On-Demand: Financial Services Year-End Tax Planning | Part III

Number two, changes in the portfolio interest exception, the BBB Act has a provision in it, which essentially shuts down a planning technique that is commonly used in structuring ECI blockers. These two does not seem to be a topic that draws much attention on Capitol hill, especially since it's unclear that Congress ever intended taxpayers to take advantage of the current law as they have been. So, one might think of this also as being a soft correction. We'll talk about what this would mean to the structures and the steps that funds and their advisors may take in response, perhaps even before it passes, if it passes.

Number three, W21042 update, the IRS released new forms W-8 in October 2021. We run through briefly what the changes on the forms are in terms of forms 1042S. The proposed regulations eliminating the lag method of reporting have not yet been finalized. And therefore the lag method is still optional. And there's no indication that this will change before the 2021, 1042 filing season begins. Finally, the IRS recently came out with an electronic data integrity tool, performs 1042S. We'll tell you briefly about what that's all about and how to access it.

And number four, Schedule K-2, K-3. It's been maybe a year and a half since the IRS rolled out this new and expanded form of reporting items and amounts of international tax relevance. The forms and instructions were finalized a few months ago, and we're about to go live with this new reporting for the 2021 tax filing season. And I'm sure the feeling of excitement is just held on this webinar. We all can't wait to begin to this, right? Schedules K-2, K-3, what do they do? Three things. They replace K-1 line 16. Number two, they replaced what essentially was an unstructured afterthought of disclosures on line 20. And number three, perhaps most significantly, it replaces the wild west of international K-1 footnotes which had no specific instructions as to what was required to be disclosed and certainly no standardized format to such disclosure.

We discuss each part and section on a very high level with a focus on investment partnerships. The IRS also recently issued a noticed 2021-29 a few months ago, which outlined the penalties that may apply for a failure to furnish complete and correct information, respect to schedules K-2, K-3, and providing transitioning leave from these penalties if the filing establishes good faith efforts to comply. We'll discuss just what this means, particularly for investment fund partnerships. We will not have the time to cover all this slides in today's presentation in detail. For that we would need probably three hours, we only have one. So we'll be skipping over and around certain slides in order to ensure that we touch on the most important points during the time that we do have. But I urge everyone at their own leisure and pace to review the slides, which are fairly detailed and are designed to be self-explanatory. I'd like to acknowledge the contributions of my colleagues, Julianna Gore, and Eli Gal to this presentation.

And with that, let's start with downward attribution. At a 30,000 foot level, let's start with the following. A US shareholder of a controlled foreign corporation, a CFC, is required to include its pro rata share of CFC's Subpart F income, and certain types of passive income, and its income. A US shareholder of CFC is also required to compute his GILTI, which is most other types of non-Subpart F income based on its pro rata share of the CFC's GILTI attributes, what we call tested income, QBI, et cetera. So we need to know what is the US shareholder and what is a CFC? A US shareholder is generally a US person who owns 10% or more. A CFC is generally a foreign corporation that is owned more than 50% by US shareholders.

Each of them own at least 10%, which begs the question, what is ownership for these purposes? Whenever we speak of ownership in Internal Revenue Code, we're generally referring to one of two types of ownership. The first type is direct or indirect ownership. It's so simple enough to understand. A person has economic rights with respect to, in this case, a foreign corporation, either directly or indirectly. But it's a second kind of ownership in Internal Revenue Code, which is called constructive ownership, in which the so-called constructive owner of the stock does not have any economic rights with respect to the corporation. But since the owner has a certain relationship with a person who does have an economic right, we treat this constructive owner as a shareholder in certain limited senses, most commonly for determining the status of the corporation or entity whose stock is constructively owned as being controlled. But a constructive owner remains a noneconomic owner, and therefore does not include any amount in this taxable income in respect of the stock if constructively owned, simply because the constructive owner will never receive such income, it's not entitled to it.

One of the forms of constructive ownership, that is what is known as downward attribution. Section 318(A)(3) (A), (B), and (C) provide that stock that is owned by a partner, a trust beneficiary, or more than 50% shareholder of a corporation is constructively owned by such partnership, trust, or corporation. Now from a strictly logical point of view, this makes about as much sense as saying that wet roads cause rain. It's exactly the opposite. But again, the context here is to pretend that the partnership or the corporation owns the stock because of the relationship it has with its partner or shareholder.

Now, prior to the TCJA, we had Section 958(b)(4), which provided that in the context of determining if a foreign corporation is a CFC, and if a US person is a 10% US shareholder of such CFC, downward attribution is blocked. Meaning stock of a foreign person will not be attributed to a US person. And this prevented many US persons from becoming US shareholders on account of the stock economically owned by their foreign owners, and thereby preventing many foreign corporations from becoming CFCs. But there was a perceived abuse that Congress tried to fix, but considering TCJA legislation. And we're going to jump to that right now.

