On June 3-4, 2021, the IRS released final versions of Schedules K-2 and K-3 for tax year 2021 (2022 tax filing season). Final instructions were released in early September of 2021, and additional changes and clarifications were released on January 18, 2022.

These new schedules are required to be filed with Form 1065, 1120-S and 8865 by partnerships and S corporations with items of international tax relevance. Schedule K-2 is an extension of Schedule K that is used to report items of international tax relevance of a partnership or an S corporation. Schedule K-3 is used to report a partner’s or a shareholder’s distributive share of items reported on Schedule K-2 and will be delivered to the partners and shareholders along with Schedule K-1 by the due date (including extensions) of the relevant partnership or the S corporation’s tax return. The new Schedules K-2 and K-3 will have a particularly significant impact on asset management clients, as most of such businesses are structured as flow-through entities for U.S. tax purposes.

Background

According to the Instructions, Schedules K-2 and K-3 are intended to replace, supplement, and clarify the reporting of certain international related information on Schedules K and K-1, as well as assist in providing partners and shareholders with information necessary to complete their returns with respect to the international tax provisions of the Internal Revenue Code. Schedule K, line 16, Foreign Transactions, will be replaced by these new Schedules. Certain amounts previously reported on Schedule K, Line 20c, and Schedule K-1, Part III, line 20, Other Information, are being replaced, supplemented and clarified.

Despite the intention to standardize the reporting of information and ease the partner’s overall compliance process, the new schedules do not eliminate the need for white paper disclosure of international related items (to the contrary, the taxpayers must brace themselves for an increased amount of white paper disclosures). Examples of common items that are not covered by the new schedules include Form 926 related information and Form 8865 footnotes. Furthermore, the new schedules require additional details that may have not been provided historically, thereby significantly increasing the tax compliance burden for the partnerships and S corporations as well as their investors.

Examples of items of international relevance that will be reported on Schedules K-2 and K-3 include:

• Foreign tax credit (FTC) related information, including source and separate category of income and deductions, foreign taxes paid or accrued and other adjustments;
• Information for allocating and apportioning interest expense, research and experimental expense and foreign-derived intangible income (FDII) deductions for purposes of the FTC limitation;
• Information for calculating the Section 250 deduction with respect to FDII;
• Distributions from foreign corporations other than distributions that are attributable to annual previously taxed earnings and profits (PTEP) accounts;
• Information to determine income inclusions from controlled foreign corporations (CFCs) under the Subpart F and Global Intangible Low-Taxed Income (GILTI) rules, and deemed paid foreign taxes;
• Passive Foreign Investment Company (PFIC) information to determine income inclusions and complete Form 8621;
• Information to calculate the base erosion anti-abuse tax (BEAT); and
• Effectively Connected Income (ECI) and Fixed, Determinable, Annual or Periodic (FDAP) income information, as well as distributive share of deemed sale items on the transfer of a partnership interest.

In addition, partnerships and S corporations are required to disclose detailed information of certain international tax items that are not reported elsewhere on the Schedule K-2 or K-3 by attaching statements, such as gain on personal property sale, high-taxed income, Form 8858 information and Form 5471 information. Some may view these requirements as excessive.

Notably, the IRS published changes to the instructions for Schedules K-2 and K-3 on January 18, 2022, which provide exceptions for some of the items. For example, a partnership needs to report detailed information about the sale of certain personal property only if the partnership pays income tax to a foreign country with respect to income from the sale or the income is eligible for resourcing under an applicable treaty. Furthermore, the partnership need not attach Forms 8858 or 5471 to the Schedule K-3 if the partnership knows or has reason to know that its direct partner (and any indirect partners) does not need the information on those forms to prepare its tax return.

