IRS Provides Guidance on Calculating Intentional Disregard Penalties for Paper Filings

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August 26, 2016

Earlier this month, the IRS announced in interim guidance that it would amend Section 20.1.7 of the Internal Revenue Manual to provide a methodology for the calculation of intentional disregard penalties under Section 6721 for filers who fail to file information returns electronically when required.  In general, filers of more than 250 information returns are required to file such returns electronically with the IRS.  For this purpose, each type of information return is considered separately, so that a filer who files 200 Forms 1099-DIV and 200 Forms 1042-S is not required to file electronically.  In contrast, if the filer was required to file 300 Forms 1099-DIV and 200 Forms 1042-S, it must file the Forms 1099-DIV electronically, but may file Forms 1042-S on paper.

Section 6721 imposes a penalty of $250 for failures that are not due to intentional disregard.  Section 6721(e) provides an increased penalty for cases of intentional disregard.  In general, the increased penalty is equal to $500 or, if greater, a percentage of the aggregate amount of the items required to be reported correctly on the returns.  Information returns required under Section 6045(a) (Form 1099-B and Form 1099-MISC, Box 14), Section 6050K (Form 8308), and Section 6050L (returns by donees relating to dispositions of donated property within two years of the donor’s contribution of such property) are subject to a penalty of 5% of the amount required to be reported.  Returns required to be filed under Section 6041A(b) (Form 1099-MISC, Box 9), Section 6050H (Form 1098), and Section 6050J (Form 1099-A) are subject only to the flat $500 per return penalty.  Information returns required under other sections are subject to a penalty of 10% of the amount required to be reported.  (Different penalties apply for failures to file correct Forms 8300, but such forms are not subject to the mandatory electronic filing requirements of Section 6011.)

According to the IRS, the amount of the penalty for intentional disregard with respect to a failure to file electronically is determined by calculating the simple average reported on all such returns, multiplying by the number of returns in excess of 250, and then multiplying by the applicable percentage penalty.  For example, if a filer was required to file 1,000 Forms 1099-INT reporting total payments of $5,000,000, the penalty would be calculated by determining the average amount reported on each form $5,000,000 / 1,000 = $5,000), multiplying by the number of returns in excess of 250 ($5,000 x 750 = $3,750,000), and multiplying by the applicable percentage ($3,750,000 x 10% = $375,000).

As the example shows, the penalty for intentional disregard can be harsh.  Fortunately, intentional disregard penalties can often be avoided as the standard is high and it is difficult for the government to meet its burden of proof.  It is far more common for filers to fail to comply with information reporting requirements due to error or mistake.  If the IRS proposes intentional disregard penalties, filers should seek assistance from experienced counsel not only because the penalties can be large but because the imposition of intentional disregard penalties can make it more difficult to obtain relief from other penalties in the future.  One step in seeking penalty relief is to show that the taxpayer has a history of compliance.  The past assessment of intentional disregard penalties can make this more difficult.

Court Decision Underscores Need for Due Diligence When Using Payroll Service Providers

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August 24, 2016

A recent decision of the U.S. District Court for the Central District of California should remind employers to regularly verify the actions of payroll service providers regardless of the provider’s reputation and the longevity of the relationship.  In particular, employers should open an e-Services account with the IRS and verify that all deposits are in fact hitting their payroll accounts timely.  This check should be performed weekly.  If deposits are not timely reflected on accounts, it is incumbent on employers to promptly determine the nature of the problem.  The IRS does not police payroll service companies, and the Department of Justice has prosecuted a number of people for embezzlement of payroll taxes over the years.

In Kimdun Inc. et al. v. United States, four McDonald’s franchises (the “Employer”) under common ownership used an outside payroll company for 30 years to process all aspects of their payroll, including the remittance of payroll taxes to the U.S. Treasury and the California Employment Development Department.  However, during the last several years of the relationship (2008-2011), the payroll company or its related bank embezzled the Employer’s payroll taxes.  To make matters worse, the Employer learned of the failure to deposit its taxes in 2009 but neglected to take any action until mid-2011 and continued to use the payroll company through 2012.  The IRS subsequently assessed approximately $425,000 in failure-to-pay penalties under Section 6651(a), failure-to-deposit penalties under Section 6656, and related interest.  Note that the penalties and interest were in addition to the payroll taxes that the Employer had to pay to the U.S. Treasury above and beyond the funds that were embezzled.

The Employer filed refund claims with respect to the penalties and related interest, which were denied by the IRS.  The Employer then sued for a refund in U.S. District Court arguing that the penalties should be abated on the grounds that the failures occurred due to reasonable cause and not due to willful neglect.  The District Court granted the government’s motion to dismiss, holding that the Employer failed to show that it had acted with ordinary business care and prudence.  In its analysis, the court considered the typical authorities that arise in reasonable cause determinations and concluded that the Employer’s reliance on the payroll company, an agent, did not establish reasonable cause.  The fact that the Employer seemed to wait passively for such a protracted period of time was a particularly bad fact.  The result may well have been different if the Employer had identified the theft within a matter of weeks, made good on the late taxes, and pursued legal action against the payroll company.

The key takeaway from this case, however, is that employers will not simply be absolved of their tax obligations based upon illegal acts committed by third-party agents.  With the tools available from the IRS through e-Services, employers should independently verify that their payroll service providers perform the tasks they agree to perform.

IRS Pushes Bad Position in Penalty Case and Loses on Reasonable Cause Grounds

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August 17, 2016

The U.S. Tax Court recently held that an individual taxpayer was not liable for failure-to-file and failure-to-pay penalties under Code Sections 6651(a)(1) and 6651(a)(2), respectively, due to reasonable cause.  In Rogers v. Commissioner, a 2007 fire nearly destroyed Rogers’ home, resulting in losses exceeding $150,000 and essentially leaving her homeless.  Rogers did not deduct the losses on her 2007 or 2008 return, believing that she could claim the deduction only in the year the insurance company resolved her claim.  In 2009, the insurance company paid her $43,964, and she did not file an income tax return or pay the related taxes because she believed that her casualty losses (to the extent not compensated by insurance) fully offset her 2009 income.

The IRS disagreed with the timing of this deduction because a casualty loss is generally deductible in the year of the casualty.  Only if and to the extent a taxpayer has a reasonable prospect of insurance recovery, the deduction is deferred until it can be ascertained whether such reimbursement will be received.  Thus, Rogers should have deducted the casualty losses in 2007 or 2008, not in 2009.  Rogers and the IRS settled the deduction issue and litigated the penalties under Sections 6651(a)(1) and 6651(a)(2).