Okay. So here, many years ago, corporations were engaging in these inversion transactions. So you had a US company that inverted and had a foreign parent. It had many foreign subsidiaries, but after the inversion, it wound up owning a minority portion of this subsidiary. So prior to TCJA, this year subsidiary only owned 20% of the foreign subsidiary. So therefore this foreign sub was not a CFC. Now, we just spoke about constructive ownership, and 80% of the foreign sub D at the bottom of this structure is owned by foreign parent B. So that with downward attribution, would attribute that 80% down to US sub and make US sub the 100% owner foreign sub. But as we said before, 958(b)(4) turned off that downward attribution. So Congress saw that, and this was a perceived abuse because essentially this US subsidiary owned 100%.

So, Congress said, "Oh, the problem is 958(b)(4). No problem, we'll get rid of 958(b)(4) and now it won't be a problem anymore." Well, what they did in doing that, was they killed the fly with a sledgehammer, because that opened up a whole host of other structures which were never intended to become CFCs, and it created really havoc. And for a while, there was a lot of talk that there was going to be a technical correction. It never happened. The IRS came out with relief that danced around some of the reporting requirements that ensued from there. But the basic damage was done, okay?

Now, let's go back right now to what the BBB Act did. So the BBB Act looks at this and says, "Okay, we're going to fix this, and we're going to fix it by doing the following. The language of the bill is extremely difficult to understand, let me boil it down to this," okay? The first thing is the BBB Act puts back Section 958(b)(4), okay? So for purposes of CFC determination and US shareholder determination in general, no downward attribution. Great. Now we have taken two. Congress is saying, "How do we address this perceived abuse?" And what they said in a nutshell is that if you have a more than 50% US shareholder of a foreign corporation, then that more than 50% shareholder and that shareholder only will be treated as being subject to Subpart F and GILTI. And here's the rub over here. For purposes of this Section 951B, and this new regime, this determination of ownership is made without regard to 958(b)(4) that would be reinstated, right? Meaning that it would be made with downward attribution.

So, in doing this, you have to learn the new terminologies. Okay. There are two very important terminologies over here. If foreign controlled United States shareholder and a foreign controlled foreign corporation, a foreign control foreign corporation means that it's owned more than 50% by a United States shareholder, and a foreign control in the United States shareholder is a United States shareholder that owns more than 50% of a foreign corporation. Not a CFC, okay? This is a separate regime, so to speak. And like I said, the determination of whether you own for these purposes and these purposes alone is made with regard to downward attribution, okay? So now let's go back before we go back to our example and see how that impacted that.

Let's now talk a little bit about the effective date. So previous versions of this legislation really just had this going back retroactive to 2018, that would've been an entire mess. This legislation does not do that. This legislation is beginning after the date of the enactment. There is a section over here that talks about no inference should be managed to what the law was before. I don't want to get into that. The IRS clearly is of the view that 958(b)(4) had all those negative ramifications that we spoke about. Total hearsay, I heard that the joint committee is considering a policy approach to make it elective. That's total hearsay. I don't know if it's going to happen, and take that for what it's worth, which is not much, okay?

Now, if we go back to this structure that we had before, so we have the same result over here, except instead of getting through the CFC determination, we get to it through the determination that US sub is treated as a United States shareholder of a foreign controlled foreign corporation. And we had the same exact result as we had before. So far no change does. But now let's go to the next slide and the next example. Okay. Over here, this is the classic example of the ill effects of the repeal of 958(b)(4), okay? You have foreign subsidiaries and a sister US called a sub, okay? So, with the downward attribution, you would have, just follow me over here, ownership going foreign parent Bs ownership. Foreign sub is going to go down to US sub over here.

That created a situation with foreign sub D was a CFC. And therefore it didn't really affect the US sub at all because US Sub C does not have an economic ownership. We had no Subpart F income. But who got affected? The US private equity fund at the top, because they owned 10% and no more than 10% of the foreign sub D. And therefore they had the repatriation, Subpart F income, GILTI. So now under the BBB Act, if it gets enacted, US PE Fund (A) would not be treated as a foreign controlled US shareholder because it does not own more than 50% of foreign sub even with downward attribution, okay? And therefore, although foreign sub D over here would be treated as a foreign controlled foreign corporation under new Section 951B.

And why is that? Because for those purposes, as we said, we do take into account downward attribution. So the downward attribution still goes up to here, down to here, and therefore foreign sub would be treated as a foreign controlled foreign corporation under new Section 951B. However, US PE Fund up here is not a foreign control US shareholder under this new code section, if it gets enacted. And therefore it will not have Subpart F income or GILTI. And as far as US sub is concerned, it doesn't make any difference to US sub.

Let's go to the next example over here. The next example over here illustrates the fact that you could run a foul. You did run a foul of the ill effects of TCJA repealing 958(b)(4) even if you didn't have in the foreign portfolio company down here, any of your subsidiaries. And how is that? Well, over here, this foreign corporation has four owners in this middle tier over here. The three on the left or US, the one on the right is Cayman, and the three on the left add up to more than 50%. However, this middle guy over here is F, only owns 9%. And as we said, it only counts if you own more than 10%, okay?