According to the Instructions, Schedules K-2 and K-3 are generally not required if a partnership or an S corporation does not have “items of international tax relevance” (typically, international activities or foreign partners). Notwithstanding this language, a partnership (or an S corporation) with only U.S. activities and only U.S. partners may find itself in a surprising situation of still being required to complete certain parts of the schedules K-2 and K-3 because its investors may have other foreign operations or activities that need to be aggregated with this entity’s data when performing certain investor-level calculations. For example, Schedule K-2, Part IV [Information on Partners’ Section 250 Deduction with Respect to Foreign-Derived Intangible Income (FDII)], must be completed by every partnership with (direct or indirect) domestic corporate partners, even if the partnership has no foreign activities and therefore has no foreign-derived deduction eligible income. Likewise, Schedule K-2, Part IX [Partners' Information for Base Erosion and Anti-Abuse Tax (Section 59A)] related information may be required if a partnership has domestic corporate partners (or is presumed to have such corporate partners). The Instructions go even further by requiring the foreign related parties of each partner to be identified (subject to an exception for small partners). It is presumed in the Instructions that the partnership will collaborate with its partners to identify the foreign related parties of each partner. In practice, however, the partners may not be willing to disclose, to the lower-tier partnership, the information regarding their other investments and activities outside a particular partnership (and there may be no legal requirement for them to do so). 

Notably, the instructions provide limited exceptions from filing specific parts of the schedules that would depend on the type and ownership of the direct and indirect partners or shareholders. For example, certain parts are not required to be completed if none of the direct or indirect partners (through pass-through entities only) is a U.S. shareholder of a CFC under section 958(a), which is held by the pass-through entity. Importantly, the instructions also provide that a partnership or S corporation that does not have or receive sufficient information regarding a partner or shareholder must presume that the filing requirement applies and therefore complete all relevant parts.

Given complex ownership structures for assets management clients with multiple tiers of flow-through entities, often a taxpayer will not possess all the information regarding the indirect partners or shareholders all the way up the ownership chain. Moreover, the upper-tier investor entity may not be willing to disclose the information regarding its investors to a lower-tier entity. As such, in practice it could be very difficult for asset management clients to assess and avail themselves of the limited exceptions provided in the instructions.

Penalties and Potential Relief

Failure to file correct and complete Schedules K-2 and K-3 of Form 1065, 8865 and 1120-S will be subject to various penalties, including penalties for failure to file correct information and for failure to furnish a correct Schedule K-3 to partners and shareholders. The IRS acknowledges the additional burden these new schedules create for the 2022 tax filing season, as well as the difficulty for the partnership and S corporation to collect all the necessary information. As a result, IRS has provided transition period penalty relief with respect to Schedules K-2 and K-3 for tax year 2021.

Under Notice 2021-39, taxpayers will not be subject to the penalties described in the notice for Schedule K-2 and K-3 reporting for tax year 2021 if the taxpayer establishes to the satisfaction of the Commissioner that it made a good-faith effort to comply with the requirements. Factors the IRS will consider for the purpose of determining whether a Schedule K-2 and K-3 filer has made a good-faith effort to complete Schedules K-2 and K-3 include whether the filers have:

• Made changes to its systems, processes, and procedures for collecting and processing information relevant to filing Schedules K-2 and K-3;
• Obtained information from partners, shareholders or the controlled foreign partnership, or applied reasonable assumptions when information is not obtained; and
• Taken steps to modify the partnership or S corporation agreement or governing instrument to facilitate the sharing of information with partners and shareholders that is relevant to determining whether and how to file Schedules K-2 and K-3.

For tax year 2021, whether or not the taxpayer intends to rely on the transition period relief, substantial changes to the compliance processes are required to ensure the necessary information from lower-tier partnerships and all partners and shareholders is collected on a timely basis. The new schedules also present difficulties to practitioners, who also need to implement new processes and perhaps make an investment in new software to meet these requirements. To ensure timely delivery of Schedule K-1 to investors, it is important for asset managers to start communicating the new requirements with their investors as soon as possible, as well as to think about potential ways to minimize the compliance burden.

Planning Considerations

The new Schedules K-2 and K-3 provide an opportunity for the asset managers to revisit the structure of their investment funds. Given the complexity of the new Schedules K-2 and K-3, the asset managers may favor setting up offshore funds over onshore funds in an effort to eliminate or reduce the overall compliance burden. Below is an example that illustrates, on a very high level, the difference between offshore and onshore funds from a compliance perspective:

Example 1: PortCos Held via US LP	Example 2: PortCos Held via Foreign LP

For both examples, we assume that no U.S. limited partner owns an interest of 10% or more in the fund (directly, indirectly or constructively). In Example 1, the limited partners invest in domestic and foreign portfolio companies via a U.S. limited partnership. The U.S. partnership is most likely required to file Form 1065, U.S. Return of Partnership Income, including Schedule K-2 and provide Schedule K-3 to all the partners. The U.S. LP also has other information return filing requirements with respect to its foreign investments, including Form 5471 and – until recently – Form 8992.