The Tax Court ruled that the taxpayer’s error was due to reasonable cause and not willful neglect for three key reasons.  First, Rogers had a significant compliance history hallmarked by timely filing and paying her federal income taxes, and “significant efforts to correctly prepare her income tax returns” by consulting tax books and articles and even the IRS.  Second, following the casualty, Rogers suffered personal hardships.  From 2007 through 2009, she suffered bouts of depression, experienced living conditions she found dehumanizing, and in 2009, fractured her skull after falling from a subway platform.  Third, Rogers’ error—deducting a loss in a year later than the correct year—was an error made in good faith and not a blatant tax avoidance technique.  Although the court did not explicitly mention the difficulty of applying the law as a factor, the court did highlight the murkiness of the issue: determining the year in which there was “no prospect of recovery from insurance.”

The reasonable cause exception exists because Congress recognized that even the most compliant taxpayers are not perfect.  Notwithstanding case law on penalties that is often viewed as unfavorable, taxpayers often prevail in penalty cases before IRS Appeals.  Although the taxpayer in Rogers was an individual, the case sheds light on why the IRS concedes penalty cases when businesses demonstrate a history of compliance and identify rational and understandable reasons for the errors at issue.  Reasonable cause exists when a taxpayer exercises “ordinary business care and prudence.”  Ordinary business care and prudence is determined based upon all the relevant facts and circumstances, and the burden of proof rests on the taxpayer.

Consistent with Rogers, taxpayers can elevate their chances for abatement by establishing a history of tax compliance.  Further, when things go awry, taxpayers should promptly take responsibility and correct the mistake, and then take steps to identify the cause of the failure and establish procedures to prevent a recurrence of the failure.  By taking swift action, the taxpayer increases the odds of overcoming its burden to show reasonable cause.

IRS Implements New Voluntary Certification Program for PEOs

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August 15, 2016

Through a flurry of guidance this summer, the IRS has finally implemented the long-anticipated voluntary certification program for professional employer organizations (PEOs).  In 2014, Congress enacted Code Sections 3511 and 7705, which brought about a sea-change in the payroll tax world by creating a new statutory employer: An IRS‑certified PEO (CPEO).  This change is significant because a common law employer (customer) who is otherwise liable for payroll taxes on wages that its PEO pays its employees may shift this payroll tax liability to a CPEO.  In May 2016, the IRS released temporary and proposed Treasury Regulations and Revenue Procedure 2016-33, providing tax and CPEO-certification rules under Sections 3511 and 7705.  After launching the online CPEO application in early July, the IRS proposed to create a new CPEO records system and last week, loosened certain certification rules by issuing interim guidance (Notice 2016-49), on which taxpayers may rely pending final regulations.  Importantly, Notice 2016-49 extended the application deadline from August 31, 2016, to September 30, 2016, for PEOs seeking to have the earliest possible effective certification date of January 1, 2017.

Although the CPEO program is welcomed by PEOs and their customers, applicants and CPEOs must carefully comply with numerous certification rules established under the recent IRS guidance.  Moreover, customers should be aware of limitations on their ability to shift payroll tax liabilities to their CPEOs.  Further, CPEOs and their customers should keep in mind that the CPEO program primarily assists payroll tax administration, and leaves difficult questions regarding CPEO sponsorship of qualified employee benefit plans and compliance with the Affordable Care Act (discussed in a separate blog post).

Background

PEOs provide customer-employers with payroll and employment services.  Before Congress enacted Sections 3511 and 7705 in late 2014, however, customers had remained liable for payroll taxes on wages paid to their employees.  Because there was no rule allowing the tacking of wages, PEOs would have to restart the applicable wage base limitations (e.g., FICA and FUTA limitations) upon moving the customers’ employees to the PEOs’ payrolls.  Under Section 3511, a CPEO is solely responsible for its customers’ payroll tax—i.e., FICA, FUTA, and RRTA taxes, and Federal income tax withholding—liabilities, and is a “successor employer” who may tack onto the wages it pays to the employees to those already paid by the customers earlier in the year.  The customers, on the other hand, remain eligible for certain wage-related credits as if they were still the common law employers of the employees.  Section 7705 called for the IRS to establish certification requirements.  It also provided a critical enforcement tool:  The IRS will publish every quarter a list of all CPEOs.

On May 5, 2016, the IRS released temporary Treasury regulations establishing certification rules under Section 7705 (temporary regulations).  These temporary regulations became effective on July 1, 2016 and will remain effective for three years thereafter.  Simultaneously, the IRS released proposed Treasury regulations under Section 3511 (proposed regulations) that establish rules on the payroll tax liabilities of CPEOs and their customers.  These rules are likely in proposed form because the IRS intends to revisit numerous issues, such as the treatment of specified tax credits.  Shortly after releasing these regulations, the IRS published Revenue Procedure 2016-33, which provides additional certification and application rules.  Although these rules do not affect an existing PEO’s established practices, a PEO must satisfy the requirements to become certified and thereby attract customers wishing to shift their payroll tax liabilities.

New Certification Requirements

The new IRS guidance establishes a robust set of certification requirements—e.g., proof of suitability, annual financial reporting and positive working capital, bonding requirements, etc.—aimed at ensuring the IRS’s collection of payroll taxes from CPEOs.

Suitability.  The temporary regulations add “suitability” requirements designed to ensure that the PEO has the capability, experience, and integrity to properly withhold and remit payroll taxes.  Showing that it has mulled over the PEO industry and its potential tax pitfalls, the IRS decided to apply many of these suitability requirements not only to the PEOs themselves, but also to certain “responsible individuals,” “related entities,” and “precursor entities” of the PEO.  Thus, for example, the IRS will not certify a PEO solely because its responsible individuals (e.g., certain owners, the CEO, or CFO) have failed to pay applicable Federal or state income taxes or have been professionally sanctioned for misconducts.  Nor can a PEO that is otherwise unsuitable for certification cleanse the taint of prior tax wrongdoings by transferring its assets to a new PEO that applies for certification.

