January 27, 2022
US IRS changes to instructions for 2021 partnership Schedules K-2 and K-3 are relevant to many partnerships, including private equity and private capital funds
On 18 January 2022, the United States (US) Internal Revenue Service (IRS) outlined changes to previously issued IRS instructions for Schedules K-2 and K-3 for the 2021 tax year IRS Form 1065, U.S. Return of Partnership Income. Schedules K-2 and K-3 are new reporting forms that pass-through entities generally must complete, beginning in the 2021 tax year.
Many partnerships must complete Schedules K-2 (detailing partners' total international distributive share items) and issue Schedules K-3 (detailing a partner's share of international income, deductions, credits, etc.) to their partners to report US international tax information. Partners use the information reported on Schedule K-3 to complete their US tax and information returns.
The revised instructions show how carefully all relevant facts must be weighed to determine whether, and to what extent, the Schedules K-2 and K-3 must be completed for partners. The changes provide more exceptions from filing, and additional clarity as to when such filing exceptions apply.
Key provisions included in revised instructions for Schedules K-2 and K-3
Partnerships with no foreign income
The IRS clarified that a partnership with no foreign-source income must file Part II (foreign tax credit limitation) and Part III (information for preparing Forms 1116 or 1118) on Schedules K-2 and K-3 if their partners have items of international tax relevance. An exception from filing Part II and Part III, Section 2, on Schedule K-3 may apply, however, for a partnership that: (i) only has US-source income; (ii) does not have income or deductions that the partners can source or allocate and apportion; and (iii) only has limited partners owning less than 10% of the capital and profits of the partnership at all times during the tax year.
These changes to the instructions highlight the broad application of the Schedules K-2 and K-3 filing requirement. The revised instructions include an example demonstrating how limited exceptions may apply. The example concerns a domestic partnership that has only US citizens as partners, no foreign-source income, and no assets generating foreign-source income. One of the two partners paid no foreign taxes for which it can claim a foreign tax credit, and the second partner qualifies for the exemption from completing Form 1116 to claim a foreign tax credit. The partners provide this information to the partnership. The example concludes that the partnership does not have to complete Boxes 1, 2, 3, 4, 5 or 10 of Part I, or Parts II or III of Schedule K-2 or of Schedule K-3. If the same facts apply, but a partner claims a credit for foreign taxes that it paid and may need certain information from the partnership to complete its Form 1116, then the partnership must file Schedules K-2 and K-3.
In addition, the instructions clarify that a partnership that only has domestic partners may still be required to complete Part IX when the partnership makes certain deductible payments to foreign related parties of its domestic partners. The information reported in Part IX will assist any domestic corporate partner in determining the amount of base erosion payments made through the partnership, and in determining if the partners are subject to the Base Erosion and Anti-Abuse Tax (BEAT).
Personal property sales
Personal property sold by the partnership is treated as sold by the partners and generally sourced according to each partner's tax residence. Part I of Schedules K-2 and K-3 asks for information on certain sales of personal property to be attached to a partner's Schedule K-3.
The original instructions required reporting of all sales of personal property (other than inventory, depreciable personal property and certain intangible property excepted from the general rule of Internal Revenue Code (IRC) Section 865(a)). The IRS narrowed this requirement by clarifying that partnership income from such sales must be reported (1) when the partnership pays income tax to a non-US country on income from the sale of that property or (2) the income from the sale is eligible for resourcing under an applicable tax treaty. Each item of property sold must be listed separately. If the property sale is taxed by more than one country, the partnership must enter a separate line for each country and indicate that the property entered on more than one line is the sold property.
International IRS Form attachments
The IRS clarified that, in most instances, a partnership does not need to attach its international IRS forms to each partner's Schedule K-3. In those cases, the partnership should check the appropriate box on Schedule K-3, Part I, to indicate that it files those IRS forms with its Form 1065. If the partnership must file either Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, or Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, the partnership must attach a separate statement indicating that the partnership has filed those forms with each partner's Schedule K-3.
Sometimes, however, IRS tax information reporting forms must be attached to a partner's Schedule K-3. If a partnership must file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, but the partnership knows, or has reason to know, that a partner (and any indirect partners) does not need this information to prepare its tax return, the partnership is relieved of its obligation to attach the IRS Form 5471 to the Schedule K-3 (for example, the partnership would not need to attach the Form 5471 to Schedules K-3 for certain tax-exempt partners). Otherwise, the partnership must attach the Form 5471 to each partner's Schedule K-3.
Certain distributions from non-US corporations
The instructions to Schedules K-2 and K-3 generally require distributions from foreign corporations to be reported on Part V of those forms. The revised instructions clarify that Part V does not have to be completed for distributions by a non-US corporation if the partnership knows that: (i) none of the distributions are attributable to previously taxed earnings and profits (PTEP) in a direct or indirect partner's annual PTEP account; and (ii) none of the partnership's direct or indirect partners may claim an IRC Section 245A deduction for any distributions by the non-US corporation. Nevertheless, the partnership may still be required to attach Worksheets 3 and 4, reporting the non-US corporation's information and certain information about the distribution, to the Schedule K-2 and to the partner's Schedule K-3.
Controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs)
The updated instructions clarify that partnerships must determine whether they are obligated to report information on CFCs and PFICs based on their actual knowledge of their direct and indirect partners (i.e., a partnership is not generally required to affirmatively obtain information from its direct or indirect partners to determine if it needs to file each part of the Schedule K-2 or Schedule K-3).
A partnership does not have to complete Part VI of Schedule K-3 with respect to a CFC if the partnership knows that no partners, direct or indirect (through pass-through entities only), are "US shareholders" (i.e., generally a 10%-vote-or-value-US-person shareholder that is either a Global Intangible Low-Taxed Income (GILTI), Subpart F or IRC Section 951(a)(1)(B) inclusion shareholder).
A partnership does not have to complete Part VII of Schedules K-2 and K-3, which reports certain PFIC-related information for a non-US corporation, if the partnership knows that all its direct and indirect partners are US persons who consist of one or more of the following: (i) persons who are not subject to the PFIC rules because they are subject to the subpart F rules with respect to the corporation; (ii) tax-exempt entities that are not subject to the PFIC rules with respect to the corporation under Treas. Reg. Section 1.1291-1(e); or (iii) pass-through entities with no indirect US taxable partners.
This is a welcome set of clarifications for many partnerships, including private equity and private capital funds. The changes reduce the scope of reporting of non-US corporation distributions and income inclusions, as well as personal property sales. They also resolve prior uncertainty, in certain respects, as to when partnerships that have solely domestic activities and US partners must file the Schedules K-2 and K-3.
Partnerships should review this guidance, which is incorporated into the 2021 partnership instructions for Schedules K-2 and K-3, when preparing their 2021 tax returns.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), FSO – International Tax and Transaction Services
Ernst & Young LLP (United States), FSO – Private Equity Tax
Ernst & Young LLP (United States), FSO – Wealth & Asset Management Tax
Ernst & Young LLP (United States), National Tax – International Tax and Transaction Services
Ernst & Young LLP (United States), Passthrough Transactions Group