New Form 1042 Instructions Shift Reporting Obligations for QDDs

The IRS recently released new Form 1042 instructions (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons), including changes to reporting for a withholding agent that is a qualified intermediary (QI) acting as a qualified derivative dealer (QDD).  As discussed in an earlier blog post, the QDD regime was developed to mitigate cascading withholding that would occur as a result of the withholding requirements imposed on dividend equivalents, pursuant to Code section 871(m).

The Form 1042 instructions appear to respond to comments received after draft 2017 Form 1120-F instructions were released last October that required the reporting of QDD liabilities on the Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) and an accompanying schedule.  The updated instructions require the same information regarding QDD tax liability that the draft instructions required to be reported on Form 1120-F, which most QIs were not required to file absent the new QDD tax liability.  Accordingly, it is expected that QDDs will report their QDD tax liability on the Form 1042 (and Form 1042‑S) rather than the Form 1120‑F.

The 2017 Form 1042 includes a new Section 4, which a QI that is a QDD (or has a branch that is a QDD) must complete if it made any payments reportable on the Form 1042 in its QDD capacity.  The updated instructions provide guidance to QDDs regarding the proper withholding agent status code to use when filing Form 1042 and Form 1042‑S.  A QI that is a QDD should use the chapter 3 status code for a QI (code 12) on Form 1042, regardless of the types of payments it made for the calendar year.  But a QI that is a QDD is required to use the withholding agent chapter 3 status code for a QDD (code 35) on Form 1042-S for a payment that it made in its capacity as a QDD.  A filer must enter both a chapter 3 and a chapter 4 withholding agent status code on the form regardless of the type of payment being made.

The updated instructions also provide guidance to QDDs applying the transitional guidance in Notice 2016-76 for 2017 (see prior coverage).  This notice allows a QDD to deposit amounts withheld for dividend equivalents on a quarterly basis, and allows a QDD applicant awaiting a QI‑EIN to wait until it receives its QI‑EIN to deposit amounts withheld on dividend equivalents.  The withholding agent should write “Notice 2016‑76” on the center, top portion of the 2017 Form 1042.  For 2017 and 2018, the columns for total section 871(m) amount and total QDD tax liability pursuant to Section 3.09(A) of the Qualified Intermediary Agreement should state “not applicable.”

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.)

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

June 3, 2016 by  
Filed under Chapter 3, FATCA, IRS

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.