Positive Working Capital & Transition Relief.  The temporary regulations add a positive-working capital rule—tweaked by Notice 2016-49—to ensure that the PEO is financially capable of fulfilling its tax obligations.  Under the temporary regulations, applicants and CPEOs must file annual audited financial statements accompanied by an independent CPA’s opinion that the financial statements (1) are fairly presented under GAAP, (2) reflect positive working capital, and (3) show that the PEO uses an accrual method of accounting.  Addressing comments that CPAs may be professionally prevented from including the last two items in a CPA opinion, Notice 2016-49 provides that, in lieu of doing so, a PEO must include in its annual filing a Note to the Financial Statements stating that the financial statements reflect positive working capital and providing detailed calculations.  Further, Notice 2016-49 provides transition relief for applicants required to submit a copy of its annual audited financial statements and CPA opinion for a fiscal year ending before September 30, 2016.

To allow reasonable fluctuation in working capital, an exception to the positive-working capital rule is available if: (1) the working capital of two consecutive fiscal quarters that year were positive; (2) the PEO explains the reason for the negative working capital; and (3) the negative working capital does not present a material risk to the IRS’s collection of payroll taxes.  The third element hinges on whether the PEO has identified facts and circumstances that will result in positive working capital in the near future.  A similar positive working-capital rule and a similar exception apply to quarterly financial statements.

Bond and Surety.  Under Section 7705(c)(2), an applicant or CPEO must post a bond (ranging from $50,000 to $1 million) with respect to its employment tax liabilities.  The temporary regulations clarified that the bond cannot be substituted with collateral, and that the bond must be issued by a qualified surety, i.e., one that holds a certificate of authority from the IRS.  Accordingly, a CPEO application must include a signed surety letter confirming that the surety agrees to issue a bond pursuant to terms set forth in Form 14751 and in the required amount to the applicant, if and when the applicant is certified.

Business Entity.  The temporary regulations provide that a CPEO must be a “business entity” organized in the United States, but may not be a disregarded entity.  Addressing concerns that PEOs may choose to be disregarded entities for legitimate business reasons, Notice 2016-49 provides that a CPEO may be a wholly domestic disregarded entity.  The Treasury and the IRS sought comments on whether they should allow partly or fully foreign disregarded entity to apply for certification.  Additionally, Notice 2016-49 provides that a sole proprietorship, which is not included in the definition of “business entity,” may apply for certification.

Consent to Disclosure.  Consistent with Section 7705(f), which requires the IRS to publish the names and addresses of all CPEOs, the temporary regulations add that the IRS will also publish the fact of the suspension or revocation of a PEO’s certification and may notify the PEO’s customers of this fact.  Accordingly, the temporary regulations also require an applicant or CPEO to provide the consents for the IRS to disclose confidential tax information to the customers and to other persons as necessary to carry out the purposes of the CPEO rules.

Functional Application of Rule.  The IRS will likely take a functional rather than a mechanical approach to applying the certification rules.  The temporary regulations permit the IRS to suspend or revoke a PEO’s certification if the PEO violates a certification requirement, but require the IRS to do so only if the violation presents a material risk to the IRS’s collection of Federal payroll taxes.  If the IRS suspends or revokes a PEO’s certification, the benefits—e.g., shifting of payroll tax liability and tacking of wages—under Section 3511 will not apply and the PEO must notify its customers of its suspension or revocation.

Employment Tax Treatment of CPEOs and Their Customers

The proposed regulations implement rules under Section 3511 pertaining to the employment tax treatment of CPEOs and their customers.

Work Site Employee.  Section 3511 shifts a customer’s payroll tax liability with respect to wages paid to a “work site employee,” and the proposed regulations apply a quarterly test.  Specifically, a covered employee is a work site employee for a calendar quarter, if at any time during that quarter, at least 85 percent of the service providers at the same work site are subject to one or more CPEO contracts between the CPEO and the customer.

Specified Tax Credits.  The proposed regulations also indicate that the IRS may change its treatment of specified tax credits under Section 3511(d)(1), for which the customer—not the CPEO—is eligible, provided that the wages at issue are paid to a work site employee.  In the preambles to the proposed regulations, the Treasury and the IRS sought comments as to whether they should expand the list of specified tax credits, and how the tax credits should apply with respect to non-work site covered employees.

Continuing Reporting Obligations.  Most significantly, the proposed regulations add three categories of reporting requirements that a CPEO must meet in order to remain certified: (1) reporting to the IRS by CPEOs, including any Form 940 (Employer’s Annual FUTA Tax Return) or Form 941 (Employer’s Quarterly Federal Tax Return) and their applicable schedules, periodic verification of compliance, notice of material changes to information provided, and independent financial review documents, such as the annual audited financial statements along with the CPA opinion; (2) reporting to customers by CPEOs, including notification of suspension or revocation of certification and notification regarding transfer of CPEO contract; and (3) inclusion of certain information in the CPEO contract.

CPEO System of Records

To ensure that an applicant or CPEO complies with the new certification rules, the Treasury and the IRS proposed to establish a records system that covers a myriad of groups of individuals involved in the certification process or administration of the applicant or CPEO.  The proposed records system keeps administrative, investigative, and tax records, which the IRS will only use and disclose consistent with the confidentiality rules under Code Section 6103.  Like the detailed certification rules, the proposed records system signals the IRS’s commitment to enforce the CPEO suitability requirements by weeding out PEOs managed by individuals with a history of tax wrongdoings.  The proposed system became effective on August 10, 2016.

Other Issues

Groundbreaking in the payroll tax world, the CPEO rulemaking project is still in its infancy, and the IRS will continue to issue new rules and clarifications as to a CPEO’s certification and reporting obligations, as well as the new CPEO records system.  Additionally, the IRS will likely address whether to expand the list of specified tax credits applicable to a customer with respect to its work site employees, and how these credits may apply in the case of non-work site covered employees.

One crucial issue the IRS has yet to address is the scope of the liability of CPEOs’ customers.  Although the new rules are intended to shift payroll tax liability to the CPEO, the customer, as the common law employer, may be liable if the IRS retroactively revokes or suspends a CPEO’s certification.  This liability may be significant, as it includes the payroll taxes that should have been but were not properly withheld and/or remitted, and may also include Trust Fund Recovery Penalties.  It is unclear if a customer can avoid this liability when its CPEO failed to withhold or remit payroll taxes properly, solely by showing that it relied on the IRS’s quarterly CPEO list.  Thus, it remains to be seen if the IRS clarifies whether customers must verify their CPEOs’ ongoing compliance with certification requirements.

