Impact of Tax Cuts and Jobs Act: Part V – Certain Changes Affecting Cross-Border Withholding and Sourcing

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November 6, 2017

Thursday, November 2, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  We are releasing a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance.  Part I of this series covered potential changes to employer-provided benefits, Part II addressed entertainment expenses and other fringe benefits, Part III discussed changes to employee retirement plans, and Part IV covered changes to the Code section 162(m) deduction limitation for executive compensation.  In this Part V, we will discuss the Bill’s potential impact on two cross-border tax issues.

Reduced FIRPTA Withholding Rates.  Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), gain or loss on the disposition of U.S. real property interests by a nonresident alien individual or foreign corporation is subject to U.S. income tax as though the taxpayer were engaged in a trade or business in the United State and such gain or loss were effectively connected with such trade or business.  Section 1445 applies a withholding mechanism to ensure the payment of any tax due.  When a domestic partnership, trust, or estate disposes of a U.S. real property interest, section 1445 requires that it (or the trustee or executor, in the case of a trust or estate, respectively) withhold 35 percent of the gain realized that is allocable to a foreign person (or allocable to a portion of a trust treated as owned by a foreign person).  Similarly, when a foreign corporation distributes a U.S. real property interest to its shareholders, it must withhold at a rate of 35 percent.  The same withholding rate applies to distributions that are treated as gains or losses from the disposition of a U.S. real property interest allocable to foreign persons from certain domestic entities (such as real estate investment trusts and registered investment companies that would be considered U.S. real property holding corporations if their shares were not publicly traded).  Section 3001 of the Bill, which reduces corporate tax rates in general, includes a corresponding reduction of the FIRPTA tax withholding rate, modifying paragraphs 1445(e)(1), 1445(e)(2), and 1445(e)(6) to require withholding at a 20 percent rate.  The reductions would take effect for tax years beginning after 2017.

Modification to Sourcing Rule for Sales of Inventory Property.  Currently, up to 50 percent of income from the sale of inventory property produced entirely within the United States and sold outside the United States (or vice-versa) can be treated as foreign-source income for purposes of calculating foreign tax credits.  Section 4102 of the Bill would require sales of inventory property to be sourced solely based on the location of production activity with respect to the inventory.  This change would be effective for tax years beginning after 2017.

First Friday FATCA Update

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October 6, 2017

Since our last monthly FATCA update, the IRS has issued Notice 2017-46, providing welcomed reprieve for U.S. financial institutions with respect to the collection of foreign taxpayer identification numbers (FTINs) required of them by FATCA to avoid Chapter 3 withholding.  The notice delays the date on which U.S. financial institutions must begin collecting FTINs to January 1, 2018, provides a phase-in period for obtaining FTINs from account holders documented before January 1, 2018, that will end on December 31, 2019, and limits the circumstances in which FTINs are required (see prior coverage).  This week, an IRS official reiterated that a change in an accountholder’s address to another jurisdiction is a change in circumstances that will invalidate the Form W-8 for payments made after the change provided an FTIN is otherwise required, necessitating the collection of an FTIN if an FTIN is otherwise required with respect to the payment(s).

Additionally, the Treasury Department has also released the Model 1A intergovernmental agreement (IGA) between the United States and Kazakhstan.

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 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 competent authority agreement (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 Updates List of Countries Subject to Bank Interest Reporting Requirements

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October 2, 2017

Last week, the IRS issued Revenue Procedure 2017-46 to supplement the list of countries subject to the reporting requirements of Code section 6049, which generally relate to reporting on bank interest paid to nonresident alien individuals.  The expansion is not unexpected, as this list of countries, originally set forth in Revenue Procedure 2014-64 and modified a handful of times since, will likely continue to expand as more countries enter into tax information exchange agreements with the U.S. in order to implement the Foreign Account Tax Compliance Act (FATCA).  Specifically, the Revenue Procedure adds the Faroe Islands and Greenland to the list of countries with which the U.S. has a bilateral tax information exchange agreement, and adds Croatia and Panama to the list of countries with which Treasury and IRS have determined the automatic exchange of information to be appropriate.  Coverage of previous updates to these lists can be found here and here.

Prior to 2013, interest on bank deposits was generally not required to be reported if paid to a nonresident alien other than a Canadian.  In 2012, the IRS amended Treas. Reg. § 1.6049-8 in an effort to provide bilateral information exchanges under the intergovernmental agreements between the United States and partner jurisdictions that were being agreed to as part of the implementation of FATCA.  In many cases, those agreements require the United States to share information obtained from U.S. financial institutions with foreign tax authorities.  Under the amended regulation, certain bank deposit interest paid on accounts held by nonresident aliens who are residents of certain countries must be reported to the IRS so that the IRS can satisfy its obligations under the agreements to provide such information reciprocally.

The bank interest reportable under Treas. Reg. § 1.6049-8(a) includes interest: (i) paid to a nonresident alien individual; (ii) not effectively connected with a U.S. trade or business; (iii) relating to a deposit maintained at an office within the U.S., and (iv) paid to an individual who is a resident of a country properly identified as one with which the U.S. has a bilateral tax information exchange agreement.  Under Treas. Reg. § 1.6049-4(b)(5), for such bank interest payable to a nonresident alien individual that exceeds $10, the payor must file Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding,” for the year of payment.

IRS Makes Good on Promise to Issue Guidance Loosening Certain FATCA Reporting Requirements

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September 26, 2017

Yesterday, the IRS issued Notice 2017-46, representing a welcome reprieve for U.S. financial institutions with respect to the collection of foreign taxpayer identification numbers (FTINs) required of them by the Foreign Account Tax Compliance Act (FATCA) to avoid Chapter 3 withholding.  As we discussed in a prior post, an official with the IRS Office of Chief Counsel previewed this forthcoming guidance earlier this month and communicated that it was intended as a response to comments received by the IRS from withholding agents.  The new guidance delays the date on which U.S. financial institutions must begin collecting FTINs to January 1, 2018, provides a phase-in period for obtaining FTINs from account holders documented before January 1, 2018 that will end on December 31, 2019, and limits the circumstances in which FTINs are required.  For example, withholding agents will not be required to obtain FTINs on Forms W-8 that the withholding agent would otherwise obtain solely to avoid Form 1099 reporting or backup withholding, or in situations where a payment is not otherwise subject to reporting on Form 1042-S.  Additionally, withholding agents will not be required to obtain FTINs from an account holder in a jurisdiction that has not entered a reciprocal tax information exchange treaty with the United States or in a jurisdiction that does not issue FTINs to its residents.  Finally, withholding agents need not acquire FTINs for governments, international organizations, foreign central banks of issue, or residents of a U.S. territory.  The IRS will revise the Instructions for Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding,” to reflect the amended FTIN requirements.

In addition, Notice 2017-46 also provides a reprieve for certain Model 1 FFIs with respect to their reporting requirements, extending the time by which they must obtain and report U.S TINs for preexisting accounts that are U.S. reportable accounts.  For such accounts, the U.S. Competent Authority will not determine that there is “significant non-compliance” with obligations under a Model 1 intergovernmental agreement solely because of a failure to obtain and report a U.S. TIN, provided that the Model 1 FFI follows certain alternative procedures specified in Notice 2017-46.

