One of the major challenges often faced by investment funds is what to do when you have a foreign investor. If you have foreign investors, you may need to file extra tax forms and pay tax on their behalf. This article provides guidance on your obligations as a fund passing through trade or business income or investment income to foreign investors.
General withholding and reporting considerations:
There are a few items to consider to determine whether you are subject to withholding and reporting. You first need to determine whether your investors are foreign. Be sure you are requesting the proper documentation from all your investors so that you know whether they are subject to withholding and at what rate. You will need a W-8 on file for any foreign investors (W-8BEN, W-8BEN-E, W-8ECI, W-8EXP, and W-8IMY).
The next step is to determine if the foreign investor is a resident of a country that has a tax treaty with the United States. If yes, the investor could be subject to lower withholding rates.
Once you have identified your foreign investors, countries of residence, and any applicable treaties, you then need to look at what type of income your foreign investors are earning as different types of income will require different withholding rates and tax filing requirements.
What do you need to do if you have US trade or business income?
Generally, when a foreign person engages in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be Effectively Connected Income (ECI).
Every partnership (other than a publicly traded partnership) that has effectively connected gross income allocable to a foreign partner must file Form 8804, regardless of whether it had effectively connected taxable income allocable to a foreign partner or whether it had a withholding tax liability under section 1446. The partnership must also file Form 8805 for each partner on whose behalf it paid section 1446 tax, regardless of whether the partnership made any distributions during its tax year.
If the partnership had effectively connected taxable income, quarterly withholding payments are required to be made with Form 8813 (due April 15th, June 15th, September 15th, and December 15th). The tax rate is 21% for corporate partners and 37% for non-corporate partners.
Planning Consideration: Can the foreign partners certify that they have other US losses to offset ECI from the partnership? If so, they can provide Form 8804-C which lets the partnership reduce the section 1446 quarterly withholding amounts. This is especially helpful when cash flow is tight and it doesn’t make sense to make a payment only to have the partner request a refund.Tax Decision Tree
What do you need to do if you have US investment income?
When a foreign person receives investment income from sources within the United States, a Form 1042 must be filed. The standard withholding rate for interest, dividends, and royalties is 30%. Be sure to check your investors’ W-8 and identify whether a reduced rate applies.
If you are reporting interest income to a foreign investor, it is important to be aware of the exceptions to the reporting requirements. Portfolio interest or bank deposit interest is exempt from withholding.
To qualify as portfolio interest, the interest must be paid on an obligation in registered form, meaning: (1) the obligation is registered as to both principal and any stated interest with the issuer (or its agent) and any transfer of the obligation may be affected only by surrender of the old obligation and reissuance to the new holder; (2) the right to principal and stated interest with respect to the obligation may be transferred only through a book entry system maintained by the issuer or its agent; or (3) the obligation is registered as to both principal and stated interest with the issuer or its agent and can be transferred both by surrender and reissuance and through a book entry system.
An obligation that would otherwise be considered to be in registered form is not considered to be in registered form if it can be converted at any time in the future into an obligation that is not in registered form.
The partnership should withhold tax when any distributions that include amounts subject to withholding are made. If no distributions of income subject to withholding are made during the year, the partnership should withhold on the earliest of the date the K-1 is provided to the foreign partner, the due date for providing the K-1, or the date in the subsequent year the income is actually distributed.
It is also important to be aware of the withholding payment due dates. Your obligation to remit the withholding payments will depend on the amount of withholding you are remitting – see below for more information:
- If at the end of any quarter-monthly period the total amount of undeposited taxes is $2,000 or more, you must deposit the taxes within 3 business days after the end of the quarter-monthly period. (A quarter-monthly period ends on the 7th, 15th, 22nd, and last day of the month). A business day is any day other than a Saturday, Sunday, or legal holiday in the District of Columbia.
- If at the end of any month the total amount of undeposited taxes is at least $200 but less than $2,000, you must deposit the taxes within 15 days after the end of the month. If you make a deposit of $2,000 or more during any month except December under rule 1 above, carry over any end-of-the-month balance of less than $2,000 to the next month. If you make a deposit of $2,000 or more during December, any end-of-December balance of less than $2,000 should be remitted with your Form 1042 by March 15th.
- If at the end of a calendar year the total amount of undeposited taxes is less than $200, you may either pay the taxes with your Form 1042 or deposit the entire amount by March 15th.
Withholding payments are required to be made through the IRS EFTPS. Please note that an EFTPS account needs to be set up for each entity with a withholding requirement.
To help illustrate the payment requirements, here is an example:
In 2017 the partnership had $30,000 of dividend income allocated to a foreign partner. No distributions of this income were made during 2017. The 2017 K-1 was issued on July 1, 2018 and a distribution of income was made February 15, 2018. Withholding of $9,000 (assuming no treaty) would be due 3 business days after February 15th.
There are many other types of income that require you to withhold tax on behalf of your foreign investors which are outside the scope of this article. It is important that someone knowledgeable in withholding taxation rules is working with your fund so that you are not penalized for failing to meet your obligations. Our team is well-versed in these rules and would be happy to discuss your particular situation. To discuss questions regarding filing and withholding obligations, please contact us.