IRS Certified PEO Program Leaves Unresolved Qualified Plan and ACA Issues

The IRS recently implemented the voluntary certification program for professional employer organizations (PEOs) (discussed in a separate blog post).  Earlier this summer, the IRS released temporary and proposed Treasury regulations and Revenue Procedure 2016-33 pursuant to Code Sections 3511 and 7705, which created a new statutory employer for payroll-tax purposes: an IRS-certified PEO (CPEO).  Last week, the IRS released Notice 2016-49, which relaxed some of the certification requirements set forth in the regulations and Revenue Procedure 2016-33.

Although a significant change in the payroll tax world, the new CPEO program does not clarify the issue of whether a PEO or its customer, the worksite employer, is the common law employer for other purposes.  Thus, even when properly assisted by CPEOs, customers may still be common law employers and must plan for potential liability accordingly.  Two key areas of potential liability are PEO sponsorship of qualified employee benefit plans and the Affordable Care Act’s employer mandate.

PEO Sponsorship of Qualified Plans

Before the new CPEO program became available, the PEO industry was already expanding, with customers pushing for PEOs to act as the common law employers for all purposes, not just payroll tax administration.  Customers particularly sought PEOs to sponsor qualified benefit plans for the customers’ workers.  This arrangement, however, clashed with a fundamental rule of qualified plans under ERISA and the Code:  Under the exclusive benefit rule, employers can sponsor qualified plans only for their common law employees and not independent contractors.  Many PEOs set up single employer plans, even though customers – not PEOs – usually had the core characteristics of a common law employer:  Exercising control over the worker’s schedule and manner and means of performing services.

In Revenue Procedures 2002-21 and 2003-86, the IRS reiterated its hardline stance on enforcing the exclusive benefit rule against PEO plans, stating that after 2003, PEOs can no longer rely on any determination letter issued to their single employer plans, even if the letter was issued after 2003.  The guidance provided two forms of transition relief available until 2003: (1) a PEO could terminate the plan, or (2) convert the plan into a multiple employer plan (MEP), which is an employee benefit plan maintained and administered as a single plan in which two or more unrelated employers can participate.  This MEP option, however, still treated customers as the common law employers, who are subject to nondiscrimination, funding, and other qualified-plan rules under ERISA and the Code.

The new CPEO program does not affect the exclusive benefit rule or the determination of common law employer status for qualified plan purposes.  Certified or not, a PEO can sponsor MEPs, but properly sponsoring any single-employer plan rests on the argument that the PEO is the common law employer.  Thus, the law still significantly limits a customer from outsourcing its qualified plan to a PEO.

ACA Employer Mandate & PEO-Sponsored Health Plan

The Affordable Care Act (ACA) imposes on employers with 50 or more full-time equivalent (FTE) employees the “employer mandate,” which, in turn, applies a tax penalty if the employer chooses not to provide health care insurance for its workers.  In general, the common law employer is required to offer coverage to its employees.  Under some circumstances, however, the common law employer can take credit for coverage offered by another entity—such as another company within the same controlled group.

The problem for PEO customers stems from a provision in the final regulations on Section 4980H.  The provision allows the PEO’s customer to take credit for the PEO’s offer of coverage to the customer’s workers only if the customer pays an extra fee:

[I]n cases in which the staffing firm is not the common law employer of the individual and the staffing firm makes an offer of coverage to the employee on behalf of the client employer under a plan established or maintained by the staffing firm, the offer is treated as made by the client employer for purposes of section 4980H only if the fee the client employer would pay to the staffing firm for an employee enrolled in health coverage under the plan is higher than the fee the client employer would pay the staffing firm for the same employee if that employee did not enroll in health coverage under the plan.

The preamble to the regulations doubles down by describing a situation in which the staffing firm is not the common law employer as the “usual case.”

This extra-fee rule puts the PEO’s customer in a difficult position.  If it does not pay the extra fee, then the PEO’s offer of health coverage cannot be credited to the customer.  Thus, the customer risks being subject to the tax penalty, if upon audit the customer is determined to be the common law employer (assuming the PEO’s customer is an applicable large employer).  Alternatively, if the customer pays the extra fee to hedge against the risk of the tax penalty, the payment could be taken as an admission that the customer—not the PEO—is the common law employer.  Being the common law employer could expose the PEO’s customer to a host of legal liabilities, including, for example, rules pertaining to qualified plans (e.g., funding, nondiscrimination), workers compensation, and respondeat superior.  This result is unacceptable for many customers, who take the position that they are not the common law employers for any purpose.  Unfortunately, the new CPEO program only allows the customer to shift its payroll tax liabilities, and does not affect whether the customer or the CPEO is the common law employer for other purposes.

Finally, there is also a reporting wrinkle for customers outsourcing their health coverage obligations to PEOs.  The ACA requires the common law employer to report the offer of coverage on Form 1095-C.  If the PEO’s customer is the common law employer, there is no rule allowing it to shift this reporting obligation to the PEO.  Thus, if the PEO, rather than the customer, files the Form 1095-C, the customer may be subject to reporting penalties for failure to file a return.

IRS Releases New Form on Which Small Businesses Should Claim Payroll Tax Credit for R&D Expenditures

The IRS released draft Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, which qualified small business (i.e., start-up businesses) will use to claim the new payroll tax credit available to start-up businesses for qualified research and development (R&D) expenses up to $250,000.  As we explained in a prior post, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) allowed start-up businesses to take advantage of the R&D tax credit by allowing them to offset the employer portion of the Social Security tax—the credit was previously only available to companies that could offset such expenditures against taxable income.  Also covered in that post were modifications to two existing forms to accommodate the reporting of the expanded R&D tax credit: Form 6765, Credit for Increasing Research Activities, and Form 941, Employer’s Quarterly Federal Tax Return.

The new form allows qualified small businesses to calculate the amount of the qualified small business payroll tax credit for the current quarter. Taxpayers will file Form 8974 quarterly by attaching it to Form 941.  Form 8974 calculates the amount of payroll tax credit available to the taxpayer based on Line 44 of the prior tax year’s Form 6765, and the amount of social security taxes reported for the quarter, which is pulled from Column 2 of Lines 5a and 5b of the Form 941 on which the credit is applied.  The amount reported on Line 12 of Form 8974 is the payroll tax credit that qualified small businesses should report on Line 11 of the Form 941 (generally, the amount of the total credit allowable based on the prior year’s Form 6765 or 50% of the reported Social Security tax reported on the Form 941 for the current quarter).