The IRS intends to amend the regulations to reflect the rules announced in Notice 2017-46, but taxpayers may rely on the Notice until it issues such regulations.

First Friday FATCA Update

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September 1, 2017

Since our previous monthly FATCA update, we have addressed the following recent FATCA developments:

  • The Sixth Circuit issued an opinion on August 18, 2017 upholding the dismissal of a challenge to FATCA brought by Senator Rand Paul and several current and former U.S. citizens living abroad who hold foreign accounts (see prior coverage).
  • The IRS posted draft instructions to the Form 8966 (FATCA Report) dated August 9, 2017, with some changes pertaining to participating foreign financial institutions (PFFIs) and other changes reflecting the final and temporary Chapter 4 regulations released in January of this year (see prior coverage).

Additionally, an official with the IRS Office of Chief Counsel recently stated that the IRS will delay the date on which U.S. financial institutions must start treating an otherwise valid Form W‑8 as invalid merely because it does not include a foreign taxpayer identification number (FTIN) or a reasonable explanation for its absence, to avoid Chapter 3 withholding.  Specifically, a valid Form W-8 obtained before January 1, 2018, will not be treated as invalid on that date if the form simply lacks the FTIN or a reasonable explanation for its absence (e.g., the account holder’s country of residence does not provide TINs).  It is unclear what form the relief will take, but it is possible the IRS will continue to allow a U.S. financial institution to treat a Form W-8 as valid if the financial institution does not have actual knowledge that the beneficial owner has an FTIN for some period of time.

This informal relief from the new FTIN requirement (issued in final and temporary regulations in late 2016) is welcomed by banks and withholding agents that report income for foreign account holders.  The relief is still reflected in FAQs on the IRS website (see prior coverage).  But since Form W-8s expire on three-year cycles, banks and agents still have to update their withholding policies and annual re-solicitation processes to comply with the new FTIN requirements.  Additionally, banks and agents are still waiting for further guidance on how they can update Form W‑8s issued before 2018 with the newly‑required FTIN or reasonable explanation.  An IRS FAQ posted in April 2017 specifies that the information can be provided in a written statement, including an email, but it is unclear what other requirements might apply to such a statement.

Since our previous monthly FATCA update, the IRS has also released the Competent Authority Agreements (CAAs) implementing intergovernmental agreements (IGAs) between the United States and the following treaty partners:

  • Anguilla (Model 1B IGA signed on January 15, 2017);
  • Italy (Model 1A IGA signed on January 10, 2014).

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 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 Updates List of Countries Subject to Bank Interest Reporting Requirements

The IRS has issued Revenue Procedure 2017-31 to supplement the list of countries subject to the reporting requirements of Code section 6049, which generally relate to reporting on bank interest paid to nonresident alien individuals.  This was an expected move, as this list of countries, originally set forth in Revenue Procedure 2014-64 and modified a handful of times since, will likely continue to expand as more countries enter into tax information exchange agreements with the U.S. in order to implement the Foreign Account Tax Compliance Act (FATCA).  Specifically, Revenue Procedure 2017-31 adds Belgium, Colombia, and Portugal to the list of countries with which Treasury and the IRS have determined the automatic exchange of information to be appropriate.  Unlike the last set of additions to the list, set forth in Revenue Procedure 2016-56 (see prior coverage), no countries were added to the list of countries with which the U.S. has a bilateral tax information exchange agreement.

Prior to 2013, interest on bank deposits was generally not required to be reported if paid to a nonresident alien other than a Canadian.  In 2012, the IRS amended Treas. Reg. § 1.6049-8 in an effort to provide bilateral information exchanges under the intergovernmental agreements between the United States and partner jurisdictions that were being agreed to as part of the implementation of FATCA.  In many cases, those agreements require the United States to share information obtained from U.S. financial institutions with foreign tax authorities.  Under the amended regulation, certain bank deposit interest paid on accounts held by nonresident aliens who are residents of certain countries must be reported to the IRS so that the IRS can satisfy its obligations under the agreements to provide such information reciprocally.

The bank interest reportable under Treas. Reg. § 1.6049-8(a) includes interest: (i) paid to a nonresident alien individual; (ii) not effectively connected with a U.S. trade or business; (iii) relating to a deposit maintained at an office within the U.S., and (iv) paid to an individual who is a resident of a country properly identified as one with which the U.S. has a bilateral tax information exchange agreement.  Under Treas. Reg. § 1.6049-4(b)(5), for such bank interest payable to a nonresident alien individual that exceeds $10, the payor must file Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding,” for the year of payment.

Recent FAA Serves as Warning to Employers Using PEOs

A recent Internal Revenue Service Office of Chief Counsel field attorney advice memorandum (FAA 20171201F) sounds a cautionary note for employers making use of a professional employer organization (PEO).  The FAA holds a common law employer ultimately liable for employment taxes owed for workers it leased from the PEO.  Under the terms of the employer’s agreement with the PEO, the PEO was required to deposit employee withholdings with the IRS and pay the employer share of payroll taxes to the IRS.  Alas, that was not what happened.

The taxpayer did not dispute that it had the right to direct and control all aspects of the employment relationship and was thus was the common law employer with respect to the employees, but asserted that it was not liable for the unpaid employment taxes. Under the terms of the contracts between the taxpayer and the PEO, the taxpayer would pay an amount equal to the wages and salaries of the leased employees to the PEO prior to the payroll date, and the PEO would then pay all required employment taxes and file all employment tax returns (Forms 940 and 941) and information returns (Forms W-2) with respect to the employees.

After the PEO failed to pay and deposit the required taxes, the Examination Division of the IRS found the taxpayer liable for the employment tax of those workers, plus interest. The taxpayer appealed, making several arguments against its liability: (i) the PEO was liable for paying over the employment taxes under a state statute; (ii) the PEO was the statutory employer, making it liable for the employment taxes; and (iii) the workers were not employees of the taxpayer under Section 530 of the Revenue Act of 1978.

The Office of Chief Counsel first explained that the state law cited by the taxpayer was not relevant because it was superseded by the Internal Revenue Code. The FAA rejects the taxpayer’s second argument because the PEO lacked control over the payment of wages, and thus it was not a statutory employer. The PEO lacked the requisite control because the taxpayer was obligated to make payment sufficient to cover the employees’ pay before the PEO paid the workers.  Finally, the Office of Chief Counsel denied the taxpayer relief under Section 530 of the Revenue Act of 1978 because that provision only applies to questions involving employment status or worker classification, neither of which was at issue.  Although the FAA makes clear that the common law employer will be on-the-hook for the unpaid employment taxes, the FAA did indicate that it would be open to allowing an interest-free adjustment because the taxpayer’s reliance on the PEO to fulfill its employment tax obligations constituted an “error” under the interest-free adjustment rules.