So now what happened? So on its surface, without downward attribution, this would not be a CFC, but Cayman LP over here owns 46%. And Cayman's GP (C) over here owns 20% of that. That's 9.2% approximately gets attributed up here, down here. And then if there's nothing preventing downward attribution, if we repealed Section 958(b)(4) as this TCJ Act did, then that 9.2% gets attributed down here to US PE LP (F), and the 9.2% gets added to the 9% direct ownership, making F a 10% US shareholder. It owns 18%. And now in conjunction with the other two, your shareholders over here, voila, we have foreign corporation H is a CFC. And these three guys over here now all have Subpart F income and GILTI.

But now under the BBB Act, what happens? Under the BBB Act, everything is cool because now you do not have downward attribution anymore, for purposes of foreign corporation (H) CFC determination. So foreign corporation (H) is not a CFC. We're not out of the woods yet, because now we have to test for status under this new regime under 951B for being a foreign controlled US shareholder of a foreign controlled foreign corporation. And it's not a problem over here, because even though you're going to- And for this purpose, what do we say? That you do take into account downward attribution. So the same 9.2% comes up to here all the way down, back to here. And now the 9.2% could be added. And it is added for this purpose to any one of these three over here. But 9.2% is not enough in and of itself in conjunction with what they own directly to make any one of these guys own more than 50%. And therefore they are not treated as United States shareholders of foreign controlled foreign corporations. And therefore all of these guys now are not subject to Subpart F, I think, GILTI anymore.

But now, let's contrast that with the next example. Next example is exactly the same, except that this guy over here, instead of owning, I forget if it was 20% or not, this guy now owns 42%, okay? So now this is going to change the landscape, because what happens over here is that this 46.2% times 20% gets attributed up to here. It's the 9.2%. 9.2% comes down here. And the 9.2% now gets added, for purposes of new Section 951B, to this guy over here, US PE Fund (D), and 9.2% together with 42% gets then to be over 51%. So that therefore this guy and this guy only, this D, would be treated as a foreign controlled United States shareholder on the new Section, IRC 951B.

And therefore this guy and this guy only has Subpart F income and GILTI with respect to foreign corporation each. How about these two other guys over here? No, because why? Because even though they have the same 9.2% attribution for these purposes, but if you add them to their 6% each, you're not going to get anywhere near more than 50%. That's in a nutshell what this does. And now we come to our first polling question. Bella?

Okay. The correct answer is D, which I see a majority of you did get. All US shareholders, 10% of CFCs would still be subject to Subpart F, GILTI, and all foreign controlled US shareholders of foreign controlled foreign corporations would also be subject to Subpart F, GILTI. Not an easy thing to understand. I realized that I ran through this very fast. I apologize, but we have a lot of other things to get to. Hopefully you got the main concept. And again, this is larger self-explanatory. Let's move on. Okay.

So, withholding exemption for portfolio interest, okay? A non-resident alien beneficial owner are subject to a 30% rate of withholding, unless they're eligible for treaty benefits. But there's an exception for certain portfolio dead instruments, which are not subject to withholding. Portfolio interest generally means interest on an obligation which is in registered form. And in respect, which US withholding agent receives a proper W-8. But, and here's the but, withholding interest does not include any interest received by 10% shareholder.

And in this regard, under current law, 10% shareholder is defined as one that in the case of a corporation is any person who wants 10% or more of the total combined voting power. Vote not value. And attribution rules apply. A little bit out of order over here, but the BBB Act would change this. Here slides a little bit out of order. And what they insert over here is, or any person who owns 10% or more of the total value of the stock of such corporation. That has a profound impact, and let's see what the impact is. So over here, you have a typical structure where you have foreign corp A over here owns 5% of the value, 45% of the values foreign investor B, and 50% is this foreign investor C. This investor over here is eligible for 0% withholding under the treaty. This is a tax exempt investor, also 0% withholding. This is a taxable investor.

So, what is the typical idea over here? Even before we get to this over here, let's talk about what we're trying to accomplish over here. So US corp is set up as a blocker to own ECI producing investments, okay? And in order to mitigate the tax leakage on this structure that the US corporate blocker would have to pay, this is financed with a significant portion of debt, 65% of this example. But if the US corporation now pays this interest, thereby lowering its taxable income and its tax, and then it distributes the interest, pays the interest up to its foreign investors, free of withholding tax, because it's treated as portfolio interest, the problem is that this guy over here owns 50% of value. And if he would own 50% of the vote as well, then that investor would not be eligible for the portfolio interest exception.

