On March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment Act (the “HIRE Act” or “Act”). The Act incorporated the provisions of the Foreign Account Tax Compliance Act of 2009 (“FATCA”). The FATCA provisions of the Act impose significant reporting and information gathering obligations on individuals and third parties, and will expand the current U.S. withholding regime. The Act will have a substantial impact on foreign investment in the U.S..
Foreign persons are generally subject to a flat tax rate of 30% on their U.S. source fixed, determinable annual or periodic (FDAP) income. In brief, income is fixed when it is paid in amounts known ahead of time and determinable whenever there is a basis for calculating the amount to be paid. Common examples of FDAP income include compensation for personal services, dividends, interest, pensions, alimony, real property income (such as rents other than gains from the sale of real property), royalties and commissions.
The current 30% withholding regulations, set forth in Chapter 3 of the U.S. Internal Revenue Code, have been in place for many years and impose a withholding requirement on payments to foreign persons of U.S. source FDAP income, unless the FDAP income is effectively connected with a U.S. trade or business, or the withholding is reduced or eliminated by operation of a tax treaty. As a result, taxes on FDAP income to foreign persons must generally be withheld by the U.S. payer (otherwise known as withholding agent) and remitted to the IRS.
The Act creates a new withholding tax, added as Chapter 4 of the U.S. Internal Revenue Code, that expands the current U.S. withholding regime by imposing a 30% withholding tax on any withholdable payments made to foreign financial institutions (regardless of whether such institutions have U.S. account holders), unless the foreign financial institution enters into a reporting agreement with the IRS. A withholdable payment is defined as any U.S. source FDAP income, and gross proceeds from the sale or disposition of any property which produces U.S. source interest or dividends. The Act’s withholding provisions will greatly expand existing law because gross proceeds from the sale of stock or debt instruments are currently not taxable to foreign persons and are not subject to withholding. Furthermore, the Act defines foreign financial institutions (“FFI”) so broadly that it includes virtually every type of foreign bank and foreign investment vehicle, including foreign private equity funds and foreign mutual funds. The reporting agreement requires FFIs to disclose the full details of non-exempt accountholders to the IRS in order to avoid the 30% withholding tax. For these reasons, foreign investors should not be surprised if their local investment bank or brokerage firm soon refuses to invest, directly or indirectly, in U.S. securities in order to avoid a withholding tax on FDAP income or, alternatively, enter into the reporting agreement with the IRS.
Additionally, an FFI that has entered into a reporting agreement with the IRS will be required to deduct and withhold a 30% tax on any pass-through payment made by the institution to an FFI that fails to enter into an agreement with the IRS. For this reason, foreign persons that receive FDAP income may potentially face a “double” withholding. As mentioned above, the current tax regime already requires that U.S. payers withhold 30% of U.S. source FDAP income to foreign recipients. Because of the provisions set forth in the Act, a foreign recipient may be subject to a prohibitive additional withholding on the same payment stream if one or more of its banks has not entered into the proscribed information agreement with the IRS. Although the Act authorizes the Secretary of the Treasury to provide rules to prevent double withholding on the same payment stream, there is no explicit provision within the bill that would limit withholding to one level. This is important because prior versions of the bill contained explicit provisions that would seemingly have prevented a double withholding scenario.
To illustrate, suppose the following set of circumstances: USCO, a U.S. firm, makes a royalty payment for the use of certain intellectual property to IndiaCo, an Indian software firm. Assume that the payment qualifies as U.S. source FDAP which is not effectively connected with IndiaCo’s U.S. trade or business, and therefore subject to a 30% withholding. USCO withholds 30% of the royalty payment and remits the remainder to IndiaCo’s foreign account. However the payment does not travel directly from USCO’s local bank account to IndiaCo’s local Indian bank. Instead, the funds are routed through a network of correspondent and intermediary banks, one of which has failed to enter into a reporting agreement with the IRS as required by the Act. Without additional clarification from the Secretary of the Treasury, it would appear that the royalty payment would be subject to an additional Chapter 4 withholding of 30%. While beneficial owners of withholdable payments will be eligible to claim a refund or credit for any withholding in excess of their tax liabilities, this will require the beneficial owner to file a U.S. tax return.
Significantly, the payment of foreign source FDAP income is not a withholdable payment under Chapter 3 or Chapter 4 of the Internal Revenue Code. The payment of foreign source income to a foreign person is not subject to U.S. withholding or reporting requirements. Except for certain limitations, wages and any other compensation for services performed by a non-resident outside the U.S. are considered to be foreign source income. The place where the services are performed determines the source of the income, regardless of where the contract was formed, the place of payment, or the residence of the payer. Other examples of foreign sourced FDAP payments include: interest payments by a foreign debtor is foreign, royalty payments for property used abroad, and rental payments for property located outside the U.S. Consequently, US firms may continue to make payments to foreign companies for services performed abroad without withholding taxes.
The withholding rules are not just relevant to the foreign recipient but the U.S. payer as well. The IRS has designated the obligation of a U.S. withholding agent to report and withhold on U.S. source FDAP income as a Tier 1 compliance issue. Tier 1 compliance issues are generally considered the highest compliance priorities within the IRS. A withholding agent is defined as any person, U.S. or foreign, that has control, receipt, or custody of, or the ability to dispose or pay, any item of income of a foreign person that is subject to withholding. The withholding agent is required to remit the withheld amount to the IRS, generally, on Form 1042 called, Annual Withholding Tax Return for US Source Income of Foreign Persons, and Form 1042-S, called Foreign Person’s US Source Income Subject to Withholding. The withholding agent is personally liable for any tax required to be withheld. If the withholding agent fails to withhold and the foreign taxpayers fails to pay its tax liability, both the withholding agent and taxpayer will be liable for the tax, interest, and penalty on the outstanding balances due.
Since its recent passage, the Act has generated a great deal of commentary within the legal and financial communities. The withholding provisions set forth in the Act are scheduled to apply to payments made after December 31, 2012. However, many observers believe that this date will be pushed back to account for the significant issues involved with the Act’s implementation, and for the Treasury to provide sufficient guidance to financial institutions to properly implement the new reporting procedures.
In conclusion, U.S. payers of FDAP income to foreign recipients should keep in mind the IRS’s increased scrutiny of FDAP reporting and withholding requirements. While payments to foreign persons for services performed abroad (and other payments of foreign source FDAP income) should not be affected by the new law, we recommend that U.S. payers nonetheless keep a watchful eye on the changing landscape of the U.S. withholding regime and maintain careful records of their transactions. Likewise, foreign recipients should note that their payments will soon be subject to an expanded withholding tax, which may make potential future investments in U.S. securities markets less attractive.Timothy D. Richards is the managing partner and founder of The Richards Group, in Miami, Florida. He specializes in domestic and international tax, estate planning and corporate law. He may be contacted by email at firstname.lastname@example.org
Alonso Sanchez is an associate in The Richards Group’s tax department. He may be contacted by email at email@example.com
by Timothy D. Richards and Alonso E. Sanchez