The FAA serves as a reminder that the common law employer cannot easily offload its liability for employment taxes by using a contract. Indeed, it remains liable for such taxes and related penalties in the event that the party it has relied on to deposit them fails to do so timely.  Employers who choose to make use of a PEO should carefully monitor the PEO’s compliance with the payroll tax rules to ensure that it does not end up in this taxpayer’s position.  Alternatively, employers should consider whether to use a certified PEO under the new regime established by Congress (earlier coverage  available here and here).  When using a certified PEO, the common law employer can successfully shift its liability to the PEO and is not liable if the PEO fails to comply with the payroll tax requirements of the Code.

IRS Issues Guidance for Early Country-by-Country Reporting

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February 7, 2017

Recently, the IRS issued guidance for multinational enterprises (MNEs) with at least $850 million in annual revenue based in the United States that may have constituent entities subject to country-by-country (CbC) reporting requirements in foreign jurisdictions because of the effective date of CbC reporting in the United States.  CbC reporting aims to eliminate tax avoidance by multinational companies by requiring MNEs to report certain indicators of the MNE’s economic activity in each country and allowing the tax authorities to share that information with one another.

In the U.S., MNEs make the CbC report on Form 8975, “Country-by-Country” report.  The report contains revenue, profit or loss, capital, and accumulated earnings data for each country of operation.  Last year, the IRS issued final regulations requiring these reports for reporting periods that begin on or after the first day of the first taxable year of the ultimate parent entity beginning after June 30, 2016.  (See prior coverage.)  However, several countries have implemented CbC reporting on constituent entities for periods beginning on or after January 1, 2016.  As a result, constituent entities of a U.S. MNE may be subject to local CbC filing in their jurisdictions for reporting periods before the effective date of the final regulations unless the ultimate parent files Form 8975 for the earlier period or reports CbC information to another jurisdiction that accepts a surrogate filing for the U.S. MNE.

Revenue Procedure 2017-23 provides that the ultimate parent of a U.S. MNE may choose to voluntarily file Form 8975 and the accompanying Schedule A for reporting periods beginning after January 1, 2016 and before June 30, 2016.  Beginning on September 1, 2017, a parent entity may file Form 8975 for an early reporting period that ends with or during the parent entity’s tax year by attaching it to its tax return for such year.  If the ultimate parent has already filed its tax return for such year, it must file an amended return and attach Form 8975 within 12 months of the end of such tax year to file the CbC report for the early reporting period.

The IRS encourages entities that file their tax returns electronically to also file Form 8975 electronically.  Form 8975 must be filed through the IRS Modernized e-File system in XML format.  Paper forms will be made available before the September 1, 2017, deadline for filers who cannot file the form in XML format.

Final Regulations Make Minor Changes to FATCA and Chapter 3 Presumption Rules

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January 5, 2017

The final regulations released by the IRS under the Foreign Account Tax Compliance Act (FATCA) on December 30, 2016 finalized the temporary presumption rules promulgated on March 6, 2014 with no substantive changes, but several changes were made to the final coordinating regulations under Chapter 3 and Chapter 61, also released on the same date.

Under FATCA, withholding agents must conduct certain due diligence to identify the Chapter 4 status of their payees.  In the absence of information sufficient to reliably identify a payee’s Chapter 4 status, withholding agents must apply specific presumption rules to determine that status.

According to the preamble to the final FATCA regulations, a commenter requested that a reporting Model 1 foreign financial institution (FFI) receiving a withholdable payment as an intermediary or making a withholdable payment to an account held by an undocumented entity be permitted to treat such an account as a U.S. reportable account.  The IRS rejected the commenter’s suggestion, explaining that a reporting Model 1 FFI that follows the due diligence procedures required under Annex I of the IGA should not maintain any undocumented accounts.  In the absence of information to determine the status of an entity account, a reporting Model 1 FFI must obtain a self-certification, and in the absence of both the required information and a self-certification, the reporting Model 1 FFI must apply the presumption rules contained in the Treasury Regulations by treating the payee as a nonparticipating FFI and withholding.

The discussion in the preamble is consistent with the rules set forth in the IGAs, which require reporting Model 1 or Model 2 FFIs to withhold on withholdable payments made to nonparticipating FFIs in certain circumstances.  The reasoning provided is also the same as provided with respect to reporting Model 2 FFIs in Revenue Procedure 2017-16, setting forth the updated FFI agreement.

Although the IRS declined to make the requested change to the final Chapter 4 regulations, it did make a number of changes to the presumption rules in the final FATCA coordination regulations.  It also rejected some changes that were requested by commenters.

Under the temporary coordination regulations, a withholding agent must presume that an undocumented entity payee that is an exempt recipient is a foreign person if the name of the payee indicates that it is a type of entity that is on the per se list of foreign corporations.   However, an entity name that contains the word “corporation” or “company” is not required to be presumed foreign because such information in itself it is not indicative of foreign status.  According to the preamble, a commenter requested that the IRS amend the presumption rules to allow a presumption of foreign status for an entity whose name contains “corporation” or “company,” if the withholding agent has a document that reasonably demonstrates that the entity is incorporated in the relevant foreign jurisdiction on the per se list.  The IRS adopted this change to the coordination regulations.

In contrast, the IRS rejected a commenter’s other suggested changes to the presumption rules.  One commenter requested that a withholding agent making a payment other than a withholdable payment to an exempt recipient be permitted to rely on documentary evidence to presume the payee is foreign.  The IRS reasoned that the documentary evidence rule was not worthwhile because it would be limited in scope because an existing rule, which requires a withholding agent to presume a payee that is a certain type of exempt recipient is foreign with respect to withholdable payments, may be applied by the withholding agent to all payments with respect to an obligation whether or not they are withholdable payments.  The IRS also expressed concern about how the proposed change would work in the context of payments made to foreign partnerships with partners who are non-exempt recipients and for which different presumption rules apply.

The IRS also declined to make a suggested change that would permit an undocumented entity to be presumed foreign if the withholding agent has a global intermediary identification number (GIIN) on file for the payee and the payee’s name appears on the IRS FFI list.  The IRS rejected the proposed change because U.S. entities can register and obtain a GIIN (for example, as a sponsoring entity), so the existence of a GIIN does not necessarily indicate the payee is foreign.

Temporary FATCA Coordination Regulations Bring U.S. Source Gross Transportation Income Saga to a Close

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January 4, 2017

On Friday, December 30, 2016, the IRS and Treasury Department released over 600 pages of new final, temporary and proposed regulations under Chapter 4 (FATCA), Chapter 3, and Chapter 61 (see earlier coverage).  The four packages finalize the temporary regulations issued in 2014 and make additional changes based on comments received by the IRS.  One issue addressed by the temporary FATCA coordination regulations issues under Chapter 3 addresses the outstanding question of whether withholding agents must document the foreign payees of U.S. source gross transportation income (USSGTI) and withhold under Chapter 3.  The temporary regulations amend the regulations under Section 1441 to specifically exempt USSGTI from amounts subject to withholding.

