Aggregate Approach for Domestic Partnerships Owning Foreign Stock
On Jan. 25, 2022, the IRS and Treasury issued final regulations on their approach to treat domestic partnerships as aggregates of their partners for purposes of Subpart F provisions applicable to U.S. shareholders of controlled foreign corporations (CFCs). Simultaneously, the IRS and Treasury released proposed regulations regarding the treatment of domestic partnerships and S corporations that own stock of passive foreign investment companies (PFICs) and their domestic partners and shareholders.
Under the present PFIC regulations, a domestic partnership or S corporation holding an interest in a PFIC generally would be responsible for reporting the PFIC on Form 8621, making the qualified electing fund (QEF) or mark-to-market (MTM) elections, and including in income the ordinary earnings and net capital gain with respect that that PFIC. A U.S. person owning an interest in a PFIC through a domestic partnership or S corporation is generally not responsible for directly reporting ownership in, making elections with respect to, or including income amounts from a PFIC.
The 2022 proposed PFIC regulations would deviate from the historical approach by generally requiring domestic partnerships and S corporations to be treated as “aggregates” of their partners for PFIC reporting, election, and inclusion purposes. Instead, the partners and S corporation shareholders would now be responsible for the Form 8621 reporting, the QEF election, and income inclusion. The partners or S corporation shareholders would also be responsible for notifying the partnership or S corporation through which they own a PFIC of any elections made so that the partnership can track relevant attributes that are impacted by those elections. Treasury argues that this aggregate approach is more consistent with its approach in the final Subpart F regulations.
The proposed PFIC regulations, if finalized in their current form, would add significant complexity and volume to investor reporting for certain domestic funds no longer able to make QEF or MTM elections at the fund level.
Tax Changes Effective for 2022
The Tax Cuts and Jobs Act (TCJA) of 2017 implemented a variety of tax changes that were scheduled to become effective in 2022. The CARES Act of 2020 introduced further temporary tax relief that will be expiring in 2022. President Biden’s planned tax legislation would have softened the impact of some of these provisions, which this article summarizes.
Bonus Depreciation Rules and Changes
The TCJA amended IRC Section 168(k) to increase the bonus depreciation from 50% to 100% for qualified property, and expanded the definition of qualified property to include the property eligible for bonus depreciation. The TCJA allows a business to immediately deduct 100% of the cost of eligible property in the year it is placed in service, through 2022. After that, the amount of bonus depreciation begins to be phased down over four years: 80% will be allowed for property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026.
Section 163(j) Limitation
IRC Section 163(j) limits a taxpayer’s deduction for business interest expense to the sum of (1) business interest income, (2) 30% of adjusted taxable income (ATI), and (3) floor plan financing interest. ATI is taxable income with certain adjustments. For tax years prior to 2022, there was an adjustment to add back to taxable income depreciation, amortization, and depletion. For tax years beginning after Dec. 31, 2021, a change in the Section 163(j) limitation goes into effect. Taxable income used in the calculation of the 163(j) limitation is no longer adjusted for depreciation, amortization, and depletion in arriving at ATI. This will result in a lower ATI and potentially an increase in the amount of business interest expense being disallowed.
Research & Development (R&D) Expenses
Under the TCJA, the current ability to deduct R&D expenses in the year incurred is being eliminated as of Dec. 31, 2021. President Biden’s Build Back Better Bill included a provision to postpone this change by five years; however, the bill’s failure to pass is leaving taxpayers with the original date provided by the TCJA. As a result, R&D expenses incurred in 2022 by calendar-year taxpayers are no longer able to be currently deducted and instead are required to be capitalized. The amortization period for R&D expenses related to work performed in the U.S. is five years, and for work performed outside the U.S. it is 15 years.
For private equity and venture capital funds, these changes could have a significant impact as the taxable income projections provided by portfolio companies may need to be adjusted to account for this change. This could also impact tax distributions as well as state and effectively connected income withholding at the fund level. Further, portfolio companies may be impacted from an earnings and profits perspective and as a result, this could change the amount of a distribution that is considered a taxable dividend.
NY Pass-Through Entity Tax (PTET) Refresher on Upcoming Due Dates
The NY PTET is an optional tax that partnerships or New York S corporations may annually elect to pay on certain income for tax years beginning on or after Jan. 1, 2021. A partnership or New York S corporation is eligible to make this election even if it has partners that are not eligible for the PTET credit.
Tax Year 2021
The PTET annual return and PTET extension for tax year 2021 will be available in early February and are due by Mar. 15, 2022. An electing entity was required to file its election for tax year 2021 by Oct. 15, 2021, but was not required to make any estimated tax payments for the PTET at the time. However, it may have chosen to make optional online estimated tax payments prior to Dec. 31, 2021. The mandatory payment is due by the due date of the return. Extending the due date of the return by filing an extension does not extend the date the payment is due.
Tax Year 2022
For PTET taxable years 2022 and later, the eligible entity may opt in on or after January 1, but no later than March 15 of the tax year. An electing entity must use the online application to pay estimated tax on the amount of the PTET calculated for the current taxable year. Estimated payments are due on or before March 15, June 15, September 15, and December 15 in the calendar year prior to the year in which the due date of the return falls. If the due date of the estimated payment falls on a Saturday, Sunday, or legal holiday, the payment is due on the next business day.
Each quarterly payment should be an amount equal to at least 25% of the required annual payment for the taxable year. The required annual payment is the lesser of:
- 90% of the PTET shown on the return for the taxable year; or
- 100% of the PTET shown on the return for the preceding taxable year.
If the entity did not opt in to the PTET for the preceding year, the required annual payment is 90% of the tax reported on the PTET return for the taxable year.
By having the partnership pay the tax on behalf of the partner rather than the partner paying it directly enables the partner to then deduct the full amount of their share of the PTET on their federal tax return, rather than being limited to $10,000 cap under the TCJA.
Foreign Tax Credit Regulations and Attribution Rules
On Dec. 28, 2021, Treasury published final regulations (T.D. 9959) following the release of proposed regulations (REG-10657-20) in Nov. 2020. The final regulations cover the requirements a foreign levy must satisfy to qualify as an allowable credit under IRC Section 901 as well as the replacement of the “jurisdictional nexus requirement” with the “attribution requirement.”
Historically, a foreign levy qualified as an in-lieu-of-tax if the foreign levy was a tax and substituted for, rather than added to, an income tax or a series of income taxes otherwise generally imposed by the foreign country. Under the final regulations, a foreign levy must satisfy the attribution requirement, to qualify as a net income tax eligible for a foreign tax credit under Section 901.
Under the attribution requirement, a foreign tax under IRC Sections 901 generally will not be creditable unless the foreign tax law requires sufficient nexus between the country and the taxpayer’s activities. A tax based on the location of customers or users would not be creditable under these regulations, nor would a tax based on the location of persons from whom the nonresident makes purchases. For a tax on nonresidents to be creditable, it must meet one of the three attribution requirements:
- Activities-based nexus: Attribution based on activities;
- Source-based nexus: Attribution based on source; or
- Property-based nexus: Attribution based on situs of property.
The foreign tax credit (FTC) rules and final regulations are very complex. For more details regarding the potential impact on your portfolio companies, please contact your tax advisor.
For More Information
For comments, questions, or more information, please contact a member of our PE/VC team.
Tracy Dalpe is a Tax Managing Director in New England and a member of the Private Equity & Venture Capital Practice. She can be reached at email@example.com or 401.626.3210.
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