So, what basically has been going on is that they've been rigging the voting percentages of the stock, doing it properly legally, but having a different value and a different class of voting stock. So that now, if you see over here, everybody's happy because these two guys anyway they don't have withholding, right? Corporate A and corporate B. Investor B does not have withholding. And investor C is not going to have withholding because he only owns 5% of the voting stock. But now with the new BBB Act, that 5% if voting stock not going to matter, because they're going to own more than 10% of the value. So therefore what's going to happen now is that they're not going to be eligible anymore for the portfolio interest exception.

So, what might you do about this? So here, this example is same exact example that we had before, except over here, foreign investors see now, checks the box over here, and let be treated as a flow through entity for your tax purposes. And this particular example, the foreign shareholders behind here do not indirectly own more than 10% of the US corporate block over here. So that by treating this now as a foreign partnership, it's not going to matter what the ownership is at the foreign partnership level, because the beneficial owner of the interest that's paid by US blocker up to the foreign investor C, the beneficial owners are really going to be the foreign shareholders. And therefore by checking the box, you basically allow them to continue to reap the benefits of the 10% of the portfolio interest exception, even though the law, if the law changes. Now, just a caveat over here that electing to be treated as a partnership for your tax purposes should generally be treated as a taxable liquidation of this investor.

So, you have to take that into account. Have to take into account if there are any US investors behind it that would be affected by this. But it's certainly something to consider. But let's say the ultimate owner is even behind the entity on 10% or more of the value of US corporation, okay? So, first of all, let's point out that the legislation provides that it's only effective with respect to obligations issued after the date of enactment. Well, what is precise definition of obligations issued after the date of enactment, right? What you might do right now is consider replacing debt. Let's say the debt is out there right now, and it matures in a year or two from now.

With the new debt, you might say, "Okay, you know what? I'm going to reissue the debt right now before this gets enacted to get, for example, five more years use out of this strategy before the underlying investment in the PE fund is fully exited." The debt would need to be the new issued debt. If you want to consider it, would have to be issued at arm’s length terms as of today, which by the way might mean that you might have a higher interest rate than as compared with the existing debt instrument. Something that you might consider, but you have to move very fast.

A few other questions, which are unanswered. What if the debt is replaced with new debt with substantially similar terms? Would that be considered newly issued? And what if the debt is modified? Would it be considered grandfathered portfolio debt or if the changes are significant enough to be deemed reissuance of the debt under federal income tax law? We don't have any regulations, we just have that one liner in the bill. And we don't really know where this is going to go. And now we have a next polling question.

Okay. The correct answer is B, the portfolio exception be eliminated for 10% shareholders of corporation by value. C, the portfolios exception be eliminated for partners and partnerships with the partnerships on 10% or more, that would not be the case because it doesn't matter if the partnerships own 10% or more, it matters what the beneficial owners own. Let's move on. Okay, we're going to run through this fairly fast. The IRS came out with new updated forms, October of 2021. And what that means is that you cannot accept an old version of this form starting May 1st, 2022, which is about six months after these were issued. That does not mean that your existing forms that have been used before the IRS releases or before six months after the IRS release, these are invalid. They remain valid until three years or a change in circumstance.

Let's run through very quickly what these changes are. Okay. So W-8BEN right now has a new check box. This is very significant. Check if FTINs are not legally required. So we all are aware that FTINs are now required on the fact to be included on form 1042S. And there are a certain handful of countries really that do not issue FTINs, or that have already acknowledged the areas that they don't wish to have this reporting. And under the old version of the form, you would have to attach an explanation if an FTIN is not required. And what they've done is they've added this box, which is very convenient. Please check the box.

Let's go on over here. And over here, this is also very important, okay? So if on a W-8BEN, which is being given by an individual, sometimes there's a power of attorney or some other capacity in which a person other than the beneficial owner is entitled to sign it. And whenever you had these capacity fields on these forms, the IRS would always get into a real conflict upon audit. Do they have the capacity? Is this capacity good? Is it not good? Over here, all you need to do is check this box over here. Certified that I have the capacity to sign for the person certified, and then you're done. Very nice and significant. Okay. Over here, W-8BEN-E, again just breaking out over here separate chapter three statuses to align with the different codes that are now required to be reported on 1042S. And again, over here, line 9C check if you have to not legally required. Same exact concept over here. Very administrative convenient anyway.

Over here, the treaty claims. So there are still some treaties that do not have an LOB article in the treaty. And then we have an extra box over here to check over here to be able to say that. And in case you want to know which countries they are, the IRS has a tax treaty table that you can reference. Not too many of them over here. This is new change to the form. Over here, special rates and conditions. Okay. So the only thing I'm going to say about this is that we've had the newly enacted 864(c)8, 1446(f) on the sale of a partnership, interest of the partnerships engaged in your trader business, and under certain very limited circumstances. Or you can claim a treaty exception. In order to do that, you cannot have a PE, a permanent establishment in the US, which means that it's usually not going to be ECI, but it is possible. So the IRS added in their instructions over here and said that you can make this claim over here on the W-8BEN-E. Not going to be very relevant to most.