Although it informally suggested that withholding agents were not required to document or withhold 30% on payments of USSGTI, the IRS has been reluctant to issue formal guidance.  To this end, IRS Publication 515 provides that such amounts are not subject to Chapter 3 withholding under Section 1441 or 1442.  However, Sections 1441 and 1442 generally require withholding agents to withhold 30% on payments subject to the tax imposed by Sections 871 and 881 (i.e., FDAP income).  However, payments of gross transportation income that is U.S. source because the transportation begin or ends (not both) in the United States are subject to a 4% excise tax under Section 887 that is self-imposed by the payee, unless an exception applies.  Section 887(c) provides that the 30% gross tax applicable to most U.S. source income of foreign persons (other than income effectively connected with a U.S. trade or business) does not apply to transportation income.

The issue that has arisen is that neither Section 1441 or 1442 explicitly reference Sections 871 and 881 as a basis for the withholding.  However, it seems illogical to require 30% withholding on U.S. source gross transportation income given that such income is only subject to the 4% excise tax.  Despite the guidance in Publication 515, examiners have asserted on audit that such payments are subject to withholding under Chapter 3.  Nevertheless, withholding agents have generally been successful in rebutting such assertions and avoiding audit assessments.

The IRS created confusion regarding this issue earlier in 2016 when it asserted in a practice unit that USSGTI did not constitute FDAP income and was therefore not subject to withholding under Chapter 3 (see earlier coverage).  The IRS later revised the practice unit to remove the reference to USSGTI (see earlier coverage) after taxpayers questioned whether such payments are FDAP income.  The preamble to the temporary regulations now clarify that although USSGTI is FDAP income, it is nonetheless not subject to Chapter 3 withholding because the tax imposed under Section 871 or 881 does not apply.  The temporary regulations now thankfully bring this saga to a close six years after the IRS Information Reporting Program Advisory Committee made its original request for the IRS to clarify this problem for withholding agents in 2010.  A discussion of this issue can be found in IRPAC’s 2013 annual report.

IRS Releases Four FATCA-Related Regulation Packages

Late Friday, December 30, 2016, the IRS and Treasury Department released four regulation packages related to its implementation of the Foreign Account Tax Compliance Act (FATCA).  Two of the packages include final and temporary regulations and two contain proposed regulations.  The packages are:

  • Final and Temporary Regulations under Chapter 4 that largely finalize the temporary regulations issued in 2014 and update those temporary regulations to reflect the guidance provided in Notices 2014-33, 2015-66, and 2016-08 and in response to comments received by the IRS.
  • Final and Temporary FATCA Coordinating Regulations under Chapter 3 and Chapter 61 that largely finalize the temporary coordination regulations issued under Chapter 3 and Chapter 61 in 2014 and update those temporary regulations to reflect the guidance provided in Notices 2014-33, 2014-59, and 2016-42 and in response to comments received by the IRS.
  • Proposed Regulations under Chapter 4 that describe the verification and certification requirements applicable to sponsoring entities; the certification requirements and IRS review procedures applicable to trustee-documented trusts; the IRS review procedures applicable to periodic certifications of compliance by registered deemed-compliant FFIs; and the certification of compliance requirements applicable to participating FFIs in consolidated compliance groups. The proposed regulations also reflect the language of the temporary Chapter 4 regulations described above.
  • Proposed Coordinating Regulations under Chapter 3 and Chapter 61 that reflect the language of the temporary coordination regulations described above.

We are reviewing the regulations and preparing a series of articles discussing various provisions in the regulations.  We will post the articles over the next several days.

IRS Releases Final Qualified Intermediary and Foreign Financial Institution Agreements

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December 30, 2016

With the end of the year upon them, the IRS has kicked into high gear with a flurry of new administrative guidance. On the heels of yesterday’s release of final reporting rules on slot machine, bingo, and keno winnings, proposed rules on horse track, dog track, and jai lai winnings, and a revenue procedure on Certified Professional Employer Organizations, the IRS released final agreements for foreign financial institutions (FFIs) and qualified intermediaries (QIs) to enter with the IRS, set forth in Revenue Procedure 2017-16 and Revenue Procedure 2017-15, respectively.

FFI Agreement

FFIs enter into an FFI agreement with the IRS to become participating FFIs for purposes of Foreign Account Tax Compliance Act (FATCA) withholding and reporting obligations. The final FFI agreement set forth in Revenue Procedure 2017-16, which was previously published in Revenue Procedure 2014-38, applies to FFIs seeking to become participating FFIs under FATCA, as well as FFIs and branches of FFIs treated as reporting financial institutions under a Model 2 intergovernmental agreement (IGA).  The update was necessary because Revenue Procedure 2014-38 was set to expire on December 31, 2016.  Accordingly, the FFI agreement contained in Revenue Procedure 2017-16 applies to FFIs with an FFI agreement effective beginning January 1, 2017.

Changes were made to the FFI agreement generally to align with subsequent changes to IRS regulations, such as the withholding and reporting rules applicable to U.S. branches that are not U.S. persons. Additionally, several changes reflect the expiration of certain transitional rules provided in the 2014 FATCA regulations including those related to limited branches and limited FFIs.  (For additional information on the expiration of the transition relief for limited branches and limited FFIs, please see our prior post).  The FFI agreement also clarifies the presumption rules applicable to Model 2 FFIs, and the ability of Model 2 FFIs to rely on certain documentation for purposes of the due diligence requirements.

The FFI agreement also contains new certification requirements applicable to FFIs attempting to terminate an FFI agreement and clarifies that the obligations imposed with respect to the period the agreement was in force survive the termination of the agreement.

QI Agreement

A QI serves as an intermediary for payments of U.S. source income made to non-U.S. persons, and it must collect a taxpayer identification number from the payee, or else it must withhold 30% on the payment. When an intermediary acts as a QI, it may agree to assume the primary withholding and reporting obligations with respect to payments made through it for purposes of Chapter 3, Chapter 4, and/or Chapter 61 and backup withholding under Section 3406 of the Code.  When a QI assumes such responsibility, it is not required to provide a withholding statement to the withholding agent/payor making payment to it.  FFIs, foreign clearing organizations, and foreign branches of U.S. financial institutions and clearing organizations are eligible to enter into QI agreements by completing Form 8957 through the IRS website, as well as Form 14345.

Notice 2016-42 set forth a proposed QI agreement (prior coverage), which made revisions to the previous final QI agreement published in Revenue Procedure 2014-39.  The proposed QI agreement created a new regime that allowed certain entities to act as qualified derivatives dealers and act as the primary withholding agent on all dividend equivalent payments they make.  Several changes in the final QI agreement were made in response to comments on the rules applicable to qualified derivatives dealers (QDDs), including provisions that reflect changes to the treatment of dividend equivalents from U.S. sources and provisions clarifying that entities acting as QIs and QDDs must file separate Forms 1042-S when acting in each distinct capacity.  Some of the changes in the final QI agreement were previously announced in Notice 2016-76 (prior coverage).  However, the final QI agreement makes further changes based on anticipated revisions to the regulations under Section 871(m), which are expected to be published in January.

