In brief

What happened?   

The Tax Court on November 15 released its long-awaited decision in YA Global v. Commissioner, 161 TC No. 11, concluding, among other things, that a foreign partnership (YA Global Investments, LP, the “Fund”) was engaged in a US trade or business (USTB) that generated US-sourced income effectively connected to that US trade or business.   

In summary, the Tax Court held that (1) the activities of the fund manager are attributed to the Fund for purposes of determining whether the Fund was engaged in a USTB; (2) the Fund was engaged in a USTB; (3) the Fund was a dealer in securities under Section 475 because it engaged with “customers;” (4) the Fund’s income was from US sources and constituted income effectively connected to a USTB (ECI); (5) the Fund was required to withhold on the foreign partner’s share of ECI without reduction for certain expenses of that partner; (6) the statute of limitations was not started by reason of its limited filings; and (7) the Fund did not demonstrate reasonable cause with respect to the matters above, subjecting it to penalties. 

Why is it relevant? 

The holdings and analysis in this case are limited to the unique facts that the Tax Court addressed. The Court’s decision focused heavily on the nature of the income earned by the Fund. The fees at issue were unusual and represent one of the key distinctions that will distinguish the decision from other situations. 

Actions to consider:  

Asset managers should understand the case's facts and the matters on which the Court ruled to address questions that may arise from investors and internal stakeholders. Going forward, partnerships with foreign partners or Offshore Feeder Funds may want to consider filing a “protective” Form 8804, Annual Return for Partnership Withholding Tax (Section 1446), in situations where there is no Section 1446 tax liability to start the statute of limitations with respect to the Form 8804 obligation. While this is an additional expense, where there may be sufficient risk of a USTB and ECI subject to withholding, it may be prudent to file the protective return to start the statute but also potentially protect against penalties if it is later determined the original assessment was incorrect.

Section 475 dealer status

The Tax Court held that the Fund was a dealer in securities for Section 475 purposes. In reaching this holding, the Tax Court concluded that (1) the Fund regularly bought securities from portfolio companies and (2) such portfolio companies were its “customers.” As a result, the securities it held should have been marked to market annually, resulting in the recognition of annual ordinary gain or loss. 

Observation: The Tax Court’s rationale could raise a concern that all regular investors or traders who hold themselves out as willing and able to purchase securities may be viewed as Section 475 “dealers” interacting with customers. It is worth noting, however, that the Court did not overrule other relevant cases concerning dealer status. Considering these authorities, taxpayers should evaluate YA Global in light of its facts – that is, a situation in which a stock distributor bought shares at a discount and sold them on the market to capture the spread. Funds concerned under the existing law authorities could consider a “protective” Section 475 identification for all its securities as held for investment to protect against a broad application of dealer status across a fund’s entire portfolio.  

Source of income and ECI 

In its determination of the source of income and ECI, the Court held that the Fund’s gains (attributed largely to the sale of stock acquired at a discount) were from US sources because the Fund had an office in the United States. For this purpose, the investment manager’s office was attributed to the Fund, because the Court found that the manager was not an “independent” agent. This last conclusion rested on the fact that the manager had no other clients; it does not address other cases in which the Court held that an agent could be independent notwithstanding that the agent had an extremely limited customer base. 

Withholding on ECI 

Section 1446(a) requires a partnership to pay a withholding tax on the portion of any ECI allocable to a foreign partner. Regulations allow partnerships to rely on certifications provided by foreign partners to substantiate non-partnership deductions available to reduce the taxable income attributable to their US businesses (and thus the amount of tax required to be withheld). The Fund’s foreign partner incurred expenses with respect to its investment in the Fund. The Fund asserted that its Section 1446 withholding tax liability should be decreased, taking these deductions into account. The Court observed that there is a procedure by which the offshore partner’s expenses could have reduced the Fund’s withholding obligation, but that, because this procedure was not followed, the Fund’s withholding obligation could not be reduced by any expenses of the foreign partner.  