On W-8IMY again, very similar types of changes. Let's go through this over here. Okay. Here is significant over here. And part eight of the W-8IMY form withholding foreign partnerships which are most. These boxes will over here, B, C, D, E, and F have been added over here. The 21(b) should be checked for by foreign upper tier partnership furnishing W-8IMY to lower tier partnership so that the later can determine the proper amount to withhold. Very specific circumstance which is now identified on the form. And then now under the new rules, which I just alluded to before, where you have to withhold under 1446(f) for the sale of a partnership interest that is engaged in your trade or business.

There is a concept of having a withholding on a modified amount realized, which means that the one that's subject to the withholding says, "Well, wait a second, I'm going to pass through entity and I have partners that are US or their tax exempt. So only withhold on this modified amount." If you want to do that now, there is a mechanism in the form W-8IMY, the new version of the form, the claim is you have to check both 21c and 21d in order to do it. And let's go to the next one. The next one is also very significant, okay? Just as a little bit of background, a non-qualified intermediary or a non-withholding foreign partnership has to issue, in addition to W-8IMY, it has to furnish its W-8s, W-9s, and it has to issue this withholding statement. And the withholding statement, it's a very elaborate statement saying what rates to withhold, for what different types of forms of income, et cetera.

And there's this concept in the regulations which is not new of an alternative withholding statement, which means that in lieu of the normal withholding statement, you can provide an abridge version of this. As long as you allocate the payment to each payee, you include any information that the withholding agent requests. And here's the biggie, okay? And this was very often missed, okay? It must contain- And the reason that you can provide this abridge version of the withholding statement is because you're anyway furnishing the withholding agent with the underlying forms W-8BENs, W-9s, right? So why should you have to go through it and summarize it again for them?

But the requirement for this alternative withholding statement in the regulations is that there must be a representation by the partnership that says that the withholding certificate are not inconsistent with any other account information, that if the underlying partnership has on file for the beneficial owner, okay? And this was very often missed, and therefore it was not valid and that caused all sorts of problems. So with the new version of the form W-8IMY adds a checkbox to simply make this representation. It being on the form, the idea is that if it applies, you just check it off and you're done. Very convenient.

Let's move on. W-8ECI, we're not going to spend any time on. Okay. Just very quickly. So 1446(f) requires 10% withholding on gross proceeds from the sale of PTP. And not PTPs. There is something that's called backstop withholding by the partnership, which means that if the transferee does not do the withholding, then it is the partnership itself that is required to do the withholding. In August, 2021, IRS released notice 2021-51, which defers the applicability dates of these things. So now these withholdings- And again, I'm not talking about all 1446(f) withholding, that already is relevant right now. But the specifically 1446(f) withholding on the transfers of PTPs and distributions made with respective PTP interests, and also withholding what we call backstop withholding under 1446(f)(4) by the partnerships themselves, if the transferee did not properly withhold, all of that withholding is deferred for another year until January 1st, 2023.

Okay. We're not going to spend time right now talking about the lag method. I think we alluded to it before. It's still alive and well. You can still elect it. No problem. If you want to understand what the lag method is and how it works and how the changes would be impacted in the year of transition, please go through the slides, they are self-explanatory. And now let's come to this. This is important. This is brand new, okay? So in October, 2021, the IRS released what's called a data integrity tool, okay? And here's the website right over here. And what this does, this is not mandatory. It's a software program that was developed by an outside vendor, and it's totally free.

And the idea is to allow withholding agent to test its data that it's about to submit to the IRS electronically, to see if certain things are just don't make any sense. I'll give you an example. If you're using code that claim no withholding because of a treaty, and the country is a non-treaty country like Cayman, then that's an obvious error. And this tool will reject that. And the idea is that instead of the IRS receiving all of these forms and rejecting them and having all sorts of audit and compliance issues, the user the withholding themselves should be able to use this tool. The withholding agent can input this data using any one of four different methods over here. They can use it to file, that's currently required by the FIRE system, CSV spreadsheet. And there are other ways to do this. The small files are processed less than a minute. The withholding I should receive notification. And then the error checking results is ready for download, and you download it.

And then there are certain error codes, and you can start looking at them, I guess similar to what we have in electronic final rejections. But the important thing to understand is that I think it works through an IRS website, but this is not really the IRS. So the tool can be used as many times as necessary, but it's just a tool that you use. After 90 days, this disappears. The IRS tracks only summary statistics, but will not track anything that's entered into this tool. So important to understand what this does and what it doesn't do, or more specifically what your responsibilities are. This does not change your responsibility withholding it to form 1042-S. What it does is it gives you an electronic tool to enable you to have more accurate reporting. Very good idea.

I can tell you though, that if you go into the system, it does not allow third party users to go into the system. You have to enter in. It has to be you. The withholding agent has to go into it. Similar to the FATCA portal. So that might be somewhat of limitation, but anyway, it's available for your use. And now we come to the next polling question, much simpler than the previous ones.

