Tax Compliance Consequences When a Partnership Invests in Offshore Entities

More and more partnerships are adding foreign investments to their portfolios. However, US partnerships may incur significant penalties if the filing requirements with respect to the foreign investments are not properly complied with. For example, a US partnership (“USP”) invests in a foreign entity and doesn’t report anything about the entity on its tax return and/or Schedule K-1.Several months later, USP is assessed tens of thousands of dollars for not filing the appropriate forms with respect to the foreign entity.

This article provides an overview of the compliance/reporting issues rules when partnerships acquire an interest in a foreign partnership (“FP”) or a foreign corporation (“FC”).

INVESTING IN A FC

When a USP acquires, directly/indirectly, stock in a FC, certain forms may be required:

Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation

Generally required by a US person (other than a partnership) to report a transfer to a FC if:

• Immediately after the transfer, the person directly/indirectly holds at least 10%; or
• The amount of cash transferred by the person during a 12-month period exceeds $100,000.

Although a partnership isn’t required to file Form 926, its partners may be. Therefore, a partnership should provide the necessary information on Schedule K-1. Even if each partner’s share is below the filing threshold, the information should be provided in case any direct/indirect partners contributed additional amounts to the FC.

Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations

Required if meet any of the 4 categories (category 1 was repealed):

• Category 2– US citizen/resident who is an officer/director of a FC in which a US person has acquired (in 1 or more transactions) 10% or more.

• Category 3 – Among others, a US person who:
  • Acquires 10% or more of a FC; or
  • Disposes of FC stock to reduce interest to less than 10%.

• Category 4 – US person who owned more than 50% of a FC for an uninterrupted period of at least 30 days during the year.

• Category 5 – US Shareholder who owns stock on the last day of the year in a CFC for an uninterrupted period of 30 days or more during the year.
  • US Shareholder – US person who owns (directly, indirectly, or constructively) 10% or more of the total combined voting stock of a CFC.
  • CFC – FC that has US Shareholders that own (directly, indirectly, or constructively) on any day of the year, more than 50% of the total combined vote or value.
    • Example – FC has the following shareholders: USP1: 55%; FP: 40%; USP2: 5%. FC is a CFC to USP1 but not to USP2 (it isn’t a US Shareholder).

A partnership needs to be familiar with the subpart F and section 956 rules when investing in a CFC as these rules can result in unexpected tax results.

There are exceptions to filing, such as multiple filers and constructive ownership. A statement may be required to be filed by the non-filer. See the instructions for more information.

Form 5471 Example

USP acquires 20% of FC on February 1. A US person owns the other 80%. None of USP’s partners are directors/officers of FC. Analysis:

• Category 2 – Not applicable – None of USP’s partners are officers/directors.
• Category 3 – Applicable. USP acquired more than 10% in the current year.
• Category 4 – Not applicable. USP owns less than 50% of FC. The other shareholder, however, is a category 4 filer.
• Category 5 – Applicable. FC is a CFC. USP needs to know who the other shareholders are in order to determine if FC is a CFC.

Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund

Required to file if certain circumstances are met, such as the US person:

• Receives certain direct/indirect distributions from a PFIC;
• Recognizes gain on a direct/indirect disposition of PFIC stock; or
• Is reporting information with respect to a QEF and/or is making a QEF election

A US person that owns PFIC stock may make a QEF Election. If made, a shareholder must include in income its share of the QEF’s income. Only the first US person that is a direct/indirect shareholder of the PFIC may make the election. Note that a QEF election can’t always be made.

If a QEF election hasn’t been (or can’t be) made, the PFIC shareholders are subject to special rules when they receive an excess distribution from, or recognize gain on the disposition of, PFIC stock. This can result in a complicated calculation and separate tax and interest charges.

A partnership investing in a FC needs to be familiar with the PFIC/QEF rules in order to determine whether it can/should make a QEF election.

INVESTING IN A FP

When a USP acquires, directly/indirectly, an interest in a FP, certain forms may be required:

Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships

Required if it meet any of the 4 categories:

• Category 1 – US person who owned more than 50% of the profits or capital of the FP at any time during the year.
  • EXCEPTION – If more than one category 1 filer, only one person is required to file – the US person with a controlling interest in capital or profits of the FP. That person will include the non-filer on its Form 8865.

• Category 2 – US person who, at any time during the year, owned a 10% or greater interest in the FP while it was controlled by US persons each owning at least 10%.
  • Control – ownership of more than 50%.
    • EXCEPTION – No person will be a category 2 filer if there is a category 1 filer.