Additionally, the final QI agreement provides greater detail on the internal compliance measures that are to replace the external audit procedures previously applicable to QIs. The final QI agreement also eliminates the ability of limited FFIs to enter into QI agreements, as limited FFI status will no longer be available beginning January 1, 2017.  Additionally, QIs seeking to use documentary evidence to document an entity claiming reduced withholding under a treaty must collect certain information regarding the applicable limitation on benefits provision, though the IRS has enabled a two-year transition period for QIs to gather this information.  The final agreement also eliminates the ability of an NFFE seeking to become an intermediary with respect to its shareholders to enter into a QI agreement.  The QI agreement also contains a modified standard of knowledge to align with the reason-to-know standard adopted in regulations, and modified documentation requirements and presumption rules to align with IGA requirements.  Finally, the term of validity for a QI agreement is six calendar years, extended from the three years provided in the proposed agreement.  The updated final QI agreement is effective beginning January 1, 2017.

IRS Finalizes Regulations Imposing Reporting Obligations on Foreign-Owned U.S. Entities

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December 13, 2016

Yesterday, the IRS issued final regulations that impose reporting obligations on a domestic disregarded entity wholly owned by a foreign person (foreign-owned DDE).  The final regulations amend Treasury Regulation § 301.7701-2(c) to treat a foreign-owned DDE as separate from its owner for purposes of reporting, recordkeeping, and other compliance requirements imposed under Code section 6038A.  The effect of these final regulations is to enhance the IRS’s access to information needed to enforce tax laws and international treaties and agreements.

We discussed the substance of these regulations in an earlier post, and the final regulations reflect the proposed regulations with only minor clarifying changes.  The primary clarification relates to the intent of the IRS to disallow the exceptions to the requirements of Code section 6038A for a foreign-owned DDE.  The proposed regulations explicitly disallowed two of these exceptions, but the application of two additional exceptions was left unclear.  In the final regulations, the IRS expressly prevents a foreign-owned DDE from utilizing either of the remaining two exceptions to the Code section 6038A reporting requirements.

Under the regulations, a transaction between a foreign-owned DDE and its foreign owner (or another disregarded entity of the same owner) would be considered a reportable transaction for purposes of the reporting and recordkeeping rules under Code section 6038A, even though the transaction involves a disregarded entity and generally would not be considered a transaction for other purposes (e.g., adjustment under Code section 482).  Thus, a foreign-owned DDE will be required to file Form 5472 for reportable transactions between the entity and its foreign owner or other foreign-related parties, and maintain supporting records.  Further, to file information returns, a foreign-owned DDE would have to obtain an Employer Identification Number by filing a Form SS-4 that includes responsible party information.

The final regulations reflect several other minor changes intended to ease the compliance burden for foreign-owned DDEs.  Specifically, a foreign-owned DDE has the same tax year as its foreign owner if the foreign owner has a U.S. tax return filing obligation, and if not, the foreign-owned DDE’s tax year is generally the calendar year.  The final regulations are applicable to tax years of entities beginning after December 31, 2016 and ending after December 12, 2017.

IRS Adds to Lists of Countries Subject to Bank Interest Reporting Requirements

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December 9, 2016

Earlier this week, the IRS issued Revenue Procedure 2016-56 to add to the list of countries subject to the reporting requirements of Code section 6049, which generally relate to reporting on bank interest paid to nonresident alien individuals.  Specifically, the Revenue Procedure adds Saint Lucia to the list of countries with which the U.S. has a bilateral tax information exchange agreement, and adds Saint Lucia, Israel, and the Republic of Korea to the list of countries with which Treasury and IRS have determined the automatic exchange of information to be appropriate.

Prior to 2013, interest on bank deposits was generally not required to be reported if paid to a nonresident alien other than a Canadian. In 2012, the IRS amended Treas. Reg. § 1.6049-8 in an effort to provide bilateral information exchanges under the intergovernmental agreements between the United States and partner jurisdictions that were being agreed to as part of the implementation of the Foreign Account Tax Compliance Act (FATCA).  In many cases, those agreements require the United States to share information obtained from U.S. financial institutions with foreign tax authorities.  Under the amended regulation, certain bank deposit interest paid on accounts held by nonresident aliens who are residents of certain countries must be reported to the IRS so that the IRS can satisfy its obligations under the agreements to provide such information reciprocally.

The bank interest reportable under Treas. Reg. § 1.6049-8(a) includes interest: (i) paid to a nonresident alien individual; (ii) not effectively connected with a U.S. trade or business; (iii) relating to a deposit maintained at an office within the U.S., and (iv) paid to an individual who is a resident of a country properly identified as one with which the U.S. has a bilateral tax information exchange agreement.  Under Treas. Reg. § 1.6049-4(b)(5), for such bank interest payable to a nonresident alien individual that exceeds $10, the payor must file Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding,” for the year of payment.

The list of countries will likely continue to expand as more countries enter into tax information exchange agreements with the U.S. in order to implement FATCA.

IRS Guidance Provides Transition Relief for Withholding Agents and Qualified Derivative Dealers under Section 871(m)

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December 7, 2016

Last week, the IRS issued Notice 2016-76 providing phased-in application of certain section 871(m) withholding rules applicable to dividend equivalents.  In addition to providing good-faith relief to certain transactions in 2017 and 2018, the Notice eases several reporting and withholding requirements for withholding agents and qualified derivatives dealers (QDDs).

Section 871(m) of the Code imposes withholding on certain payments that are determined by reference to or contingent upon the payment of a U.S. source dividend.  Thus, when a foreign financial institution issues derivatives based on U.S. equities to non-U.S. investors, it must withhold on the dividend payments it makes to the non-U.S. investors.  In 2015, the IRS issued final and temporary regulations (T.D. 9734) specifying certain withholding and reporting requirements under section 871(m).  Earlier this summer, the IRS proposed a qualified intermediary (QI) agreement (Notice 2016-42) that spells out a new QDD regime, which was developed to mitigate cascading withholding that would occur as a result of the withholding requirements imposed on dividend equivalents (see prior coverage).

Good-Faith Relief

Notice 2016-76 provides good-faith transition relief during 2017 for delta-one transactions and during 2018 for non-delta-one transactions.  (Delta means the “ratio of a change in the fair market value of a contract to a small change in the fair market value of the property referenced by the contract.”  A delta-one transaction is a transaction in which changes in the fair market value of the derivative precisely mirror changes in the fair market value of the underlying property.)  The IRS will take into account the extent to which a taxpayer or withholding agent made “a good faith effort” to comply with the section 871(m) regulations.  Relevant factors include a withholding agent’s efforts to build or update documentation and withholding systems and comply with the transition rules under Notice 2016-76.

Quarterly Deposit of Withholdings in 2017

During 2017, a withholding agent will be considered to have satisfied the deposit requirements for section 871(m) dividend equivalent payments if it deposits amounts withheld during any calendar quarter by the last day of that quarter.  The agent should write “Notice 2016-76” on the center, top portion of the 2017 Form 1042.

Qualified Derivative Dealers

The Notice also eased, in four ways, the reporting obligations of intermediaries applying for QDD status.  First, the IRS’s enforcement of the QDD rules and the 871(m) regulations in 2017 will take into account good-faith efforts by intermediaries to comply with the regulations and the QI agreement.