Notice 2016-48 Implements PATH Act’s ITIN Changes, Clarifies Application of New Rules to Information Returns

The IRS recently issued Notice 2016-48 to implement changes to the individual tax identification number (ITIN) program that had been adopted by Congress.  The notice explains the changes made to the ITIN program, as well as how the IRS plans to implement those changes, and the consequences to taxpayers who do not comply with the new rules.

ITINs are issued to taxpayers who are required to have a U.S. taxpayer identification number but who are not eligible to obtain a social security number.  As discussed in an earlier post, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act), signed into law in December 2015, made it more difficult for nonresident aliens to maintain valid ITINs by amending Section 6109 of the Internal Revenue Code, the provision that permits the IRS to issue taxpayer identification numbers and request information to issue such numbers.  Specifically, under the PATH Act, Treasury must move toward an in-person ITIN application process, ITINs must be renewed to avoid expiration, and ITINs must be used to file a U.S. tax return to avoid expiration.

Application Procedures.  Under the current application procedures, taxpayers may apply for an ITIN by submitting Form W-7, Application for IRS Individual Taxpayer Identification Number by mail or in-person.  Notice 2016-48 does not execute Congress’s directive to establish an exclusively in-person application program, instead continuing the current application procedures, while the IRS takes additional time to determine how to implement the PATH Act’s mandate.  The IRS announced that further guidance will be issued.

ITIN Expiration.  The PATH Act made ITINs no longer indefinitely valid.  Any ITIN that is not used on a federal tax return for three consecutive years will expire on December 31 of the third year.  Taxpayers with an ITIN that has expired because they have not used it in three consecutive years may renew the ITIN any time after October 1, 2016 by submitting Form W-7 and the required accompanying documentation.

The PATH Act sets forth a schedule by which ITINs issued before 2013 will expire.  That schedule, which is based upon the issue date of the ITIN, was modified by Notice 2016-48 because many individuals do not know when their ITINs were issued, making the PATH Act’s schedule impractical.  Under Notice 2016-48, ITINs will expire under a multi-year schedule based upon the fourth and fifth digits of the ITIN.  Under this renewal system, ITINs with the middle digits 78 or 79 will expire on January 1, 2017, and future guidance will set forth the expiration schedule for other middle digit combinations.  The IRS will send Letter 5821 to individuals who used an ITIN with the middle digits 78 or 79 on a U.S. income tax return in any of the previous three years, notifying them of the upcoming expiration.

The IRS will accept returns with expired ITINs, but it warns taxpayers that processing delays may result and certain credits may not be allowed.  The processing delays and unavailability of certain credits could result in additional penalties and interest and a reduced refund.

Information Returns.  Expired ITINs are permitted to be used on information returns, meaning that holders of expired ITINs that are only used on returns filed by third parties, such as the Form 1099 or Form 1042 series, are not required to renew their ITINs.  Filers of information returns are not subject to penalties under Section 6721 or 6722 for the use of an expired ITIN on information returns. (However, many individuals who receive such information returns are required to file U.S. income tax returns necessitating that they renew their ITINs.)

First Friday FATCA Update

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August 5, 2016

Recently, the IRS released the Competent Authority Agreements (CAAs) implementing the Intergovernmental Agreements (IGAs) between the United States and the following treaty partners:

  • Georgia (Model 1B IGA signed on July 10, 2015);
  • British Virgin Islands (Model 1B IGA signed on June 30, 2014).

Since our last monthly FATCA update, we have also addressed other recent FATCA developments:

  • The IRS announced that on January 1, 2017, Treasury will update the IGA list to provide that certain jurisdictions that have not brought their IGA into force will no longer be treated as if they have an IGA in effect (see previous coverage).
  • The United States and Singapore issued a joint statement announcing that they are negotiating a Tax Information Exchange Agreement and Reciprocal Model 1A IGA to replace the nonreciprocal Model 1B IGA currently in effect (see previous coverage).

Under FATCA, IGAs come in two forms: Model 1 or Model 2.  Under a Model 1 IGA, the foreign treaty partner agrees to collect information of U.S. accountholders in foreign financial institutions (FFIs) operating within its jurisdiction and transmit the information to the IRS.  Model 1 IGAs are drafted as either reciprocal (Model 1A) agreements or nonreciprocal (Model 1B) agreements.  By contrast, Model 2 IGAs are issued in only a nonreciprocal format and require FFIs to report information directly to the IRS.

A CAA is a bilateral agreement between the United States and the treaty partner to clarify or interpret treaty provisions.  A CAA implementing an IGA typically establishes and prescribes the rules and procedures necessary to implement certain provisions in the IGA and the Tax Information Exchange Agreement, if applicable.  Specific topics include registration of the treaty partner’s financial institutions, time and manner of exchange of information, remediation and enforcement, confidentiality and data safeguards, and cost allocation.  Generally, a CAA becomes operative on the later of (1) the date the IGA enters into force, or (2) the date the CAA is signed by the competent authorities of the United States and the treaty partner.

The Treasury Department website publishes IGAs, and the IRS publishes their implementing CAAs.

IRS Releases Drafts of Forms 941 and 6765 to Enable R&D Payroll Tax Credit Under Section 3111(f)

The IRS released drafts of Form 941 and Form 6765 to facilitate a new payroll tax credit intended to allow start-up businesses to take advantage of the research and development (R&D) credit in Section 41 of the Internal Revenue Code.  In the past, start-up businesses took issue with the R&D tax credit because the credit was an income tax credit.  Because start-up businesses may not have taxable income for several years, they were not able to take advantage of the credit.

The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) expanded the R&D credit by adding new Sections 41(h) and 3111(f) to the Code.  Those sections allow “qualified small businesses” to elect to claim the credit (up to a maximum of $250,000) as a payroll tax credit. Those employers may elect to use the credit to offset the employer portion of Social Security tax.  It may not be used to reduce the amount of Social Security tax withheld from employees’ wages, nor may it be used to offset the employer or employee share of Medicare tax.  For purposes of the credit, a “qualified small business” is an employer with gross receipts of less than $5 million in the current taxable year and no more than five taxable years with gross receipts.  Qualified small businesses may claim the R&D payroll tax credit in tax years beginning after December 31, 2015.

