholding provisions in both the domestic and foreign area.

5. In particular, the Service should revise the Final and Temporary Regulations to accomplish the following:

a. A partnership should be permitted to take into account partner-level deductions attributable to partnership items. These items should include (i) previously suspended partner losses that are released because of an increase in basis resulting from the allocation of ECTI to the partner, (ii) partner-level Section 199 deductions, (iii) deductions for state income taxes on ECTI paid by the partnership on the foreign partner's behalf, and (iv) partner-level credits derived from the partnership,

b. The current treatment of the overlap between Sections 1445(c)(1) and 1446 should be reversed. Section 1445(e)(1) deals with a specific situation -- the sale by a domestic partnership of a U.S. real property interest -- that should prevail over the more general withholding requirement of Section 1446. There is no evidence that Congress intended to repeal or substantially limit Section 1445(e)(1).

c. The Service should provide for relief from the treatment by the Final Regulations of cashless COD income and gain from foreclosures and deeds in lieu of foreclosure. The remedy proposed in the Temporary Regulations is insufficient, especially because any exclusion of COD income will occur during the same year as the COD income and cannot therefore be certified to the partnership under the Temporary Regulations in their current form. The result is a significant and unfair burden on withholding agents. The Final and Temporary Regulations balance the interests of taxpayers and the government without apparent consideration of the interests of withholding agents. There is no indication that Congress intended withholding agents to pay the foreign partners' tax from their own resources, especially in situations where the tax is refunded to the foreign partners and may never be returned to the withholding agents.

6. The following are specific comments about the Temporary Regulations:

a. The Service should reduce the period for a foreign partner to become eligible to provide a certificate to the partnership from four to two years. Foreign estates and trusts should be permitted to provide certifications to partnerships, and foreign estates should be permitted to take into account the decedent's compliance record.

b. The 90% limitation on the use of net operating loss carryovers in foreign partner certificates should be tied to the continuing applicability o the 90% alternative minimum tax limitation on the use of NOL carryovers (see Code Sections 56(a)(4) and (d)).

c. The Service should consider a simplified procedure for updating certificates. The approach of requiring a fully amended and restated certificate every time information changes is unnecessary. The regulations should provide for a short-form certificate that identifies the superseded certificate and simply states what has changed, signed under penalty of perjury. A short-form certificate would help avoid confusion caused by the need for the partnership to make a line-by-line comparison of the new and original certificates. One full certificate for a particular year should be sufficient.

d. The Service should amend the rules relating to the time when foreign partner certificates must be provided if they are to be relied on by partnerships. The rule should be expressed as follows: "A partnership may rely on any certificate received prior to the making of a payment of 1446 tax or the filing of a return with respect to that tax, but will not be penalized if it does not take account of a certificate received less than ten days before the due date for such payment or filing. The receipt of a certificate less than ten days before the due date for payment of the 1446 tax or the filing of a return shall not constitute reasonable cause for late payment or filing."

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Thank you for your consideration of these comments.

² Department of the Treasury Internal Revenue Service, 68 Fed. Reg. 52,466 (September 3, 2003).