MAYER & RISER, PLLC
ATTORNEYS AT LAW
HIGHLANDS, NORTH CAROLINA
(828) 526-3731

NOW THE RISER LAW FIRM PLLC
404-942-3533 / 828-526-8886
criser@riserlaw.com

Big Changes in Store for Many Foreign Investment Funds

As reported in the November/December 2000 issue of The Riser Report in connection with the new qualified intermediary rules, new IRS regulations went into effect on January 1, 2001 regarding withholding on payments from U.S. payors to foreign payees, including foreign investment funds. Judging from the number of email and phone inquiries I’ve received asking for assistance, there seems to be a good bit of confusion about the new rules. The most drastic changes affect investment funds taxed as foreign partnerships, concerning the responsibilities for withholding and backup withholding by U.S. payors and by the foreign funds themselves when they accrue income allocable to the funds’ investors. The latter issue also will be of concern to U.S. partnerships with foreign partners as U.S. partnerships are responsible for withholding tax on its foreign partners’ distributive shares of partnership income.

Under U.S. foreign withholding rules, U.S. payors who pay to foreign payees U.S.-source fixed or determinable annual or periodic income not effectively connected to a U.S. trade or business generally must withhold tax at a 30% rate, unless an exemption or a lower treaty rate applies and the exemption or treaty applicability has been properly certified to the payor by the foreign payee. Also, under U.S. backup withholding rules, U.S. payors who pay interest, dividends, and gross proceeds from the sale of securities or other property must withhold tax at a 31% rate unless the payee has certified its taxpayer identification number (“TIN”) or has otherwise properly established its exemption from backup withholding.

So, U.S. payors who pay income to foreign investment funds, such as custodians, must either withhold tax or obtain the proper certification from the payee to show that withholding is not required. Also, the foreign investment funds themselves must either withhold or obtain the proper certification of exemption lest it find itself liable to the IRS for income paid to or allocable to its investors.

Under the old withholding rules, a fund organized as a foreign partnership could file certifications of exemptions without identifying the underlying investors. Under the new rules, the fund will have to obtain certifications from each investor in addition to filing its own certifications, and must explain how allocations of income will be made among the investors. Alternatively, the fund can enter into an agreement with the IRS to become a “withholding foreign partnership” which will allow it to file a much simpler blanket certification with U.S. payors, but will also require the fund to assume responsibility for withholding compliance.

All old Form W-8 certifications (certification of foreign status for the portfolio debt exemption) and Form 1001 certifications (certification of exemption from withholding under a treat) certifications expired on December 31, 2000. New certifications are required on new Forms W-8BEN (for foreign corporations and foreign individuals) and W-8IMY (for foreign partnerships). The new forms are more complex than the old forms, and in some cases, a foreign payee may need to obtain a U.S. TIN.

While funds taxed as foreign corporations should not find the new rules too problematic since not much has changed for them, funds taxed as foreign partnerships will be dealing with some complex issues this year. As noted above, generally a fund taxed as a foreign partnership must obtain certifications from each investor and attach those certifications to its own certification along with an explanation of the allocation of income among its investors. Essentially, the U.S. payor will look through the fund and treat each investor as a separate payee.

At first glance, this may not seem like such a big deal, but in practice there will be a number of complex issues to address. For example, whereas a fund’s custodian once dealt with one withholding issue for the entire fund, it will now deal with as many withholding issues as there are investors. Surely fees will increase. If a fund is open-ended, every time an investor is admitted or redeemed, certification and allocation information must be updated with the custodian. Disproportionate allocations will also cause complexity, especially in those not-so-uncommon cases where special allocations are not determinable until the end of a particular accounting period. Foreign investors must be identified by name to the U.S. payor must in turn identify them on Form 1042 to the IRS, which then may share this information to other countries with which the U.S. has tax treaties. Clearly, there are a number of issues which if not already addressed must be addressed immediately.

Some smaller or simpler investment funds may not find the new rules too difficult. Neither will, most likely, master partnerships in master-feeder structures where the foreign payee is a foreign feeder fund taxed as a corporation. Others might reconsider restructuring the fund to allow for simplicity. Alternatively, the fund could apply to become a withholding foreign partnership (WFP) which essentially serves the same function as a qualified intermediary, as discussed in the November/December 2000 issue of The Riser Report. Essentially, a WFP is treated the same as a domestic partnership. It is the partnership’s responsibility to withhold tax on allocations to its foreign partners.

Because the WFP regime is new, it is difficult to predict the costs involved in applying for WFP status or the ease with which WFP status can be achieved. However, it may be preferable where economically feasible, certainly from the perspective of U.S. payors and, in certain circumstances, from the perspective of foreign funds taxed as partnerships, where WFP status would appeal to a fund’s customers. In Rev. Proc. 2000-12 dealing with applications for QI status, the IRS stated that while Rev. Proc. 2000-12 does not apply to a foreign partnership seeking to qualify as a WFP, it will, however, consider applying the principles of the QI withholding agreement provided in Rev. Proc 2000-12 to a foreign partnership acting on behalf of its partners in appropriate circumstances.

If we can help you or your clients with foreign fund withholding issues, give Chris Riser a call at 828-526-8886 or send an e-mail message to criser@riserlaw.com.