Observation: Partnerships (and the foreign partners subject to Section 1446 withholding) wishing to include non-partnership deductions in the computation of withholding taxes (i.e., deductions incurred at the foreign partner level) must follow the procedures of Reg. sec. 1.1446-6. The procedures provide, among other things, that the foreign partner will provide a certificate (with valid documentation) via a Form 8804-C, Certificate of Partner-Level Items to Reduce Section 1446 Withholding, to the partnership to substantiate the deductions against ECI that the partnership may include in computation of the withholding tax liability. The certification is to be provided before the partnership prepares the Form 8804 for the tax year. Additionally, the foreign partner must file a valid US tax return for the year, in order for deductions to be applied at the partnership level. Certain partners and foreign funds may consider providing a Form 8804-C on an annual basis to protect the ability to apply deductions against ECI at the partnership level. There are specific requirements under Reg. sec. 1446-6 if this is the first year the foreign partner is providing a Form 8804-C, in particular that valid returns are required for the three prior years, if applicable. 

Statute of limitations and penalties 

Although the Fund filed Forms 1065, U.S. Return of Partnership Income, reporting its income and losses for each of the relevant years, it did not file Forms 8804 to report any withholding taxes due. The Fund argued extensively that the Forms 1065 and Schedule K-1s contained the necessary information for the IRS to assess the Section 1446 liability, but the IRS argued and Court held that (1) the Forms 1065 were not sufficient to establish the partnership’s Section 1446 tax liability and were not a substitute to Forms 8804, and (2) the partnership did not meet its burden of proving that the failure to file the Forms 8804 and pay withholding tax was due to reasonable cause. The Fund, therefore, was subject to a 25% penalty for failing to file Forms 8804 without reasonable cause. The Court further held that the statute of limitations begins to run from the date the appropriate tax form was filed. Given that the Fund did not file Forms 8804, the statute of limitations never began to run.  

Observation: Many non-US corporations (Offshore Feeder Funds) historically have filed protective returns (i.e., Form 1120-F, U.S. Income Tax Return of a Foreign Corporation) pursuant to Reg. sec. 1.882-4(a)(3)(vi) to preserve the right to deductions if the IRS ultimately determined that such corporation was engaged in or invested in a partnership in a USTB. Despite a view that the entity or fund was not engaged in a USTB and/or qualified for the US trading safe harbor, the protective return would be filed based on the potential risk and uncertainty. The decision in YA Global highlights that Form 8804 is a separate return and filing requirement under a different statutory provision and neither the filing of the Form 1065 by the partnership nor the filing of the protective Form 1120-F would be considered sufficient to start the statute of limitations with respect to the Section 1446 withholding tax liability reported on Form 8804. In addition, given the substantial underpayment as no tax was reported, the IRS could assess tax for up to six years under Section 6501(e) even if a return were filed. Going forward, many partnerships with foreign partners or Offshore Feeder Funds may consider filing a “protective” Form 8804 in situations where there is no Section 1446 tax liability to start the statute of limitations with respect to the Form 8804 obligation. While this is an additional expense, where there may be sufficient risk of a USTB and ECI subject to withholding, it may be prudent to file the protective return to start the statute but also potentially protect against penalties if it is later determined the original assessment was incorrect. In the YA Global case there was discussion of existing case law and what is considered a valid return, including those filed demonstrating a reasonable, good faith effort to comply with existing tax law. As such, a blank Form 8804 with all zeroes and no explanation may not be considered sufficient. Therefore, it is advised to attach a statement that describes the activities of the entities and the reasons for filing the protective return, similar to what is required under Reg. sec 1.882-4(a)(3)(vi). 

Observation: The Fund in the case was audited by the IRS under the procedures of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). As such, any taxes covered under Subtitle A of the Internal Revenue Code, including income taxes (and ECI) under Chapter 1 as well and withholding taxes under Chapter 3 could be reviewed and assessed under the examination of the partnership. It should be noted that the Bipartisan Budget Act (BBA) Centralized Audit Regime,2 as written, only covers Chapter 1 income taxes for partnerships. As such, it does not appear that the IRS can review Chapter 3 withholding taxes under the BBA and instead would need to open a separate Chapter 3 audit of the Fund to establish liability for the withholding taxes.