• Category 3 – US person who contributed (directly/indirectly) property during the year, if that person either:
  • Owned, directly or constructively, at least 10% of the FP immediately after the contribution; or
  • The value of the property (when added to the value of any other property contributed by that person during a 12-month period) exceeds $100,000.

• Category 4 – US person that had a reportable event during the year:
  • Acquisitions –
    • the person didn’t own a 10% or greater direct interest in the FP but does after the acquisition; or
    • the person’s direct interest has increased by at least 10% since the last reportable event
  • Dispositions –
    • The person owned a 10% or greater direct interest in the FP and, after the disposition, owns less than 10%; or
    • The person’s direct interest has decreased by at least 10% since the last reportable event
  • Changes in the proportional interests – The person’s interest has increased/decreased by at least 10% since the last reportable event.
  • EXCEPTION – If the USP qualifies as a category 3 and 4 filer because of a contribution, the USP isn’t required to report this transaction under both categories. If the contribution is properly reported under Category 3, the USP isn’t required to report it under Category 4.

There are exceptions to filing, such as multiple filers and constructive ownership. A statement may be required to be filed by the non-filer. See the instructions for more information.

Form 8865 Examples

Example 1 – USP contributes $1M to FP in exchange for a 20% interest. None of the other partners of FP are US persons. Analysis:

• Category 1 – Not applicable. USP owns less than 50%.
• Category 2 – Not applicable. Although USP owns more than 20%, FP isn’t controlled by US persons. USP needs to understand the ownership of FP in order to make an informed decision.
• Category 3 – Applicable. USP contributed more than $100,000 to FP. If, instead, USP contributed $50,000, Form 8865 would still be required because USP owns more than 10%.
• Category 4 – Not applicable. USP falls under the exception because it will file under category 3 for the contribution.

Example 2 – USP owns a 70% interest in FP’s losses and 20% in FP’s profit/capital, which was acquired several years ago. The other partner of FP is a US person. USP made no contributions to FP in the current year. FP admitted a new non-US partner during the year, which resulted in USP’s loss interest decreasing from 70% to 55%. Analysis:

• Category 1 – Applicable. USP owns more than 50% of FP. However, there are multiple category 1 filers. The other US person will be required to file under category 1 because it owns the controlling interest in capital and profits.
• Category 2 – Not applicable. Although USP meets the requirements, it isn’t a category 2 filer because FP has a category 1 filer.
• Category 3 – Not applicable. USP didn’t contribute property in the current year.
• Category 4 – Applicable. USP’s proportional interest in FP’s losses decreased by more than 10%.

Other Foreign Forms

Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities
Required by the following U.S. persons who are direct/indirect tax owners of a foreign disregarded entity (“FDE”):

• US Persons that are tax owners of a FDE – The tax owner is the person that is treated as owning the assets and liabilities of the FDE for purposes of US income tax law. The tax owner may not be the direct (or legal) owner – if FDE1 is wholly owned by FDE2, which is wholly owned by USP, the direct owner of FDE1 is FDE2 but the tax owner is USP.
• Categories 4 and 5 filers of Form 5471
• Categories 1 and 2 filers of Form 8865

There is a multiple filer exception. A statement may be required to be filed by the non-filer. See the instructions for more information

Additionally, any of the FC forms discussed may be required by partners of a FP if the FP directly/indirectly holds FC stock.

Schedule K-1 Footnotes
A FP will not file any of the forms discussed because it isn’t a US person. However, its direct/indirect partners may be required to file. Therefore, a FP should include information on its Schedule K-1, such as:

• Direct/indirect contributions to a FC so that direct/indirect US partners can determine if they have a Form 926 or Form 5471 category 3 filing requirement
• Ownership of a FC that may fall under any of the other Form 5471 categories
• Information on a FC that is a PFIC
• Information on the FP itself for purposes of filing Form 8865 and/or Form 8938, Statement of Specified Foreign Financial Assets
• Information on any FPs or FDEs directly/indirectly owned

Penalties
The penalties for not complying with the filing requirements can be significant.

Sample of penalties:

Conclusion
Any time a partnership invests in an offshore entity, additional analysis needs to be done to determine if any of the forms discussed need to be filed or if the information needs to be provided to its partners. Without the proper analysis, the partnership and/or its partners could incur significant penalties.