In contrast, if the limited partners invest in the portfolio companies via a foreign partnership (e.g., Cayman Islands) as illustrated in Example 2, to the extent that the investments do no generate effectively connected income (ECI) or other U.S.-sourced income, the foreign partnership may not be required to file Form 1065. The foreign partnership does need to provide pro forma Schedules K-1 to its partners to report the partner’s share of income. However, assuming the foreign partnership is not a controlled foreign partnership (CFP) and no U.S. limited partner owns 10% or more of the partnership interest, the foreign partnership can avoid completing the complex Schedule K-2 and K-3. There also may not be a Form 5471 or Form 8992 filing requirement for the foreign partnership.

As illustrated by the above examples, under certain circumstances, using a foreign partnership instead of a U.S. partnership as the investment vehicle might eliminate some of the compliance burden associated with the structure. However, all the relevant facts need to be carefully analyzed before reaching a conclusion regarding the best investment vehicle going forward. For example, the ownership of the limited partners and the structure of the portfolio investment (e.g., flow-through structure or blocked structure) may affect the filing requirements of the fund. It is also important to consider the constructive ownership rule under section 318. For example, using a U.S. partnership for some investments and a foreign partnership for others may cause the U.S. partnership to constructively own the investments owned by the foreign partnership, due to the downward attribution rules under section 318(a)(3), which would create additional filing requirements for the U.S. partnership.

The above comparison is solely from a compliance perspective. Of course, there are many other tax and non-tax considerations that need to be taken into account when choosing the fund’s jurisdiction. When it comes to U.S. tax, however, the final GILTI regulations and section 958 regulations[1] treat a domestic partnership as an aggregate of its partners and assess GILTI and Subpart F income at the partner level instead of the partnership level. These rules intend to treat domestic partnerships in the same manner as foreign partnerships for GILTI and Subpart F purposes.

However, the regulations did not eliminate all differences between domestic partnerships and foreign partnerships. One notable difference is that a domestic partnership that owns 10% or more of a foreign corporation continues to be treated as a “United States shareholder” of a foreign corporation under section 951(b) and may still have a Form 5471 filing requirement with respect to the foreign corporation, whereas a foreign partnership is not a U.S. shareholder of the foreign corporation and only the U.S. partners that meet the definition of a U.S. shareholder may need to file Form 5471.

Additionally, the regulations specifically state that domestic partnerships are not treated as aggregates under section 1248. As a result, a domestic partnership that sells stock in a CFC will continue to be subject to section 1248 while in the case of a foreign partnership selling stock in a CFC, only the partners that are U.S. shareholders of the CFC may be subject to section 1248.

Last, but not least, for those who wish to redomicile their investment vehicles from onshore to offshore, local tax in foreign jurisdictions is another factor that should be considered. For example, some countries may treat the re-domiciliation as a sale of the underlying portfolio investments and impose tax on the transfers even though the ultimate investors remain the same.

Conclusion

The new Schedules K-2 and K-3 pose challenges to asset management clients by requiring the collection and reporting of substantial information and making significant changes to the existing compliance processes in a short period time. The additional compliance cost may be the catalyst for asset managers to re-assess the cost and benefits of different fund structures and may tilt the scale towards using offshore vehicles. However, there is no one-size-fits-all solution. A holistic approach should be taken and all relevant facts should be carefully analyzed.

The opinions expressed in this article are those of the authors. They do not purport to reflect the opinions or views of their employers or any other person.

Joe Zhou, CPA, is a private equity, specialized tax services international manager at BDO. Joe has more than eight years of experience in international tax focusing on financial service clients, including private equity funds and hedge funds.

Natallia Shapel, CPA, MST, MBA, is a partner, international tax services at BDO. She specializes in advising U.S. and foreign multinationals on various aspects of international tax laws, including tax planning and structuring of U.S. in- and outbound investments, supply chain planning, cross-border reorganizations, tax treaties, due diligence and U.S. tax compliance.

Stephen Arber, CPA, JD, LLM, is a managing director, international tax services at BDO. His experience includes international tax consulting and compliance, GILTI, BEAT, FDII, foreign tax credit planning, earnings & profits analyses as well as ASC 740 for both domestic and foreign companies.