US Partnership Audit Rules for Hong Kong Funds: Centralized Partnership Audit Regime Implications

For Hong Kong-based fund managers with US-connected investors, the Bipartisan Budget Act of 2015 (BBA) fundamentally altered the US federal income tax audit landscape for partnerships, and the IRS’s subsequent enforcement focus has made this a live compliance risk for offshore funds. Effective for tax years beginning after 31 December 2017, the BBA’s Centralized Partnership Audit Regime (CPAR) replaced the former TEFRA rules, shifting the primary tax liability for audit adjustments from individual partners to the partnership itself at the entity level. For a Hong Kong fund structured as a US partnership (e.g., a Delaware LP or LLC treated as a partnership for US tax purposes), this means an IRS audit adjustment—whether for a mischaracterized expense or a valuation dispute—could result in a direct tax assessment at the highest marginal rate (currently 37% for individuals under IRC § 1(j)(2)(A) for 2024, plus potential state-level liability), payable by the fund’s assets, regardless of whether the current partners benefited from the original deduction. The 2025-2026 examination cycle has seen the IRS’s Large Business & International (LB&I) division specifically targeting cross-border partnerships with “imputed underpayment” calculations under IRC § 6225, making this regime a critical operational and structuring consideration for any Hong Kong fund with US tax nexus.

The Mechanics of the Centralized Partnership Audit Regime (CPAR)

Entity-Level Assessment and the Imputed Underpayment

Under IRC § 6221, as amended by the BBA, the IRS may conduct a single audit at the partnership level, and any adjustments to items of income, gain, loss, deduction, or credit are determined and taken into account at the partnership level. The partnership is then liable for any “imputed underpayment” calculated under IRC § 6225. The imputed underpayment is computed by netting all adjustments for the reviewed year and applying the highest rate of tax for individuals or corporations (whichever is applicable) for that reviewed year. For a Hong Kong fund with a mix of US individual, corporate, and foreign partners, this default calculation can be punitive. For example, if an adjustment disallows a management fee deduction of USD 1,000,000 for the 2022 tax year, the imputed underpayment could be USD 370,000 (at the 37% rate), even if many partners were tax-exempt or in lower brackets.

The “Push-Out” Election: A Path to Partner-Level Liability

A Hong Kong fund may avoid the entity-level assessment by making a valid “push-out” election under IRC § 6226. This election, made on the partnership’s tax return for the adjustment year (the year the audit is completed), shifts the liability for the imputed underpayment to the partners who were partners in the reviewed year. Each reviewed-year partner must then report their share of the adjustments on their own tax returns, with interest calculated from the due date of the reviewed year’s return. The election must be made within 45 days of the date of the notice of final partnership adjustment (FPA) under IRC § 6226(a). For a Hong Kong fund with a high proportion of US tax-exempt partners (e.g., US pension funds) or non-US partners with no US filing obligations, the push-out election may be administratively burdensome, as it requires each reviewed-year partner to file amended or supplemental US tax returns. The IRS has issued final regulations (T.D. 9944, 2021) clarifying the mechanics, including the requirement to provide reviewed-year partners with a statement of their share of the adjustments within 60 days of the FPA.

Implications for Hong Kong Fund Structures

Tax-Exempt and Foreign Partners: The UBTI and Withholding Concerns

For a Hong Kong fund with US tax-exempt investors (e.g., university endowments, pension funds), an entity-level assessment under CPAR may trigger unrelated business taxable income (UBTI) implications. Under IRC § 512, tax-exempt entities are generally subject to tax on UBTI. An imputed underpayment paid by the partnership may be treated as a reduction in partnership income, potentially creating or increasing UBTI for the exempt partner. More critically, for foreign partners (including Hong Kong institutional investors), the entity-level assessment raises questions about US withholding tax obligations. If the partnership pays the imputed underpayment from its assets, it is effectively reducing the distributable income to foreign partners. Under IRC § 1446, a partnership with foreign partners must generally withhold tax on effectively connected income (ECI). The IRS has clarified in Rev. Proc. 2020-23 that a partnership’s payment of an imputed underpayment is not itself a distribution subject to withholding, but the underlying adjustments may affect the calculation of ECI for foreign partners in the reviewed year. This creates a compliance gap: the partnership pays the tax, but foreign partners may still need to file Form 1040-NR to report their share of the adjustments, even if no cash is distributed.