The IRS added two lines to Form 941 (Employer’s Quarterly Federal Tax Return). Qualified small businesses will report the amount of the credit on Line 11 and report the total applicable taxes after adjustments and credits on Line 12.  In addition, qualified small businesses will elect to take a portion of the R&D credit as a payroll tax credit by completing new Section D on Form 6765 (Credit for Increasing Research Activities).  Comments on the forms can be submitted on the IRS web site.

The IRS subsequently released a draft Form 8974 that is used to calculate the payroll tax credit.

Singapore Seeks Reciprocal IGA to replace Nonreciprocal IGA Currently In Effect

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August 3, 2016

During a state visit by Singapore Prime Minister Lee Hsien Loong, Singapore and the United States announced they were negotiating a reciprocal Model 1 IGA.  The countries had previously entered into a nonreciprocal Model 1 IGA in 2014 that went into effect on March 28, 2015.  Unless Congress enacts legislation providing for greater collection of information from U.S. financial institutions, the reciprocal agreement will provide for limited exchange of information regarding Singapore residents who maintain accounts with U.S. financial institutions.  The obligations of Singapore financial institutions would be unchanged.  As part of the effort, the countries are negotiating the terms of a Tax Information Exchange Agreement (TIEA), and continue to discuss whether an income tax treaty should be negotiated.  According to the statement, the countries hope to complete negotiations on the TIEA and reciprocal IGA by the end of 2017.

IRS Proposed Regulations Clarify College Tuition Reporting Requirements Following TPEA and PATH Act

The IRS released proposed regulations on July 29 to reflect changes made to the Form 1098-T reporting requirements by Congress as part of the Trade Preferences Extension Act of 2015 (TPEA) and the Protecting Americans from Tax Hikes Act of 2015 (PATH Act).  The proposed regulations were issued in response to requests for additional guidance made by college financial officers and industry analysts.  The proposed regulations were published in the Federal Register today, and they will become effective on the date that final regulations are published.

Penalty Relief.  The proposed regulations amend the regulations under Section 6050S of the Internal Revenue Code to reflect new Section 6724(f) of the Code.  That provision was added by the TPEA and prohibits the IRS from imposing information reporting penalties under Sections 6721 and 6722 on educational institutions for failing to include a correct TIN on Form 1098-T if the educational institution certifies under penalty of perjury that it complies with the IRS’s rules governing TIN solicitations.  The applicable TIN solicitation rules are the same as under the existing regulations.  In general, if the educational institution does not have a record of the individual’s correct TIN, it must solicit the TIN on or before December 31 of each year during which it receives payments of qualified tuition and related expenses or makes reimbursements, refunds, or reductions of such amounts with respect to the individual.  If the individual does not provide his or her TIN upon request, the institution must file Form 1098-T without the TIN but with all other required information.

Reporting Exceptions.  The TPEA amended Section 25A of the Code so that a taxpayer may only claim an education credit if it receives a Form 1098-T from the educational institution that includes all of the required information, including the taxpayer’s TIN.  The proposed regulations amend the existing regulations under Section 6050S of the Code to eliminate a number of exceptions to the Form 1098-T reporting requirement that the IRS determined would frustrate the purpose of TPEA by depriving students of the Form 1098-T required to claim an education credit for which they may otherwise be eligible.  The current regulations under Section 6050S provide four exceptions to the Form 1098-T reporting requirement: (i) nonresident aliens, except upon request by the nonresident alien; (ii) individuals whose qualified tuition and related expenses are paid entirely with scholarships; (iii) individuals whose qualified tuition and related expenses are paid under a formal billing arrangement; and (iv) information with respect to courses for which no academic credit is awarded.  The proposed regulations maintain the exception related to courses for which no academic credit is awarded but eliminate the other three reporting exceptions.

New Reporting Requirement.  Additionally, the proposed regulations require educational institutions to report the number of months that a student was a full-time student during the calendar year on Form 1098-T.  The change is intended to help the IRS determine whether a parent properly claimed the student as a dependent, and therefore, properly claimed the credit for the student’s educational expenses.  For this purpose, one day during a month is treated as an entire month.

Amounts Reported.  In addition, the PATH Act requires educational institutions to report the amount of payments actually received for qualified tuition and related expenses on Form 1098-T, rather than simply the amount of payments billed.  This requirement is carried through to the proposed regulations, subject to the transition relief announced in IRS Announcement 2016-17 that allows educational institutions to report the amount billed for 2016, as explained in our earlier article.

To determine the amount of payments received for qualified tuition and related expenses, the proposed regulations instruct educational institutions to treat payments received during a calendar year as payments received for qualified tuition and related expenses up to the amount billed for such expenses, and any amount in excess of the amount billed as payments for other expenses.

IRS Clarifies Several Issues Related to Section 6055 Reporting in Proposed Regulations

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August 1, 2016

On July 29, the IRS issued proposed regulations under Section 6055 that seek to clarify a number of issues raised by commenters in response to the original proposed regulations under Section 6055 and Notice 2015-68.  Filers may rely on the proposed regulations for calendar years ending after December 31, 2013, making them applicable at the option of filers for all years during which Forms 1095-B and Forms 1095-C were required to be filed.  In addition to the clarifications contained in the regulations themselves, the IRS’s comments in the preamble to the regulations provide additional helpful guidance to filers.  Ultimately, the proposed regulations are helpful but continue to overlook some areas where further binding guidance in regulations would be helpful.  Specific changes are discussed below:

Catastrophic Coverage.  Unlike other coverage purchased through an exchange, the proposed regulations implement the change announced in Notice 2015-68, requiring that insurers providing the coverage report it.  This change is effective for catastrophic coverage provided in 2017 and required to be reported in 2018.  Insurers are not required to report catastrophic coverage provided in 2016 (and otherwise required to be reported in 2017), although they are encouraged to do so on a voluntary basis.  A filer who voluntarily reports catastrophic coverage provided in 2016 is not subject to penalties on those returns.

Supplemental or Duplicative Coverage.  Consistent with Notice 2015-68, the proposed regulations simplify the rule contained in the final regulations relating to supplemental coverage. Under the proposed regulations, a reporting entity that during a month provides minimum essential coverage under more than one plan that it provides (such as an HRA and a high-deductible health plan) need only report coverage under one plan.

