Fund Taxation Alert 2022-02

The US Internal Revenue Service (IRS) is increasing its efforts to ensure that US and non-US entities (including Luxembourg investment funds or partnerships) comply with US tax rules. Making US investments may lead to US tax compliance obligations. In the particular case of a partnership (e.g. Luxembourg SCS or SCSp or any other partnership for US tax purposes), you may need issue K-1 statements to your US and non-US investors. Schedule K-1 is a schedule of IRS Form 1065, U.S. Return of Partnership Income. It is provided to partners in a business partnership to report their share of a partnership’s profits, losses, deductions and credits to the IRS.

Form 1065 must be filed by any US partnership unless it neither receives income nor incurs any expenditures treated as deductions or credits for federal income tax purposes. Generally, a non-US partnership that has gross income effectively connected with the conduct of a trade or business within the United States (ECI) or has gross income derived from sources in the United States (U.S. source income) must file Form 1065, even if its principal place of business is outside the United States or all its members are non-US persons. Few exceptions apply.

In this regard, we want to highlight a change in US tax reporting that will impact US tax reporting.

The IRS has created new Schedules K-2 and K-3 for Form 1065 U.S. Return of Partnership Income for tax year 2021. As the form instructions outline, these new schedules replace, supplement, and clarify the Schedule K-1 Lines 16 and 20. The new schedules assist partnerships in providing partners with the information necessary to complete their tax returns in accordance with the international tax provisions of the Internal Revenue Code. 

Schedule K-2 is an extension of the current Form 1065 Schedule K and is used to report items of “international tax relevance” from the operation of a partnership.

Schedule K-3 is an extension of the Form 1065 Schedule K-1 and is generally used to report each partners share of items reported on Schedule K-2. These schedules are intended to provide greater clarity for partners and shareholders on how to compute their U.S. income tax liability with respect to items of international tax relevance, including claiming deductions and credits.  

Schedule K-2 (replacing Form 1065 Schedule K, Line 16) is 19 pages with 12 parts while Schedule K-3 (replacing Form 1065 Schedule K-1, Line 16) is 20 pages with 13 parts.  There is a great deal still unknown about them, with new revisions to the forms and FAQ’s released just recently on January 19.

For reference, the forms and draft instructions can be accessed on IRS website:

• 2021 Schedule K-2 (Form 1065) (PDF, 845KB)
• 2021 Schedule K-3 (Form 1065) (PDF, 869KB)
• 2021 Partnership Instructions for Schedules K-2 and K-3 (Form 1065) (PDF, 448KB) 
• 2021 Partner's Instructions for Schedule K-3 (Form 1065) (PDF, 248KB) 

Any partnership required to file Form 1065 (or Form 8865) that has items relevant to the determination of the U.S. tax or reporting obligation of its partners under the international provisions of the Internal Revenue Code must complete the relevant parts of the Schedules K-2 and K-3.

The partnership should not complete the schedule “if the partnership does not have items of international tax relevance (typically, international activities or non-U.S. partners).” However, this statement may be misleading because “items of international tax relevance” may be broader than commonly construed. For example, even partnerships with solely U.S. activity may be required to file the Schedules K-2 and K-3.

The post release changes to the instructions acknowledges the general misconception that Schedules K-2 and K-3 have limited relevance and indicate that the Schedules K-2 and K-3 may apply even if the partnership has no non-U.S. source income, no assets generating non-U.S. source income, and no non-U.S. taxes paid or accrued. “For example, if the partner claims a credit for non-U.S. taxes paid by the partner, the partner may need certain information from the partnership to complete Form 1116.”

KPMG would be happy to help you navigate the unchartered waters of schedules K-2 and K-3 or any other US tax compliance obligations. Should you have any queries, please contact us.

Partner, Financial Services Tax
+352 22 51 51 5492 
jean.kizito@kpmg.lu 

Manager
+352 22 51 51 5596 
frederic.jadoul@kpmg.lu