Second, the Notice allows an intermediary to certify its QDD status during interim periods.  Generally, a QDD must provide a valid Form W-8IMY certifying QDD status to a withholding agent, and the agent is not required to withhold on its payments regarding a potential or actual section 871(m) transaction to a QDD in its QDD capacity.  An intermediary that has submitted a QI application by March 31, 2017 may claim QDD status on Form W-8IMY for six months after submitting the application, pending approval of its QI agreement and QDD status.  If an intermediary has not yet submitted a QI application but intends to do so by March 31, 2017, it may claim QDD status on Form W-8IMY until the end of the sixth full month after the month in which it actually submits the QI application (provided the application is submitted by March 31, 2017).  An intermediary may not represent QDD status if it no longer intends to submit an application by March 31, 2017, or if its application has been denied.

Third, the Notice allows an intermediary to provide a Form W-8IMY certifying its QDD status to a withholding agent before it has received a QI-EIN from the IRS.  The intermediary must write “awaiting QI-EIN” on line 8 of Part I of the Form W-8IMY.  While the intermediary must provide its QI-EIN to the withholding agent as soon as practicable after receiving it, the intermediary need not provide a newly executed form, provided the original form remains accurate and valid.  If QDD status is denied, however, an intermediary must notify the withholding agent immediately, and the agent must notify the IRS such notification when it files its Form 1042, listing the name and EIN (if available) of any intermediary whose QDD status was withdrawn for any of these reasons.

A withholding agent may rely on the “awaiting QI-EIN” statement unless it knows or has reason to know that the intermediary cannot validly represent that it is a QDD.  Thus, a withholding agent is not required to determine when a QDD has applied for or actually possesses a QI agreement.  Nor is it required to verify whether a QDD’s EIN is a QI-EIN.  A withholding agent may only rely on an “awaiting QI-EIN” statement for up to six months after receiving the form, unless a QI-EIN is provided within that time.

Fourth, the Notice provides that failure-to-deposit penalties will not be assessed against a QDD before it actually receives its QI-EIN (which the IRS issues upon approving a QI application).  This relief from penalty is available only if the QDD deposits the amounts withheld within 3 days of receiving its QI-EIN.  Extended relief is available to a QDD that applies to enroll in the Electronic Federal Tax Payment Systems (EFTPS) within 30 days of receiving a QI-EIN, provided that the QDD deposits the amounts withheld within 3 days of enrolling in EFTPS.

Other Rules

The Notice also addressed other issues under the section 871(m) regulations.  Specifically, the Notice provided: (a) a simplified standard that withholding agents may use to determine whether transactions are combined transactions under Treas. Reg. §1.871-15(n); (b) a net-delta exposure test for a QDD’s section 871(m) amount; and (c) transition relief for certain existing exchange-traded notes listed in section V.d of the Notice until January 1, 2020.

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).

IRS Simplifies Filing Requirements for Section 83(b) Elections

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July 27, 2016

On July 25, the IRS released final regulations eliminating the requirement that taxpayers making a Section 83(b) election file a copy of the election notice with their federal income tax return.  Under Section 83, the fair market value of property received (less any basis in the property) for the performance of services is generally included in income when the property is no longer subject to a substantial risk of forfeiture or when the taxpayer’s interest in the property is transferable.  However, taxpayers may elect under Section 83(b) to include the property’s fair market value (less any basis in it) as of the date of transfer in income in the year of transfer.  Despite the upfront tax liability, this election may actually defer taxation on the appreciated value of the property and subject the appreciation to capital gains rates rather than ordinary income rates.  Under the prior regulations, taxpayers who make an 83(b) election must submit to the IRS a copy of the election notice not only within 30 days after the date of the transfer, but also with their federal income tax return for the year of the transfer.  Last summer, the Treasury and the IRS proposed to eliminate the latter filing requirement, and after receiving no comments, adopted the final regulations without modification.

The requirement to file an election notice with the annual return was duplicative and easy to miss because taxpayers making an 83(b) election were already required to submit to the IRS the election notice within 30 days after the date of the transfer.  Further, as the IRS explained in the preambles to the proposed regulations, this requirement had become an obstacle to electronic filing of returns for certain taxpayers, since commercial e-filing software does not consistently allow for submitting an 83(b) election notice with the return.  The final regulations apply to transfers on or after January 1, 2016, and taxpayers can also rely on these regulations for transfers in 2015.  As a result, taxpayers are not required to file a copy of any 83(b) election made in 2015 with their 2015 tax returns.

Significantly, the final regulations ease compliance for non-resident alien employees of multinational companies.  Although foreign tax consequences can make transfers of restricted stock to such employees undesirable from the employee’s perspective, it may be desirable for the employee to make a section 83(b) election when restricted stock is transferred.  This is particularly true for start-ups and other companies where the value of the shares is small when granted and is likely to increase.  (It is often undesirable to make an 83(b) election for a mature company where the value of the stock is high at transfer and may decline.)

When nonresident alien employees working outside of the United States receive non-vested equity compensation, they may have no obligation to file a U.S. tax return, and could easily neglect to file a return for purposes of filing the election notice.  (Because the employees are nonresident aliens working outside the United States, the income from their 83(b) elections would presumably be foreign source income resulting in no U.S. income tax due in the year of transfer.)  But if these employees become U.S. residents between the grant and vesting dates, their failure to file nonresident returns and attach the 83(b) election notices would invalidate their 83(b) elections, thereby subjecting the value of the property to U.S. income tax upon vesting based on their U.S. resident status at the time of vesting.  Under the final regulations, these employees – and any other service providers – must simply file an election notice with the IRS within 30 days after the date of the transfer.

Although the final regulations simplified filing obligations under Section 83(b), the IRS emphasized taxpayers’ recordkeeping responsibilities under Section 6001, especially to show the basis of property reported on taxpayers’ returns.  Thus, to protect themselves from tax-return audit liability, executives and other service providers who receive restricted property under an 83(b) election must be careful to keep records of the original cost of the property received, and retain the records until at least the period of the limitations for the returns expires.

Print Out IRS FAQs and Other Informal Guidance While You Have the Chance

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July 26, 2016

When you find favorable informal guidance posted on the IRS website, print it out and save it.  A few years ago, a Treasury official from the Office of Tax Policy rebuked someone who proposed addressing a technical issue through IRS FAQs, conveying that the Treasury frowns on issuing such informal guidance.  At the time, we wondered whether the official had recently visited the IRS website and understood how much informal guidance the IRS provides to taxpayers and practitioners in this manner.

The U.S. tax system is complicated, and significant guidance is necessary to foster compliance.  Yet, the IRS and Treasury does not publish adequate formal guidance (e.g., regulations, revenue rulings, notices, etc.) each year to keep up, so the IRS fills the gaps through FAQs and other informal guidance on its website.  The problem is multifaceted, from the IRS brain drain due to the loss of retiring seasoned technicians, to difficulty recruiting qualified personnel at IRS Chief Counsel related to inadequate Congressional funding and compensation that is no longer reasonably competitive with the private sector, to a logjam of draft guidance at the Treasury Office of Tax Policy.  The IRS seems to feel that the issuance of informal guidance on its website is better than nothing, and it is probably right.