Truncated TINs.  Consistent with Notice 2015-68, the proposed regulations clarify that a filer may use a truncated TIN in place of the TIN of each covered individual, the responsible individual, and if applicable, the sponsoring employer’s EIN.

TIN Solicitation.  Responding to comments from Section 6055 filers, the proposed regulations clarify how the reasonable cause rules relating to TIN solicitation under Section 6724 apply to Section 6055.  The IRS acknowledged in the preamble, that the existing rules were difficult to apply outside of the financial context for which they were written.  The clarifications include:

  • Under Section 6724, a filer is required to make an initial TIN solicitation at the time an account is opened. Commenters had requested clarification regarding when an account is opened for purposes of applying the TIN solicitation rules to Section 6055.  The proposed regulations specify that the account is “opened” when the filer receives a substantially completed application for coverage, including an application to add an individual to existing coverage.  The application may be submitted either by the individual or on the individual’s behalf (for example, by an employer).  As a result, providers of minimum essential coverage who are required to report under Section 6055 should strongly consider changing their applications forms to include a request for TINs, if they have not already done so. (See the discussion of transition relief below for the treatment of coverage in effect before July 29, 2016.)
  • If the initial solicitation does not result in the receipt of a TIN for each covered individual and the responsible individual, the filer must make the first annual TIN solicitation within 75 days of such date, or in the case of retroactive coverage, within 75 days after the determination of retroactive coverage is made. The second annual solicitation must be made by December 31 of the following year.  (See the discussion of transition relief below for the treatment of coverage in effect before July 29, 2016.)
  • Under Section 6724, initial and first annual solicitations relate to failures on returns for the year in which the account is opened. In other words, to demonstrate reasonable cause for the year in which the account was opened, a filer must generally show that it made the initial and first annual solicitations.  In contrast, the second annual solicitation relates to failures on returns for all succeeding years.  Because the first return required under Section 6055 will often be required for a year after the year in which the account is “opened” (as described above), the proposed regulations provide that the initial and first annual solicitations relate to the first effective date of coverage for an individual.  The second annual solicitation relates to subsequent years.  The IRS did not discuss how these rules related to an individual who has been covered continuously since a date prior to the requirement to solicit a TIN from an individual.  Presumably, the initial and first annual solicitations will relate to the first year for which a Form 1095-B or Form 1095-C would have been required to be filed by the filer.  These changes generally relate only to the solicitation process for missing TINs and not the process for erroneous TINs.
  • An open question was whether a separate TIN solicitation was required to each covered individual on Form 1095-B or Form 1095-C. The proposed regulations provide that a filer may satisfy the TIN solicitation rules with respect to all covered individuals by sending a single TIN solicitation to the responsible individual.  This is welcome news and alleviates the concern about sending separate solicitations to children and other covered individuals.  However, the proposed regulations do not adopt commenters’ suggestion that if an individual is later added to existing coverage that prior annual TIN solicitations, if those solicitations were unsuccessful, made to the same responsible individual would satisfy the annual TIN solicitation requirement with respect to the new covered individual.  Instead, even though a filer may have made an initial and two annual solicitations to the responsible person, the addition of a new covered individual will require the filer to make a new series of solicitations with respect to the new individual’s TIN.
  • Although not addressed in the regulations, the preamble indicates that a filer may solicit TINs electronically consistent with the requirements in Publication 1586. The guidelines for electronic solicitations generally require an electronic system to (1) ensure the information received is the information sent, and document all occasions of user access that result in submission; (2) make it reasonably certain the person accessing the system and submitting the form is the person identified on the Form W-9; (3) provide the same information as the paper Form W-9; (4) require as the final entry in the submission, an electronic signature by the payee whose name is on the Form W-9 that authenticates and verifies the submission; and (5) be able to provide a hard copy of the electronic Form W-9 to the IRS if requested.  Although it is helpful to know that the IRS believes filers may make use of an electronic system for TIN solicitations like filers under other provisions of the Code, it would have been helpful for the IRS to update its outdated regulations under Section 6724 to specifically permit electronic TIN solicitations.  Ultimately, because Forms 1095-B and 1095-C do not report income that an individual may seek to avoid having reported by using an erroneous name/TIN combination, a less complicated means of electronic solicitation would have been appropriate in this case.

The preamble declines to make four changes requested by commenters:

  • First, the preamble declines to amend the regulations to clarify that a renewal application satisfies the requirements for annual solicitation. Instead, the preamble states that the provision of a renewal application that requests TINs for all covered individuals “satisfies the annual solicitation provisions” if it is sent by the deadline for those annual solicitations.  Although the rule stated in the preamble would be helpful, it is not the rule contained in the regulations.  The regulations under Section 6724 include detailed requirements for annual solicitations including that they include certain statements, a return envelope, and a Form W-9.  Accordingly, a renewal application is unlikely, on its own, to satisfy the annual solicitation requirements as stated in the preamble.  Commenters had requested some changes to these rules, but as discussed below, the IRS declined to adopt such changes in the proposed regulations.
  • Second, the proposed regulations do not remove the requirement to include a Form W-9 or substitute form in a mailed annual solicitation. The preamble indicates that this change was not needed because filers are already permitted to include a substitute Form W-9 with a TIN solicitation.  Although this is true, it sidesteps the concerns raised by commenters relating to the inappropriateness of a Form W-9.  The preamble indicates that an application or renewal application would be an acceptable substitute.  However, the IRS drafters do not seem to understand what constitutes a substitute Form W-9  because an application under the new proposed rule would have to meet several requirements that such documents are unlikely to meet.  For example, a substitute Form W-9 must include a statement under penalties of perjury that the payee is not subject to backup withholding due to a failure to report interest and dividend income and the FATCA code entered on the form indicating that the payee is exempt from FATCA reporting is correct.  Neither of these certifications is relevant to Section 6055 reporting.  Moreover, the references to a “payee” is confusing in the context of Section 6055 reporting, which does not involve a payee (and to the extent there is a payee at all, it would be the filer).  The reference to FATCA exemptions is also not relevant, especially given that only individuals would be completing the form and no U.S. person is exempt from FATCA reporting even if it were relevant.  Moreover, because an application would likely require the applicant to agree to provisions unrelated to these required certifications (such as their age being correct, gender being correct, and other information on the application being correct), a separate signature block or conspicuous statement that the IRS requires only that they consent to the certifications required to avoid backup withholding would have to be included on the form.  It seems doubtful that any applications would satisfy these requirements currently.  Given the misleading nature of the statements and the simple fact that the discussion of backup withholding is completely irrelevant to Section 6055 reporting, it even seems doubtful that many filers will redesign their application forms to satisfy the substitute form requirements even though the drafters of the proposed regulations seem to believe that such forms would be acceptable substitutes.
  • Third, the proposed regulations do not remove the requirement that a mailed TIN solicitation include a return envelope. While retaining the rule in the existing Section 6724 regulations, the preamble does, however, clarify that only a single envelope is required to be sent consistent with the decision to allow a single TIN solicitation to the responsible individual to satisfy the TIN solicitation requirement for all covered individuals.
  • Fourth, commenters had requested that the IRS adopt rules specifically permitting filers to rely on the sponsors of insured group health plans to solicit TINs from their employees on the filer’s behalf. Although the IRS indicated that a filer may use an employer as an agent for TIN solicitation, it declined to provide a distinct ground for reasonable cause when the filer contracted with the employer-sponsor to perform the TIN solicitations.  As a result, the employer’s failure to satisfy the TIN solicitation requirements will leave a filer subject to potential penalties.

