The investment management industry has been significantly impacted by new tax reporting requirements this filing season. As we approach the September 15th extended filing deadline, that pain only becomes more apparent for fund of fund structures. Wolf & Company’s international and investment management tax teams have been implementing many changes to ensure clients are ready for these new reporting requirements.
As we reported previously, in June 2021 the Internal Revenue Service (IRS) released final versions of two new international-related schedules to be included as part of 2021 pass-through entity tax returns:
- Schedule K-2, Partners’ Distributive Share Items – International
- Schedule K-3, Partner’s Share of Income, Deductions, Credits, etc. – International
These new schedules were designed to be attached to Schedule K-1 to provide more clarity for investors on how to calculate their U.S. income tax liability, as well as international information reporting requirements. The IRS provided some first-year relief from filing if partnerships or S corporations had no items of international relevance. Given the nature of the investment management industry, this exception would not apply. Most funds have foreign investors or foreign taxes paid on dividends that would require the completion of these forms.
Since our February article, many questions have been answered regarding these filings. Below we will summarize key questions and trends that we are seeing in the investment management industry leading up to the September 15th extended filing deadline.
Common Questions Concerning Filing Requirements:
Who must file?
At the outset, the IRS determined the forms should be completed by pass-through entities with items of “international relevance.” This was met with varying degrees of interpretation in the tax community.
The IRS subsequently released updates and amendments in late January of this year clarifying that a pass-through entity with no foreign partners or shareholders, no foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued would still need to complete Schedules K-2 and K-3. Despite having only domestic operations, the information contained in the Schedules K-2/K-3 is used to assist partners/shareholders in completing Form 1116 or 1118 and calculate their applicable foreign tax credit.
As a result of this clarification, pass-through entities would be required to provide Schedule K-3 to partners and shareholders unless notified by all that the information is not needed to complete any foreign tax credit filings. This results in nearly all investment funds being required to file.
Does the limited relief exception apply to investment funds?
Late in the unextended filing season, the IRS provided an additional exception for tax year 2021 that eliminated the need to file Schedules K-2 and K-3 for certain domestic partnerships and S corporations. To qualify for this exception, the following requirements must be met:
- In tax year 2021, the direct partners in the domestic partnership are not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts.
- In tax year 2021, the domestic partnership or S corporation has no foreign activity, including foreign taxes paid or accrued or ownership of assets that generate, have generated, or may reasonably expected to generate foreign source income (see section 1.861-9(g)(3)).
- In tax year 2020, the domestic partnership or S corporation did not provide to its partners or shareholders nor did the partners or shareholders request the information regarding (on the form or attachments thereto):
- Line 16, Form 1065, Schedules K and K-1 (line 14 for Form 1120-S), and
- Line 20c, Form 1065, Schedules K and K-1 (Controlled Foreign Corporations, Passive Foreign Investment Companies, 1120-F, section 250, section 864(c)(8), section 721(c) partnerships, and section 7874) (line 17d for Form 1120-S).
- The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021.
The exception is a bit unclear as funds are unable to demonstrate that they have “no knowledge” that the investors have requested that information given the small amount of time that the IRS has given us to assess eligibility for this new exception.
We also note that should investors notify the fund that they require the information contained in the Schedule K-3 for foreign tax credit purposes, the fund will need to furnish that information directly and complete those forms.
Finally, if the exception is limited to this one tax year, it is a limited fix for a larger issue.
If the investment fund has U.S.-sourced activity only, does it need to complete these forms?
Most likely, yes. A pass-through entity with no foreign partners or shareholders, no foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued would still need to complete Schedules K-2 and K-3. Despite having only domestic operations, the information contained in the Schedules K-2/K-3 is used to assist partners/shareholders in completing Form 1116 or 1118 and calculating their applicable foreign tax credit.
As mentioned above, limited relief was granted for the 2021 tax year. All pass-through entities will be required to complete these forms beginning in the 2022 tax year.
Delays in Reporting & Issues Unique to Investment Funds:
Are we seeing delays in Schedule K-1s because of Schedule K-3 reporting’s inclusion?
Yes, in addition to firms and funds requiring additional time to properly report the required income and expense information, the IRS has delayed the release of XML formats required for e-filing tax returns. In IRS FAQ 9, the IRS indicated that it worked diligently to get the new schedules available for filing season 2022 and that technical resource limitations prevented the IRS from implementing the XML formats. The XML formats for Form 1065 were just released in the past few weeks and we are still awaiting the XML format to be released for Form 1120-S. These XML delays have significantly compressed the electronic filing season for Forms 1065 and 1120-S.
What makes this more complicated for investment funds?
Investment funds have various types of income sources. These income items are broken down into general, passive, or sourced by partner/shareholder categories on Schedule K-2 and K-3. From there, these categories of income are also detailed by country. Fund administrators and tax advisors are working to summarize interest and dividend income by country and category for the first time this year. With investments across many countries, this can lead to a high volume of pages in the Schedule K-3s issued to investors.
What unique issues are fund of funds going to see this September filing season?
Fund of funds receive Schedule K-1s from many underlying investments. They will now begin receiving a Schedule K-3 along with the Schedule K-1 from all investments that are required to file the Schedule K-2. Unique issues because of this include:
- Delays in Schedule K-1 timing due to Schedule K-3 delays.