The knock on FAQs and its ilk is twofold.  First, taxpayers probably cannot rely on it because it is informal, unreviewed, and occasionally wrong.  Second, it has a way of disappearing from the website without a trace.  This happened recently with respect to slides made public by the LB&I International Practice Service Concept Unit, which were issued last month and revised this month.  We wrote about how the original slides addressed “transportation income” in an earlier post.

The original slides included a reference to “transportation income” with a parenthetical indicating that such income was “not FDAP.”  FDAP stands for fixed or determinable annual or periodical income.  This struck us as odd, because we felt that transportation income likely was FDAP income, but practitioners have been asking the IRS to issue formal guidance to clarify withholding rules regarding transportation income for years, without success.  (If you are interested, see the IRPAC briefing books on the IRS website to see a discussion of the requests for guidance from 2010 through 2013.)  Thus, any discussion from the IRS to address Chapter 3 withholding related to U.S. source gross transportation income is of great interest to those of us who have been requesting it. Publication 515, for the record, indicates Chapter 3 withholding is not required on U.S. source gross transportation income.  Taxpayers paradoxically should not really rely on statements of law included in IRS publications either.

Alas, someone must have told the responsible LB&I unit that transportation income is FDAP, so when the slides were updated, the statement about transportation income not being FDAP income was removed.  The older version of the practice unit has been replaced with the updated version, so the statement can no longer be found on the IRS website.  Unfortunately, the latest hope for a trump card on U.S. source transportation income disappeared like so many FAQs on other issues before it – into the ether.  The before and after slides are shown below.

Original Practice Unit [Click Image to Enlarge]

OldPracticeUnitPage8

Updated Practice Unit [Click Image to Enlarge]

UpdatedPracticeUnitSlide8

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.

Proposed QI Agreement Includes Rules for Qualified Derivatives Dealers

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July 7, 2016

The IRS recently issued a proposed qualified intermediary (QI) agreement (Notice 2016-42) that spells out the new qualified derivatives dealer (QDD) regime.  The final QI agreement will be issued later in 2016 and will apply to agreements in starting January 1, 2017, replacing the 2014 QI agreement that will expire on December 31, 2016.  The QDD regime replaces the qualified securities lender (QSL) regime in Notice 2010-46.  The QSL rules will continue to apply for substitute dividend payments made under sale-repurchase or securities lending transactions.

The QDD regime was developed to mitigate cascading withholding that would occur as a result of the withholding requirements imposed on “dividend equivalents.”  Section 871(m) of the Code imposes withholding on certain payments that are determined by reference to or contingent upon the payment of a U.S. source dividend.  As a result, when a foreign financial institution holds U.S. equities and issues derivatives to non-U.S. investors that are based on the stock, it may be subject to withholding on dividend payments made with respect to the underlying equities and have to withhold on the payments it makes to the holders of the derivatives.

Under the proposed QI agreement, only a subset of QIs called “eligible entities” will be permitted to act as QDDs.  Eligible entities are: (1) regulated securities dealers; (2) regulated banks; and (3) certain entities wholly-owned by regulated banks.  Under the QDD regime, a dividend payment to a QDD is not subject to withholding if the QDD provides the withholding agent with a Form W-8IMY indicating the QDD’s status.  The QDD certification is made on Form W-8IMY even though the QDD is acting as a principal with respect to the transaction.

If a QI acts as a QDD, it must act as a QDD for all payments made as a principal with respect to potential Section 871(m) transactions, including any sale-repurchases or securities lending transactions that qualify as such, and all payments received as a principal with respect to potential Section 871(m) transactions and underlying securities, excluding payments effectively connected with a U.S. trade or business. All securities lending and sale-repurchase transactions the QI enters into that are Section 871(m) transactions will be deemed to be entered into by the QI as a principal.

When a QI is acting as a QDD, it must assume primary withholding responsibilities under Chapters 3 and 4 and primary Form 1099 reporting and Section 3406 backup withholding responsibility for all payments related to potential Section 871(m) transactions that it receives as a principal—even if such payments are not dividend equivalent payments.  As a consequence, a QDD will be required to withhold to the extent required for the applicable dividend on the dividend payment date.  In contrast, when a QI is acting as intermediary, i.e., not as a principal, with respect to such a payment, it may choose to act as a QI (and choose whether or not to assume primary withholding and reporting responsibility with respect to the payment) or a nonqualified intermediary (NQI).

A QDD is liable for any tax on any dividends and dividend equivalents it receives in its dealer capacity to the extent the QDD is not contractually required to make offsetting payments that reference the same dividend or dividend equivalent that it received as a dealer.  For purposes of determining the QDD tax liability, payments received by a QDD acting as a proprietary trader are treated as payments received in a non-dealer capacity, while transactions properly reflected in a QDD’s dealer book are presumed to be held in its dealer capacity.  A QDD will reports its QDD tax liability on Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons.  When a foreign branch of a U.S. financial institution acts as a QDD, the branch is not required to report the QDD tax liability for income related to potential Section 871(m) transactions and underlying securities; instead, the U.S. financial institution will file the appropriate tax return to report and pay its tax liability.

The proposed QI agreement also updated requirements relating to periodic review and certification of compliance, substitute interest, limitation of benefits for treaty claims, and other items.

IRS Guides for the Field Summarize U.S. Withholding Agent Responsibilities and Confuse Issue Related to U.S. Source Gross Transportation Income

[UPDATE: LB&I revised the practice unit “FDAP Payments – Source of Income” on July 15.  The link below now accesses the updated version, which removes the statement regarding transportation income described in this article.  For our discussion of the change and images of the original and updated language, see this article.]

The Large Business and International division of the IRS released two new practice units (slide presentations) that can serve as a guide to U.S. withholding agents with respect to several key compliance issues.  The first practice unit, “FDAP Withholding Under Chapter 3,” serves as a quick summary of U.S. withholding agents’ obligations under Chapter 3 and the risks of noncompliance (i.e., penalties), while the second practice unit, “FDAP Payments – Source of Income,” can help U.S. withholding agents determine the source of income for purposes of deciding whether Chapter 3 applies.

One issue that U.S. withholding agents have struggled with relates to whether withholding is required  for payments of U.S. source transportation income to foreign persons.  Generally, Sections 1441 and 1442 require withholding agents to withhold 30% on payments subject to the 30% gross tax under Sections 871 and 881 (i.e., FDAP income).  However, payments of gross transportation income that is U.S. source because the transportation begin or ends (not both) in the United States are subject to a 4% excise tax under Section 887 that is self-imposed by the payee, unless an exception applies.  Section 887(c) provides that the 30% gross tax applicable to most U.S. source income of foreign persons (other than income effectively connected with a U.S. trade or business) does not apply to transportation income.

