IRS Audit Guidelines Provide Insights for Withholding Agents

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July 21, 2016

In audit guidelines contained in a recent International Practice Unit, the IRS advised its agents that when a U.S. business buys intangibles, such as patents, copyrights, formulas, good will, brands, or franchises, from a foreign seller and agrees to pay for them contingent on their productivity, the contingent payments should be treated as royalties.  As such, the payments are potentially subject to withholding under Chapter 3 of the Internal Revenue Code.

Generally, Chapter 3 withholding is required on payments to foreign persons of fixed, determinable, annual, or periodical (FDAP) income from sources within the U.S. that are not ECI.  Royalties, such as those from an intangible or a patent, are U.S. source FDAP income if the intangible or patent is used in the U.S.  In contrast, payments for the purchase of an intangible or patent are treated as non-FDAP sales proceeds, and hence are not subject to Chapter 3 withholding.  The IRS’s Practice Unit reminds agents that when a U.S. business buys intangibles, such as patents, from a foreign seller and agrees to pay for them contingent on their productivity, the contingent payments are treated as royalties, not sales proceeds.

Withholding agents should carefully consider whether any payments for intangibles should be treated as royalties and are thus subject to withholding.  The audit guidelines also provide an important reminder to withholding agents about the importance of understanding the source of payments it makes to foreign persons.  The Practice Unit emphasizes that if the source of a payment cannot be determined or is not known, the IRS examiner should treat the amount as U.S. source.  Accordingly, withholding agents should document the source of its payments to foreign persons and ensure that they know whether amounts are U.S. source before making payment to avoid secondary liability for withholding failures.