IRS Audit Guidelines Provide Insights for Withholding Agents

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.

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.

IRS Signals Intent to Scrutinize Foreign Payments

March 10, 2016 by  
Filed under Chapter 3, FATCA, IRS

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.