Treasury and the IRS have finalized regulations under section 871(h) that apply an aggregate concept to determine whether U.S. source interest received by a partnership is “portfolio interest” exempt from withholding tax. The final regulations adopt the aggregate approach and may apply retroactively to interest paid in prior years.
Under sections 871 and 881, nonresident alien individuals and foreign corporations are subject to 30 percent withholding tax on certain fixed and determinable annual or periodical income (“FDAP”) from U.S. sources including interest paid by a U.S. borrower. The tax is collected or withheld by the withholding agent. Under a statutory exception, the 30 percent withholding tax does not apply to “portfolio interest,” defined as interest otherwise subject to 30 percent withholding tax that is paid on a registered obligation provided the beneficial owner of the interest provides documentation showing that it is not a U.S. person. Interest paid on a bearer obligation may also qualify as portfolio interest provided there are arrangements reasonably designed to ensure that U.S. persons will not acquire the obligation, interest is payable only outside the United States and the obligation has a statement on its face that any U.S. person who holds the obligation will be subject to limitations under U.S. income tax law.
Among other things, portfolio interest does not include interest received by a 10-percent shareholder or a 10-percent partner of the borrower (“related person interest”). The section 318 ownership attribution rules (with some modifications) apply in measuring ownership under this rule. Prior to the issuance of regulations, it was not clear how the related person interest test was to be applied with respect to interest received by
The Final Regulations
The final regulations generally follow the proposed regulations. The regulations determine whether interest received by a partnership is related person interest under the aggregate theory of partnership taxation. Thus, the related party interest test applies at the partner level and each partner is considered to own a pro rata share of what the partnership owns. The final regulations clarify when the test is applied: when any distributions that include interest are made or, to the extent a foreign partner’s distributive share of interest has not been distributed, on the due date for filing the Form K-1 for the year in which the partnership recognized the interest income (or the date such form is actually mailed, if earlier). This timing rule is consistent with general provisions in the section 1441 regulations.
The final regulations are effective for interest paid after April 12, 2007. Taxpayers may also apply the regulations to interest paid in any open year provided they do so consistently for all relevant partnerships during such years. This effective date represents a significant taxpayer victory over the proposed regulations’ prospective effective date (applying only to interest on obligations issued after finalization of the regulations).
The most significant provision in the final regulations is the retroactive effective date allowing taxpayers to apply the aggregate approach to interest paid on all outstanding obligations. Treasury and the IRS should be commended for responding to taxpayer critiques of the proposed regulations’ prospective effective date. Still to come perhaps is guidance on application of the 10-percent shareholder test where a partner’s interest in the partnership varies during the year or where the partners have different shares of different classes of income.