The Designated Individual and the Partnership Representative

Under the BBA, each partnership must designate a “partnership representative” (PR) who has the sole authority to act on behalf of the partnership in IRS proceedings. The PR is the sole point of contact for the IRS and has the power to bind the partnership and all partners to an agreement with the IRS, including a settlement. For a Hong Kong fund, the PR is typically a US-based individual (e.g., a managing partner or a US tax director) who must have a substantial presence in the US. The PR cannot be a non-US entity. This requirement under IRC § 6223(a) has practical implications: the PR must be accessible for IRS meetings, have a US address for service of process, and maintain records for the duration of the audit. The IRS’s 2023-2024 Priority Guidance Plan lists potential regulations on the PR’s authority and liability, but as of early 2025, no final rules have been issued. Fund documents (e.g., the limited partnership agreement) should explicitly name the PR and define their authority, indemnification, and removal procedures.

Practical Compliance Steps for Hong Kong Fund Managers

Reviewed Year vs. Adjustment Year: A Two-Tier Filing Obligation

A Hong Kong fund that is a US partnership must file a US Form 1065 (U.S. Return of Partnership Income) for each tax year. Under CPAR, the fund must also track the “reviewed year” (the year under audit) and the “adjustment year” (the year the audit is completed). If the fund makes a push-out election, it must file a Form 1065-X (Amended Return or Administrative Adjustment Request) for the reviewed year and issue Schedule K-2 and K-3 to partners for the adjustment year. The IRS has increasingly focused on K-2/K-3 compliance, particularly for partnerships with foreign partners or foreign-source income. For a Hong Kong fund, failure to properly file K-2/K-3 can result in penalties under IRC § 6721 (failure to file correct information returns) of USD 310 per return (2024 rate), with a maximum of USD 3,783,000 per year. The fund must also maintain a complete and accurate partner-level allocation schedule for the reviewed year, including the tax status of each partner (US individual, US corporation, foreign corporation, tax-exempt, etc.), to properly compute the imputed underpayment or push-out adjustments.

The “Eligible Partnership” Exception: A Narrow Safe Harbor

Certain small partnerships may be eligible for an exception from the BBA rules under IRC § 6231(a)(1)(B)(ii). A partnership is an “eligible partnership” if it has 100 or fewer partners (each a direct partner, not a look-through for tiered structures) and each partner is an individual (not a trust, estate, or partnership), a C corporation, or an S corporation. For a Hong Kong fund, this exception is rarely available, as most funds have institutional partners (e.g., corporate or partnership feeders) or are themselves part of a tiered structure. The IRS has clarified in Notice 2018-53 that a partnership with a partner that is a grantor trust is not an eligible partnership. Therefore, the vast majority of Hong Kong funds with US tax nexus will be subject to the full BBA regime.

Modifications to the Imputed Underpayment: A Strategic Option

A Hong Kong fund subject to an imputed underpayment may request a “modification” under IRC § 6225(c) to reduce the amount of the imputed underpayment. Modifications allow the partnership to demonstrate that the highest marginal rate should not apply because, for example, the partners in the reviewed year were tax-exempt or foreign. The partnership must provide the IRS with documentation (e.g., Form W-8BEN, Form W-9, or a tax-exempt determination letter) for each partner for the reviewed year. The IRS’s final regulations (T.D. 9944) provide detailed procedures for modifications, including a requirement that the partnership file Form 8985 (Pass-Through Partners’ Tax Basis Statement) and Schedule A to Form 8985. For a Hong Kong fund with a significant number of non-US partners, a modification can reduce the imputed underpayment to zero if all partners are foreign and have no US tax liability on the adjusted items. However, the modification process is complex and requires the partnership to have maintained thorough partner-level documentation for the reviewed year—a record-keeping burden that many Hong Kong funds may not have anticipated.

