Considerations for Asian Fund Managers under the U.S. New Partnership Audit Regime

by Akin Gump Strauss Hauer & Feld LLP
Contact

Akin Gump Strauss Hauer & Feld LLP

The Bipartisan Budget Act of 2015, as modified by the Protecting Americans from Tax Hikes Act of 2015, resulted in a fundamental change in the way the U.S. Internal Revenue Service (IRS) will conduct audits of collective investment vehicles treated as partnerships for U.S. tax purposes. In particular, it creates a liability at the level of a partnership for any unpaid tax. Thus, the tax burden falls on the current-year partners even if such tax is with respect to a tax liability arising in a different tax year when investors may not have been partners (much like shareholders in a corporation).

This new audit regime has significant implications to both U.S. and non-U.S. funds and fund managers.  It is likely to be a high priority issue for investors (coming up in comments to fund documents, side letter negotiations and fund diligence for secondary transfers) and, if not structured correctly, may have significant adverse consequences to managers and non-U.S. investors, otherwise not subject to U.S. tax.

You should continue to read if you are a manager of a fund that:

  • is a partnership or has a feeder that is a partnership for U.S. tax purposes (including a non-U.S. corporation that has made an election to be treated as a partnership)
  • has U.S. investors
  • files U.S. tax returns (particularly, partnership information returns and K-1s) or is required to file U.S. tax returns.

Key Points:

  • The new partnership audit regime is applicable to any entity treated as a partnership for U.S. tax purposes that is required to file U.S. income tax returns or actually files returns as a partnership for U.S. tax purposes. Certain partnerships (those with 100 or fewer partners where none of the partners is another partnership, a trust or a disregarded entity) can elect out of this new audit regime and be subject to audit separately at the partner level.
  • Under the new regime, audit, assessment and collection of tax are done directly at the partnership level (with some very limited exceptions). As a result, the partnership must pay the tax (and related interest and penalties) resulting from an IRS audit even though a partnership is not otherwise a taxpayer under U.S. tax law and even if it only generates income and gains from non-U.S. securities.
  • The new regime is effective for tax years beginning after December 31, 2017. Note that this effective date is for tax years subject to the new audit regime, meaning that a tax audit for 2018 may not occur until, for example, 2020. For tax audits for tax years before 2018, current law would continue to apply.
  • The new partnership audit regime would require amendment to the constitution documents of foreign funds, which are otherwise treated as partnerships for U.S. tax purposes and are required to file a U.S. income tax return (which requirement may still be applicable even if the fund only invests in non-U.S. securities), to ensure that the burden of any tax resulting from an audit falls on the appropriate investors and compliance with the requirements of the new partnership audit regime.
  • This is more of an issue for hedge funds (where investors may change over time) as opposed to private equity funds (where the same group of investors stay from inception until liquidation of the fund).

What should you do next?

The first step is to determine whether the new audit regime is applicable to any of the funds you are managing.  This analysis is relevant even if the funds are formed outside the United States, invests only in foreign securities and do not currently file U.S. tax returns as to new audit regime is also applicable to funds that are required to file U.S. returns (which requirement is determined under a set of complicated rules).

If the audit regime is applicable to one of the funds you are managing, the second step it to amend the fund documents to accommodate the new audit rules. In particular, the amendment needs to deal with the following three issues:

  • Provide for a Mechanism to Elect and Supervise a Partnership Representative. The fund documents need to have the correct procedure for the designation of a “partnership representative,” which has the sole authority to act on behalf of the fund in an audit situation with the IRS. In particular, the partnership representative may bind the partnership and the partners regardless of any limitation on that authority under the partnership agreement or applicable state law. Disputes among the partners are resolved through local law mechanisms (arbitration or litigation) even if the partnership representative acted contrary to instructions in the partnership agreement. Thus, choice of an appropriate person to act as the partnership representative is critical:
    • A partnership may designate any person to be the partnership representative, provided that such person has a substantial presence in the United States. The designation is made on the partnership tax return for the tax year. Any designation in the partnership agreement will not be binding on the IRS; it must be reflected on the partnership’s tax return. Very restrictive rules apply for revoking a designation or appointing a successor before an audit of the partnership begins.
    • Substantial presence in the United States:
      • The partnership representative must be able to meet in person with the IRS in the United States at a reasonable time and place as determined by the IRS.
      • The partnership representative must have a U.S. address and telephone number where the partnership representative can be contacted during normal business hours.
      • The partnership representative must have a U.S. Tax Identification Number.
    • The partnership representative may be an entity (e.g., management company), but, in such a case, the partnership must:
      • appoint an individual to act on behalf of such entity
      • identify such individual on the partnership’s federal income tax return.
  • Provide for a Mechanism to Allocate the Economic Burden of the Tax to the Appropriate Partners. The fund documents need to have a mechanism for maximizing the likelihood that the economic burden of any tax liability attributable to an audit is allocable to the partner with respect to whom the tax liability has arisen. In particular, any such tax liability should reduce the applicable partner’s capital account or be indemnified by such applicable partner to the extent of any shortfall (or if the applicable partner is not an investor in the fund at the time the tax is paid by the partnership, a mechanism needs to be put in place to claw back the appropriate share of tax from such former partner). Such mechanism should also provide that the manager compensation should be determined without regard to any such tax liability even if it is a liability of the fund.
  • Provide for a Procedure Regarding the Method used by the Fund to Calculate the Amount of Tax Liability of the Fund Attributable to an Audit. The fund documents need to have a procedure that deals with the different regimes that may be applicable to the fund under the new audit rules and provide for the cooperation of the partners (and former partners) to allow the fund to select the most appropriate regime. For example, the new law allows for an election for the partnership “to push” the liability for the tax to those investors who were partners during the tax year that is audited. In that case, those partners would pay the tax for the year that the tax liability is resolved, and the partnership would not owe any partnership-level tax. Alternatively, the partnership can reduce the amount of its tax payment if one or more of the partners agrees to file certain amendment U.S. tax returns and pay the tax or if one or more partners is subject to a special tax regime, such as a partner who is not subject to U.S. income tax or has favorable tax attributes.

Please note that the above amendments to your fund documents may or may not require consent of the investors and you should consult with your legal counsel as to the amendment procedure applicable to your specific fund documents.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Akin Gump Strauss Hauer & Feld LLP | Attorney Advertising

Written by:

Akin Gump Strauss Hauer & Feld LLP
Contact
more
less

Akin Gump Strauss Hauer & Feld LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.