The issue that has arisen is that neither Section 1441 or 1442 explicitly reference Sections 871 and 881 as a basis for the withholding.  However, it seems illogical to require 30% withholding on U.S. source gross transportation income given that such income is only subject to the 4% excise tax.  To this end, IRS Publication 515 provides that such amounts are not subject to Chapter 3 withholding under Section 1441 or 1442.  Nonetheless, various large taxpayers have had examiners raise the issue on audit asserting that such amounts are subject to Chapter 3 withholding notwithstanding the inapplicability of the underlying tax that Chapter 3 is intended to collect although the examiners have ultimately retreated with respect to the issue.  As a result, U.S. withholding agents have struggled to determine their withholding obligations with respect to such payments, and the IRS has ignored repeated requests from the IRS Information Reporting Program Advisory Committee (IRPAC) (for example, see the 2013 IRPAC report) and others to provide formal guidance in this area.

The “FDAP Payments – Source of Income” practice unit confuses the issue further by definitively stating that transportation income is not FDAP income.  Because Chapter 3 applies only to payments of FDAP income, the 30% withholding for payments subject to Chapter 3 would not apply to payments of transportation income.  Although this might seem like welcome news, the conclusion is puzzling given that FDAP income is generally defined very broadly to include all income, except gains derived from the sale of real or personal property and items of income excluded from gross income.  This broad definition would seemingly include U.S. source gross transportation income, which is a payment for a service paid in an amount known ahead of time or calculable.  Moreover, this is not the basis given in Publication 515 for excluding such amounts from withholding.  Thus the conclusion in the practice unit would seem incorrect and suggests that the document was not reviewed for accuracy by the Chief Counsel attorneys in Branch 8, the international withholding branch.

The pronouncement of law contained in the practice unit continues a worrying trend toward informal guidance in frequently asked questions, publications, comments at conferences, and on the IRS website.  Taxpayers are not permitted to rely on informal guidance, but have often been left without any formal guidance upon which to rely.  Until the IRS issues formal guidance, taxpayers are left to navigate an issue that could arise on audit but truly should not be an issue in most cases.  It would be preferable if the IRS issued a notice announcing the IRS and Treasury intend to amend the Section 1441 regulations to preclude withholding on U.S. source gross transportation income that is subject to the 4% excise tax under Section 887.

Regulations Limiting Refunds and Credits for Chapter 3 and Chapter 4 Withholding Due Soon

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June 3, 2016

John Sweeney, Branch 8 Chief in the IRS Office of Associate Chief Counsel International, said on June 2 that proposed and temporary regulations limiting refunds and credits claimed by nonresident alien individuals and foreign corporations for taxes withheld under Chapter 3 and Chapter 4 of the Code will be released soon.  According to Sweeney, who was speaking at the Federal Bar Association Insurance Tax Seminar, most of the work on the regulations is complete.

The IRS announced its intent to amend the regulations under Chapter 3 and Chapter 4 last year in Notice 2015-10.  According to the notice, the temporary regulations will amend Treas. Reg. §§ 1.1464-1(a) and 1.1474-5(a)(1) to provide that, subject to section 6401(b), a refund or credit is allowable with respect to an overpayment only to the extent the relevant withholding agent has deposited (or otherwise paid to the Treasury Department) the amount withheld and such amount is in excess of the claimant’s tax liability.  The IRS said the regulation is needed because allowing a credit or refund based on the amount reported as withheld on Form 1042-S represents a risk to the Treasury if a foreign withholding agent fails to deposit the withheld tax with the U.S. Treasury.  The IRS has limited ability to pursue foreign withholding agents for such failures making it difficult to recover the amounts allowed to be claimed as credits or refunds.

According to Sweeney, the regulations will adopt the pro rata method described in Notice 2015-10 for allocating the amount available for refund or credit with respect to each claimant. Under this method, a withholding agent’s deposits made to its Form 1042 account will be divided by the amount reported as withheld on all Forms 1042-S filed by the withholding agent to arrive at a “deposit percentage.”  Each claimant will then be allowed to claim as a credit or refund the amount reported on its Form 1042-S multiplied by the deposit percentage for the withholding agent.  The pro rata approach is necessary because of the inability for the IRS to trace deposits back to specific payments made to a claimant based on the information reported on Form 1042 and Form 1042-S.

IRS Releases New W-8BEN-E and Instructions

On April 13, the IRS released a revised version of Form W-8BEN-E, which is used by foreign entities to report their U.S. tax status and identity to withholding agents. Accompanying updated instructions were also released. The new Form W-8BEN-E, which had not been updated since 2014, includes several notable new items. First, 10 check boxes have been added to Part III, Item 14b, “Claim of Tax Treaty Benefits,” to require the foreign entity to identify which limitations on benefits provision it satisfies. The updated instructions include substantial information on these limitations on benefits provisions.

The second significant change relates to the requirement that certain disregarded entities complete Part II. Disregarded entities generally do not complete Form W-8BEN-E, but disregarded entities that receive withholdable payments and either (i) have a Global Intermediary Identification Number (GIIN) or (ii) is a branch of a foreign financial institution (FFI) in a country other than the FFI’s country of residence. Part II previously did not state that a disregarded entity with a GIIN must complete Part II.

The third notable change is in Part IV and Part XII, which now contains a place for sponsored entities and sponsoring entities to provide their GIINs. In Notice 2016-66, the IRS extended the deadline for sponsored entities to obtain their own GIINs to December 31, 2016, from December 31, 2015. In October 2015, the IRS updated the FATCA registration portal to allow sponsoring entities to register their sponsored entities and obtain GIINs for them. The change to the Form W-8BEN-E reflects the increase in sponsored entities receiving their own GIINs as the deadline approaches.

The FATCA regulations permit withholding agents to accept prior versions of Form W-8BEN-E for up to six months following the revision date shown on the new form, and withholding agents may continue to rely on prior versions of the form for the validity period provided under the FATCA regulations. Accordingly, withholding agents may accept the February 2014 version of the Form W-8BEN-E through October 2016. For Form W-8BEN-E, the validity period generally starts on the signature date and ends on the last day of the third subsequent calendar year, absent a change in circumstances.

IRS Signals Intent to Scrutinize Foreign Payments

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March 10, 2016

The IRS intends to more closely scrutinize payments made to foreign corporations, as indicated by its creation of a new international LB&I “practice unit,” which will provide guidance for IRS auditors.  With respect to foreign corporations, auditors are instructed to focus significantly on whether FDAP income is paid to foreign corporations, and if it is, whether 30% withholding should apply under Chapter 3. Though the practice unit does not issue official pronouncements of law, its guidance to the field can provide taxpayers with valuable insights into issues of importance to the IRS.  Further, guidance issued by the new unit can help to educate taxpayers on the process auditors will use to analyze transactions.  The development of this new practice unit highlights the IRS’s focus on compliance with respect to outbound payments of U.S.-source income.  Taxpayers should ensure that they carefully consider the character and source of payments to determine whether withholding might apply under either Chapter 3 or Chapter 4 (FATCA) of the Code.  Failure to withhold as required subjects withholding agents to secondary liability for amounts that should have been withheld.