Okay. We have an overwhelming majority that say yes. For those of you who answered no, that's probably the wrong answer. But maybe not, maybe you're very up to date with this. Let's dive into this schedules K-2, K-3. Okay. So K-2 is at the partnership level, K-3 is an allocated version similar to a K-1, being an allocated version of the schedule K. And now, as far as we know, 2021, we're up and ready to go. Do not seem to be any talk about any series, talk about delaying this. So this is upon us. Okay. What does Schedule K-2 do? Like I alluded to before, it reports items of international text relevance, replacing the former line 16 and also all the other wild west footnotes. Now we have a standardized format. And the idea is to be clear that everybody should be reporting, partnerships should be reporting completely what all of their partners need in standardized format that will enable better compliance both in the part of the taxpayers, as well as on the part of the IRS in examination.

Okay. Now very important. This is an overwhelming form, okay? So what I'm going to tell you that's probably most valuable, we're not going to get into the nitty gritty, this number goes in this box. That's not what we're going to do today. The most valuable thing that I can tell you is to study the form carefully and to make a determination as to which part you need to complete, not all parts and all sections need to be completed by everybody. But let's start off with the basic. Who needs to file this all together? Any partnership that has any partners that have any items that are relevant to the determination of your tax or withholding reporting obligations, okay? It's going to be almost everybody. Even if you don't have foreign transactions and probably even if you don't have foreign transactions or foreign partners, certain sections, you won't have to complete, but the form as a whole will be relevant to you.

Okay. Now this is important. Many of the parts is to be completed only if the partnership has a certain type of partner. Now, you know generally what kind of partners you have directly, but this includes indirect partners through other pass through entities with a certain tax profile. So how are you supposed to know that? And this is key over here. The notice, the IRS said that they are aware that the filer may not have systems or procedures in place to obtain information about its indirect partners, or maybe even about its partners, okay? Or to have to complete the part. And what they're saying is that unless the Schedule K-2, K-3 filer has specific knowledge to the contrary, it must file complete certain parts, assuming that the information would be relevant to the partner and the shareholder. That is an extremely burdensome approach, okay?

Now, under the notice, there's a transition period that the filer will not be subject to penalties, if it establishes to dissatisfaction of the commission that it made a good faith effort to comply. And what does that mean? What's a good faith effort? Well, the IRS will assess the effort that the filer made to obtain this information and the reasonableness of any assumptions taking to account the relationship between the K-2 filer and its partners or shareholders, okay? So for example, if you have a partner that owns more than 10% that might weigh on that determination.

So, what I'm going to tell you over here is that there's a strategic decision to be made. Either you want to go full blown and to complete every single part of this, which is extremely burdensome, or you're going to either have to whittle it down to saying we don't have these kinds of partners, and you might consider, and you might weigh going back to your partners and asking them, "Do you have any of this? Do you have any need for this kind of reporting? Are you a partner? Do you have any indirect partners to the best of your knowledge that have this certainly US tax profile?"

And you can't quote me on this, I'm just expressing my opinion right now. If you send out this request to your partners, it seems to me, Jay Bakst, that that is a reasonable effort to get the information, even if they don't respond to you. But again, that's a strategic decision that needs to be made. And I think it should be documented also. Who's taking responsibility for making the determination of, if you have this partner, this type of partner profile or no? Okay. Let's dig in over here. So the form starts out with a summary. Does this part apply? Yes or no? If so, complete these final part.

Now, the first part over here has 12- This is information that's not reported anywhere else. You're supposed to check if this is relevant and then instructions tell you what to do, okay? I'd like to point out to you what I think is the most relevant over here. And you could miss this easily, okay? So from my perspective, an investment partnership should be, the most common boxes that are going to be checked, are box four, which is required the partnership paid foreign taxes, must be completed. And there's other things to me, the instructions tell you what to do if you've paid foreign taxes. Box five, and this is an easy one to miss, okay? Box five says, high tax income. Oh, I don't have any high tax income. As a matter of fact, I don't have any foreign income that was subject to a foreign tax. That does not mean that you're not required to complete. If you go into the instructions, the instructions will tell you specifically if you had passive income and which investment partnership does not. You have to complete this.

And there's even in the information that needs to be reported in respect of this. There's even a category that says passive income that was not subject to any withholding, okay? So clearly this is something that can be missed. I want to call to your attention. Boxes seven through nine are just if the partnerships file certain forms, 8858, 5471, 8621, 8865, they have to check the box and attach those forms to here. This would only apply to a US partnership because foreign partnerships do not file these kinds of forms.

Let's move on. Okay, part two. Now, one of the very frustrating things about this form is that it will appear that a lot of the information that's being asked is duplicative. For example, this part two goes through basically all your items of gross income and expense, and it asks you to categorize them, okay? At the same time, part 10, I think it's part 10, maybe part 11, will do something that appears to be the same but it's with a different concept, okay? These parts over here are modeled after the ultimate reporting that the partners are going to have to do. So, in this case, part two is going to model what the individual is going to have to- The tax credit is going to have to complete form 1116 or corporation form 1118. And the information is in the same format as that, okay?