- Increased tax preparation fees due to the significant level of data being analyzed on Schedule K-3s from all underlying investments.
- Additional work required to summarize all Schedule K-3 data and prepare the combined filings at the fund level.
- Publicly traded partnership Schedule K-1s historically are issued in March and April. They are currently projecting September delivery dates for the Schedule K-3 that needs to be attached to the Schedule K-1.
What questions might my tax preparer ask about our investors?
Requests for copies of W-8s and/or W-9s may be the most common. Investors Forms W-8BEN, W-8BEN-E, W-8IMY, and/or W-9 should all be up to date and maintained by the fund. These forms are how U.S. vs. non-U.S. status can be confirmed.
Questions about Schedule K-3 & Changes to Schedule K-1 Investor Reporting:
What are the common sections that need to be completed?
|Part||Title||Areas of Reporting Covered|
|I||Partnership’s Other Current Year International Information||International information not included on the Schedule K-3 itself, namely 5471/8865/etc.|
|II||Foreign Tax Credit Limitation||Foreign Tax Credit|
|III||Other Information for Preparation of Form 1116 or 1118||Foreign Tax Credit|
|IV||Information on Partners’ Section 250 Deduction with Respect to FDII||GILTI/FDII|
|V||Distributions from Foreign Corporations to Partnership||Distributions from previously tax earnings and profits|
|VI||Information on Partners’ Section 951(a)(1) and Section 951A Inclusions||Subpart F and GILTI|
|VII||Information to Complete Form 8621||Passive Foreign Investment Companies|
|X||Foreign Partners’ Character and Source of Income and Deductions||Effectively Connected Income|
|XIII||Foreign Partner’s Distributive Share of Deemed Sale Items on Transfers of Partnership Interest||Schedule K-3 ONLY/1446(f) Withholding|
Can the fund file its tax return if it hasn’t received certain Schedule K-3s along with Schedule K-1s?
The fund could, but we do not recommend it. The information contained in the Schedule K-3 does not only relate to foreign information reporting requirements, but also contains the information needed to accurately calculate any applicable foreign tax credit. If the Schedule K-1 box labeled “Schedule K-3 is attached if checked” is checked, you should assume the Schedule K-1 is either in draft form or not complete until a Schedule K-3 is provided.
What foreign information reporting is not included on the Schedule K-3 that might still be in Schedule K-1 footnotes to investors?
The Schedule K-2/K-3 included only standardized reporting for Form 8621- Information Return by a Shareholder of a Passive Foreign Investment Company (PFIC reporting).
As such, the reporting for the following forms will continue to be included and disclosed via the Schedule K-1 footnote:
- Forms 5471 – Information Return of U.S. Persons with Respect to Certain Foreign Corporations
- Form 8858 – Information Return of U.S. Persons with Respect to Foreign Disregarded Entities and Foreign Branches
- Form 8865 – Return of U.S. Persons with Respect to Certain Foreign Corporations
- Form 926 – Return by a U.S. Transferor of Property to a Foreign Corporation
Why is there increased detail on the Foreign Tax Credit reporting?
The IRS indicated that the Schedules K-2/K-3 were updated to provide more clarity for investors on how to calculate their U.S. income tax liability, as well as international information reporting requirements. The form itself is designed to provide country-by-country level detail in the foreign tax credit reporting sections, as well as the GILTI reporting sections, which would be standard reporting under the changes proposed by the Build Back Better Act.
As we know, the Build Back Better Act is stalled – indefinitely at this point – so the foreign tax credit reporting updates appear to have stalled as well. While the detail is required for the Schedules K-2/K-3 we are not seeing this similar level of detail on any other reporting, such as in the Form 1099 space.
How do I prepare for country-by-country reporting of things like interest and dividends?
Currently, this is difficult. While some institutions will provide that level of detail, many others have not. Nearly all Form 1099 reporting packages do not include country-by-country detail regarding interest and dividends. This may require funds to maintain more country-by-country internal reporting data.
What is “sourcing by partner” vs. country on things like capital gains?
Generally, when sourcing income and deductions for reporting in Part II and III we use the U.S. sourcing rules to determine the source of that income. In instances where there are foreign partners – specifically, instances where there is the sale of personal property, the sourcing rules indicate that the partner must determine if that is a reportable piece of income to the U.S.
Capital gains of that category are sourced to the tax residence of the partner, so the Schedule K-3 is designed to specifically break out those items for foreign partners. Their tax advisors can then make the appropriate decision on reporting to the U.S.
Industrywide, practitioners and fund administrators have already spent countless hours adjusting internal processes to account for these increased reporting requirements and navigating this ever-evolving landscape. Though this first season has seen delays, the filing of many extensions, and various adjustments, the groundwork has been set for smoother reporting in the coming years.
The takeaway from this tax filing season is to be patient – tax practitioners and advisors are working within the confines of IRS timelines to file and provide information to funds and investors. In the meantime, the international and investment management teams at Wolf & Company are constantly monitoring IRS guidance in this space and working with clients to ensure that information required to complete these forms is ready for the September extended filing deadline.