Transition Relief. The preamble provides that if an individual was enrolled in coverage on any day before July 29, 2016, the account is considered opened on July 29, 2016. Accordingly, reporting entities have satisfied the requirement for the initial solicitation with respect to already enrolled individuals so long as they requested enrollee TINs at any time before July 29, 2016.

As discussed above, the deadlines for the first and second annual solicitations are set by reference to the date the account is opened.  Accordingly, the first annual solicitation with respect to an individual enrolled in coverage before July 29, 2016, should be made at a reasonable time after that date (the date on which such account is considered open) consistent with Notice 2015-68. Accordingly, a filer that makes the first annual solicitation within 75 days of July 29, 2016 (by October 12, 2016), will be treated as having made such solicitation within a reasonable time.

The preamble states that filers that have not made the initial solicitation before July 29, 2016, should comply with the first annual solicitation requirement by making a solicitation within a reasonable time of July 29, 2016. The preamble reiterates that as provided in Notice 2015-68, a filer is deemed to have satisfied the initial, first annual, and second annual solicitations for an individual whose coverage was terminated prior to September 17, 2015, and taxpayers may continue to rely on this rule as well.  Because a filer is not required to make an annual solicitation under Section 6724 during a year for which it is not required to report coverage, presumably, a filer need not make any solicitations with respect to an individual for whom coverage was terminated at any time in 2015.

AIR System Messages.  The preamble to the proposed regulations formalizes the position of the IRS with respect to TIN mismatch messages generated by the ACA Information Returns (AIR) filing system.  In a footnote, the preamble states that such error messages are “neither a Notice 972CG, Notice of Proposed Civil Penalty, nor a requirement that the filer must solicit a TIN in response to the error message.”  However, given the IRS’s stated position that error correction is a necessary part of demonstrating “good faith” required for penalty relief, it is unclear what, if anything, a filer should do in response to these error messages.  In any event, filers may wish to demonstrate good faith by making an effort to obtain correct TINs from responsible individuals and head-off future errors by working to do so now, rather than later, when such efforts will likely be required.

Treasury to Remove Jurisdictions from List of Countries Treated as Having IGAs in Effect

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August 1, 2016

Last week, the IRS announced that on January 1, 2017, the U.S. Treasury will remove some jurisdictions from the list of foreign jurisdictions that are treated as having intergovernmental agreements (IGAs) in effect.  To remain on the list after December 31, 2016, each jurisdiction that seeks to continue to be treated as having an IGA in effect must provide to the Treasury a detailed explanation of its failure to bring an IGA into force and a step-by-step plan and timeline for signing the IGA, or if the IGA has already been signed, to bring the IGA into force.  Since 2013, the Treasury has provided a list of jurisdictions that are as having an IGA in force as long as the jurisdiction is taking “reasonable steps” or showing “firm resolve” to sign the IGA (if no IGA has been signed) or to bring the IGA into force.

As of today, the United States has signed IGAs with 83 jurisdictions and 61 of those IGAs are in effect.  Another 30 jurisdictions are considered to have an agreement in substance, but have not yet signed an IGA.  The jurisdictions who are treated as having an IGA in effect that have not yet signed an agreement or who have signed an agreement but not yet brought it into effect are: Anguilla, Antigua and Barbuda, Armenia, Bahrain, Belgium, Cabo Verde, Cambodia, Chile, Costa Rica, Croatia, Curaçao, Dominica, Dominican Republic, Georgia, Greece, Greenland, Grenada, Guyana, Haiti, Hong Kong, Indonesia, Iraq, Israel, Kazakhstan, Macao, Malaysia, Montenegro, Montserrat, Nicaragua, Paraguay, Peru, Philippines, Portugal, San Marino, Saudi Arabia, Serbia, Seychelles, South Korea, St. Lucia, Taiwan, Thailand, Trinidad and Tobago, Tunisia, Turkey, Turkmenistan, Ukraine, United Arab Emirates, and Uzbekistan.

Under FATCA, an IGA is a bilateral agreement between the United States and a foreign jurisdiction to collect information related to U.S. accountholders at foreign financial institutions (FFIs) in the foreign jurisdiction and transmit the information to the IRS.  If a foreign jurisdiction lacks an IGA in force, then FFIs in that jurisdiction face greater FATCA compliance burdens.  First, they must register with the IRS as participating FFIs (rather than registered deemed compliant FFIs) to avoid the mandatory 30% withholding on payments of U.S. source FDAP income that they receive.  This subjects them to the full requirements of the Treasury Regulations governing FATCA rather than the streamlined procedures in the IGAs.  Further, they are often subject to conflicting obligations, because the foreign jurisdiction may have privacy or bank laws that conflict with the disclosure requirements of FATCA.

In the announcement, the IRS stressed that a jurisdiction initially determined to have shown firm resolve to bring an IGA into force will not retain that status indefinitely (e.g., if the jurisdiction fails to follow its proposed plan and timeline for bringing an IGA into force).  If the IRS determines that a jurisdiction ceases to be treated as having an IGA effect, an FFI in the jurisdiction generally will have to enter into a FFI Agreement to comply with the FFI’s FATCA reporting obligations within 60 days.