And this needs to be completed. Even though the partnership does not have indirect partner, it must be completed if there is a direct partner that's eligible to claim a foreign tax credit, okay? That means that even if the partnership does not have foreign taxes, or maybe not even foreign source income, okay? Or not even foreign source income, still, it could be relevant because if you do individual taxes and you complete the foreign tax credit, you have to bucket your income from all sources as being foreign versus not foreign, including through a partnership. So, it doesn't really matter that you don't have foreign taxes or maybe not even foreign source income. You have to complete this part, okay? And one of the other things IRS is finally cracking down on is this business of where the country code, where we were all guilty of this, right? Line 16. We would put in various other country, OC attached, available upon request. IRS specifically in the instruction, say, you cannot do that. You have to list them by country.

And by each country, going back to here, if you go back to the income form of this, see this A, B, C? This A, B, C is for each and every country. And if you need, if you add more than three countries, you have to provide a duplicative form to this and give it in the same exact format as this basic form. So again, a lot more resources are going to be required to do this. And the information gathering process should take this into account.

Let's move on. Section K-2, K-3. Okay. So here part three, we're going to have section one RNA, not really going to be applicable in most private equity funds, or most hedge funds either. Interest expense apportionment, okay? The factors that are applicable for partnerships with corporate individual partners with 10% or more direct of indirect interest in the partnership. This is a very complex section to complete. And you have to really parse through this, make sure that you really do have interest expense. And it's not just some bench charges or fees that are treated that might be presented as interest expense, but not all really because it's a bear to complete.

Let's move on. Section three. And by the way, I see one of the questions is what type of the profile of the tax partners that we're talking about. We're going to see very soon. So here, section three. Perfect example, okay? This is FDII portion of factors. Applicable for partnerships with domestic corporate partners eligible for the FDII deduction. There you go. If you don't have any domestic corporate partners direct or indirect, you don't have to complete this.

Section four. Required if the partnership has foreign taxes paid or accrued during the year. You have to attach a statement with the dates that the taxes were paid or accrued and the exchange rates used, okay? That means each date, each payment of foreign taxes. We're not used to this kind of detailed reporting. It's not going to be required. Section five over here deals with if you have a 743(b) adjustment, which we're not going to go into. But basically, if you have a mandatory step-down adjustment, or even not mandatory, if you made a 754 election, and that impacts your reporting, that asset that was step-down has some sort of tax realization event during the year, could be depreciation, it could be a realization of a portfolio company, then you have to complete this section as well.

Moving right along, section four. Okay. This is talking again about foreign derived intangible income. Now I will go on a limb over here. I will say that most funds do not have corporate US domestic partners that will be eligible for FDII. I'm not saying that none do, but if we're talking about the investment partnership world, most will not. So I think that your first way to address this is to really try to say, "Do we have? Are we comfortable? Can we verify one way or another that we don't have these partners and not have to fill this out?" And this of course is tracking form 8993, that the ultimate beneficial owner or the partner will need to use in order to claim this if they're eligible for it. It just explains what FDII is briefly. Again, very rare that a domestic corporation is going to invest in a fund.

Okay. Part five. This is one of my favorite parts. I'm saying that sarcastic because it's half a disaster. What I mean by half a disaster, it is really not clear who has to complete this. So, what do we know? What is this all about? This part five deals with distributions from foreign corporations to partnerships. So the idea is over here to enable the partners that have PTEP accounts, that's previously tax earns and profits from patrol foreign corporations, to keep track of their PTEP accounts, and not double up on the income as the income is distributed from the foreign corporations to the partnership. And also to report foreign currency gain or loss under section 986(c) with respect to that distribution.

So clearly, if you have a partner, direct or indirect, that is a 10% shareholder of a CFC, you have to complete this. And that makes sense. And even the instructions to the form also reference certain schedules, 5471, Schedule J, 5471 Schedule Q and R. We'll see in some of the other parts. And that is evidence that the IRS has in mind 10% your shareholders of CFCs, which is not to say that it applies to every single distribution from every single foreign corporation to a partnership. In addition to that, we also- Okay, there's Section 245(a) to claim a dividend received deduction. Again, that's only for domestic corporations that own certain percentage, not going to be very relevant.

These instructions also suggest that this section should be completed for distributions from PFICs to enable partners that have made QEF elections determine the amount of their dividend income from a company distribution that should be excluded under section 1293(c), right? Because if you made a QEF election, you've picked up the income already, and now that you're receiving the distribution at least through the partnership, you shouldn't have to pick it up again.