The 2025-2026 Enforcement Landscape

IRS LB&I’s Focus on Cross-Border Partnerships

The IRS’s Large Business & International (LB&I) division has identified cross-border partnerships as a compliance priority for the 2025-2026 examination cycle. In its 2024-2025 Priority Guidance Plan, the IRS listed projects related to the BBA’s interaction with foreign partnerships and the application of IRC § 704(b) (partner’s distributive share) in the context of CPAR. The IRS has also increased the use of data analytics to identify partnerships with “imputed underpayment” exposure, particularly those with large management fee deductions, carried interest allocations, or valuation adjustments. For a Hong Kong fund, this means that an IRS audit is no longer a theoretical risk but a tangible possibility, particularly if the fund has significant US-source income or US-connected investors.

Statute of Limitations and the “Reviewed Year” Trap

Under the BBA, the statute of limitations for assessing an imputed underpayment is generally three years from the later of the date the partnership’s return is filed or the due date of the return (IRC § 6235(a)). However, the IRS may extend this period by agreement with the partnership representative. A critical trap for Hong Kong funds: if the partnership fails to file a valid return (e.g., a Form 1065 that does not include required Schedules K-2/K-3), the statute of limitations does not begin to run (IRC § 6501(c)(3)). This means the IRS could potentially audit a fund for an open year indefinitely. For a Hong Kong fund that has historically filed incomplete returns, the 2025-2026 period is a window to file amended returns (Form 1065-X) to start the statute of limitations clock and reduce exposure.

State-Level Implications for Hong Kong Funds

For a Hong Kong fund with US investors, state-level partnership audit regimes add another layer of complexity. States like New York, California, and Illinois have adopted versions of the BBA or have their own partnership audit rules. For example, California’s Revenue and Taxation Code § 18633.5 requires partnerships to file a notice of partnership audit with the Franchise Tax Board (FTB) within 90 days of receiving an IRS notice of final partnership adjustment. Failure to file can result in a penalty of USD 1,000 per partner. For a Hong Kong fund with US investors in multiple states, the compliance burden multiplies: the fund may need to file amended state returns for the reviewed year in each state where partners reside. The fund’s partnership agreement should address whether the fund or the partners bear the cost of state-level adjustments.

Actionable Takeaways

1. Hong Kong fund managers should review their partnership agreements to ensure a designated partnership representative is named, with clear authority and indemnification, and that the agreement addresses the allocation of any imputed underpayment among current and former partners.
2. Funds with foreign or tax-exempt partners should maintain a complete and current file of Forms W-8BEN, W-9, and tax-exempt determination letters for each reviewed year, as these are essential for requesting a modification of the imputed underpayment under IRC § 6225(c).
3. The push-out election under IRC § 6226 should be evaluated as a default strategy, but fund managers must confirm that reviewed-year partners are capable of filing amended US returns and that the fund can provide the required partner-level adjustment statements within 60 days of the FPA.
4. For the 2025-2026 tax year, Hong Kong funds should file complete Form 1065 returns, including all required Schedules K-2 and K-3, to start the three-year statute of limitations under IRC § 6235(a) and reduce the risk of an indefinite audit window.
5. Fund managers should engage a US tax practitioner experienced with CPAR to conduct a “mock audit” of the fund’s reviewed-year returns, identifying potential adjustment items (e.g., management fee deductions, valuation of contributed assets) and quantifying the maximum imputed underpayment exposure.

本文不構成稅務建議。涉及個人稅務情況請諮詢持牌會計師或稅務師。 This does not constitute tax advice. Consult a licensed CPA or tax advisor for your specific situation.