spillinthebeans logo550

Interaction of Interest Expense Limitation with ECI Expense Allocation for Inbound Investment Partnerships

As tax laws seem to multiply with each enacted legislation it is rare that they get easier to comprehend.  In fact, it is more likely that the existing framework remains in place while new layers of regulations are added to accomplish the most recent goals of Congress. This constant layering tends to ignite a friction of complexity, if not a brushfire of confusion, in determining how the old and new rules apply and potentially interact with each other.

One such area arises with the recent change to Section 163(j) in the context of foreign investment in US partnerships. The change in Section 163(j)’s interest deduction limitation brings with it many disruptions in the previously settled thinking around how partnership level expenses are classified and reported by the partnership, whether they are deductible in the current year, a future year or at all and by whom, related partner basis implications, a new group of defined terms and disclosures and reportable items that need deciphering, as well as some other interesting items, not the least of which is how a partnership with foreign partners determines its withholding requirements with respect to the foreign partners. This last item is what we focus on below.

As a general and high-level refresher, under Code Section 163(j)(1), as recently amended by the Tax Cuts and Jobs Act, the deduction for business interest expense cannot exceed the sum of (1) the taxpayer’s business interest income for the year; (2) 30% of the taxpayer’s adjusted taxable income for the year; and (3) the taxpayer’s floor plan financing interest expense. This limitation only applies to interest that is properly allocable to a trade or business.

Consider a US real estate investment partnership with some foreign partners that has interest expense allocable to its trade or business (not an “electing real property trade or business”) and is therefore subject to Section 163(j) deduction limitations. Once the partnership determines its deductible interest expense based on the rules above it includes that expense accordingly to reduce its reportable US trade or business income for tax purposes. Any interest expense that is otherwise limited by Section 163(j) in a given year is reported to the partners as an item separate from their respective shares of the partnership’s aforementioned US trade or business income. Notably, this limited interest expense amount will never be reported as a deduction by the partnership in arriving at US trade or business net income in the future. Once it is determined to be disallowed at the partnership level it becomes an item that is tracked at the partner level where it may become a trade or business deduction (at the partner level) in a future year. This multi-tiered approach to determining the deductibility of partnership expenses or losses is not uncommon in partnership taxation (e.g., Sections 704(d), 465 and 469 all have dibs here). This Section 163(j) newcomer however introduces the potential to alter cash flow at the partnership level because of its impact on a partnership’s annual withholding requirement with respect to its foreign partners.

Very generally, a foreign partner in a US partnership is attributed the partnership’s US trade or business activities and is subject to US tax at graduated ordinary income tax rates on their distributive share of the income effectively connected with such US trade or business (“ECI”). Expenses that are properly allocable to the ECI reduce the net taxable ECI to a foreign partner. The IRS’s collection of the tax on the foreign partner is enforced through required withholding by the partnership in the year the ECI is recognized and allocated by the partnership under US tax principles.

When Section 163(j) applies to limit interest expense of a partnership that has foreign partners an interesting and transitory complexity arises since withholding on ECI is determined and remitted by the partnership while the determination of the deductibility of a portion of the partnerships interest expense (which reduces ECI) is made at the partner level and not even in the same tax year. In our view, a question arises as to whether the partnership factors in the disallowed interest expense in calculating a foreign partner’s ECI that is ultimately subject to US tax withholding.

If the answer is no, then the partnership would determine its current year withholding liability based on ECI without considering the interest that is subject to the Section 163(j) limitation. With no clear mechanism at the partnership’s disposal to carry forward that limited interest to reduce future withholding liabilities, the partnership may be remitting more tax on behalf of the foreign partner than the partner will actually be incurring in liability since the partner may eventually get the benefit of the interest expense that is limited. Notably, when a partnership remits tax to a taxing jurisdiction on behalf of one of its partners it is treated as though the partnership is making a distribution to the partner under the governing LPA or LLCA (i.e. tax distribution). Implications to the partnership include potential overdistribution of cash on behalf of its foreign partners compared to other partner groups and the related basis and cumulative distribution tracking complexities that result. Additionally, the foreign partners might not be aware that the partnership is essentially overpaying tax for them when claiming the withholding on their personal filings. More savvy foreign partners may realize the overpayment issue and pursue refund claims in future years, but at the cost of potentially burdensome and time consuming filings.

If the answer is yes, however, the partnership would reduce ECI by the interest limited that is allocated to the foreign partner and consequently withhold less US tax in the current year, which could require the partner to come out of pocket to make up any current year withholding shortfalls with no guarantee that the withholding short-fall will be corrected through future withholding. Additionally, by taking this position, the partnership may have penalty liability for inadequate withholding and unpaid tax.

In any event, the Section 163(j) rules layer on significant complexity when applied to partnerships with foreign partners doing business in the US.  By introducing a multi-tiered landing spot for partnership sourced deductions while still requiring the partnerships to sort out the withholding requirements which are partner centric, uncertainty is created with respect to cash-flow at both the partnership and partner level.  Since these Section 163(j) rules are relatively recent, having been enacted as part of a massive legislation with minimal history, their application in the ECI context necessitates a careful study and understanding of how the ECI rules and other Code Sections interact. Various Treasury Regulations in the ECI expense allocation rules, the ECI withholding tax rules, general interest expense allocation rules, and analogous Code provisions offer support for a position that is favorable to the foreign partner taxpayer while also providing reasonable support for the partnership that is primarily liable for the tax.

704beantown advisers, LLC is keenly focused and interested in these topics. Contact us for more information.

Disclaimer

* The information contained on this page is not intended to be relied upon for tax advice. For Tax Advice please contact us directly.
background t5

subscribe sample

855 Boylston Street | Suite 10 | Boston MA 02116 | 857.263.5656