So again, that makes sense over here. What doesn't make sense is that if that was the intention, then why is there no box over here to check off that this is from a PFIC, right? It doesn't say over here. So I guess maybe if you made a QEF election, you would know the name of the foreign corporation in respect to which you made the election, and therefore you would know this would be useful. But the instructions are unclear as to whether this part needs to be completed for partnerships that are invested in non-CFCs, in non-PFICs, or if they have less than 10% partners. I can go either way with this. I can argue either way with this. Just realize and understand that if you're going to really expand this to what this literally says, you're talking about a hedge fund that invests in foreign securities and has dividends from there. That this schedule could be endless.

And how would you even get the information as to the spot rate and the distribution in US dollars? And you anyway have whatever you need to report on the foreign source dividends in other forms. So it really doesn't make a whole lot of sense to me. Personally, I think that this part and the instructions were very poorly conceived as a hodgepodge of everything, but it leaves questions at least in my mind.

Let's move on. Part six is your basic Subpart F and GILTI inclusions, okay? This is information that the partnership is going to pass through to its 10% or more US shareholders, okay? Which I'm going to tell you once again, very important. If you know that you don't have any 10% US shareholders as partners directly or indirectly in any CFC in which your partnership is invested, then you don't have to complete this, right? And the question is, how do you know that? Again, back to the discussion that we had before. I'm going to go out on the limb over here, I'm going to say that I think the majority of funds nowadays are foreign funds. Even though there are plenty of US funds out there, but over the last 10, 15 years, people have wisened up to not creating CFC status. They've used Cayman partnerships to organize their investor pool. And therefore it's going to be relatively uncommon that a foreign partnership will have an investor in it, a partner in it that owns 10%, not just of the fund itself but also of an underlying CFC.

So, you could probably hopefully in most cases, not have to report this. But if you do have to report this, if you cannot eliminate the requirement to report this, then what you're going to have to do is you're going to have to report it as if everybody is a US shareholder. Okay. I see that we are running a little short on time. Let me just talk very briefly about PFICs over here.

So, you have over here two sections. And this is nothing new over here, but in the next section, what is new over here is that you have to report Section 1291 and other information the very same way. It doesn't matter that you think that your investors made QEF elections. The instructions are pretty clear that you need to report two sets of information side by side, QEF information for those investors that made the QEF election and 1291 information for those who may have not. And this is going to be very burdensome. There's a lot of information over here. Distributions the last three years, apparently that this is required no matter what. Start gathering the information now.

Let's move on very quickly. Section 960. This is only going to be relevant to again 10% shareholders of CFCs that want to claim a foreign tax credit for the CFCs foreign taxes that they paid. Okay, we're going to skip over this BEAT because it's not going to be very applicable, a certain type of profile partner that's going to be very rare. And let's come now to this Schedule K-2, K-3 part 10, okay? Here we want to spend a little bit of time. Not that we have much time, okay? Here, this is foreign partners characterization and source of income and deduction. So basically you take all of your income and expense items, and they're basically broken out in category similar to your Schedule K-1 and you allocate it between partner determination and partnership determination. And within partnership determination, what is ECI, US source and foreign source, pretty rare foreign source, and not ECI, US source for that, US source other, or foreign source, okay?

This income section is going to be relatively easy to break out. The next section of deduction and losses is more complex, because really what this is getting at is, this is getting at what deductions that you have that are directly allocable to your ECI. And only to your ECI, because as we know-

Okay. As expected. Yes, I realized that we've went through a lot of these things very quickly, but please go back and view the slides. I just want to finish off. I'm going to take more than another two or three minutes. So those of you who want to bear with me, the point that I was making before over here about these allocable expenses is that there's no such a thing as a deduction that goes against the data, okay? So there's really no reason that the IRS should be requiring this. Point of this section two is to really parse through what deductions are going to be allocable directly to ECI. And then there are certain deductions that are made at the partner level, and it's not directly, so you have to be allocated and apportioned. And in section three, you need to provide all sorts of data that ratios that are already in existing law that allow a partner at their level to allocate and apportion deductions to ECI. And that's going track form 1120-F Schedule H.

Okay. So that's basically what this is. And then we're going to skip over part 11. It's going to only really applies to PTPs. Schedule K-3 is of course the K-1 form. Okay, this is the last part over here, okay? Section is relevant if the partnership is directly or indirectly engaged in the conduct of US trade or business and had a foreign partner, if either of the following took place, either the foreign partner transferred his interest in the partnership, or if the partnership directly or indirectly transferred his interest in an underlying partnership that is engaged in US trade or business, right? So either way, the new section 1446(f), or I should say 864(c)8, it requires a certain amount to be treated as ECI. And where are they going to get the information from? They're going to get the information from the partnership, which is going to be in this section over here. You either have it or you don't. This is only part of Schedule K-3, not part of Schedule K-2.

And with that, I thank you very much for listening. I'm sorry that we didn't have a chance to go through everything. But again, the slides basically give you a lot of important and relevant information. Review them at your leisure. And thank you very much for joining us today.

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