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Businesses should pay attention to detail re foreign payees
A day doesn’t pass without all of us being impacted by foreign trade activity. Technology, the lifting of trade barriers and the demands of customers and vendors are all responsible for the growth of international business activity. Many U.S.-based businesses are involved with international transactions in their daily business activity. This includes operating through foreign subsidiaries and conducting cross-border transactions with vendors and customers. A business engaging in international activity increases the need for the business to consider the tax implications and compliance requirements with respect to the foreign activities.
On June 22, the Joint Committee on Taxation released a report that it provided to Congress entitled “Present Law and Background Related to U.S. Activities of Related Persons,” available at www.jct.gov/publications.html?func=startdown&id=3799. This report highlights the U.S. taxation rules on income earned in the U.S. by foreign persons related to their activities
Much of this income is required to be reported to the foreign recipients by the U.S. payers on Form 1042-S. The reporting is similar to Form 1099 and often includes withholding tax. The JCT report indicates that more than $600 billion in such payments was reported on Form 1042-S for the 2008 tax year. Form 1042-S indicates the location (country) of where such payments are made. The summary, by country, for where payments were paid was included in the JCT report. The United Kingdom was the first name listed, and some of the others in the top 10 were also predictable: Germany, Japan, Switzerland, Canada, France and the Netherlands are all in the top 10.
The surprise is the country in the No. 2 position: the Cayman Islands. In 2008, approximately $74 billion was paid to Cayman-Island-registered companies or individuals. There appears to be a reasonable explanation for part of it: Many private equity fund and hedge fund entities and some of the fund owners are Cayman-Island-registered entities for commercial and tax purposes. The receipt of dividends, interest and other income paid by U.S. payers to the Cayman entities results in placement of the Cayman Islands on the list.
The JCT report does get into some detail on the U.S. tax rules for the income earned in the U.S. by foreign recipients. Income of non-resident aliens or foreign corporations is generally subject to tax at a rate of 30 percent for any U.S.-source interest, dividends, rents, royalties, or other similar types of income that are fixed or determinable, annual or periodical gains, profits and income, commonly known as FDAP income, that is not effectively connected with the conduct of a U.S. trade or business. The withholding tax may be reduced under tax treaties with the U.S.
FDAP income encompasses a broad range of types of gross income but has limited application to gains on sales of property, including market discount on bonds and option premiums. In addition, gains from the sale or exchange of intangibles are subject to tax and subject to withholding if they are contingent upon productivity of the property sold and are not effectively connected with a U.S. trade or business. Withholding on FDAP payments to foreign payees is required unless the withholding agent ( i.e., the person making the payment to the foreign person receiving the income) can establish that the beneficial owner of the amount is eligible for an exemption from withholding or a reduced rate of withholding under an income tax treaty. The principal statutory exemptions from the 30 percent withholding tax apply to interest on bank deposits and a classification of interest commonly known as portfolio interest.
The complications that come with the withholding obligation often place U.S. payers offside with the IRS. Accounts payable departments often are not aware of the requirements, and this often results in a business not being in full compliance of the rules.
The 30 percent tax on FDAP income, or a reduced amount based on a tax treaty reduction or exemption, is generally collected by means of withholding. In many instances, the income subject to withholding is the only income of the foreign recipient that is subject to any U.S. tax. No U.S. federal income tax return from the foreign recipient is generally required with respect to the income from which tax was properly withheld. Accordingly, although the 30 percent (or reduced amount under a tax treaty) gross-basis tax is a withholding tax, it is also generally the final tax liability of the foreign recipient.
The payer is generally considered a withholding agent for purposes of reporting the income and remitting any tax withheld. As a withholding agent, the payer that makes payments of U.S.-source amounts to a foreign person is required to report and remit over any amounts of U.S. tax withheld. Form 1042-related reports are due to be filed with the IRS by March 15 of the calendar year following the year in which the payment is made. This due date differs from the Form 1099 due date.
To the extent that the withholding agent deducts and withholds an amount, the withheld tax is credited to the recipient of the income. If the agent withholds more than is required and results in an overpayment of tax, the excess may be refunded to the recipient of the income upon filing of a claim for refund.
The U.S. withholding tax rules are administered through a system of self-certification. A nonresident investor seeking to obtain withholding tax relief for U.S.-source investment income must certify to the withholding agent, under penalty of perjury, the person’s foreign status and eligibility for an exemption or reduced rate. This self-certification is made on the relevant IRS form (generally Form W-8BEN, W8-ECI, W8-IMY or other W-8 series form). This is a similar process to those used by U.S. persons to establish an exemption from the rules governing information reporting on IRS Form 1099 and backup withholding.
The IRS has increased its resources in the international area in recent years. The reporting and withholding is a high priority: It is listed as a Tier 1 issue for IRS examination agents. The Tier 1 status means that there are specific procedures and requests that will be made during IRS examinations of business taxpayers. Significant penalties can be assessed for late filing and non-payment or underpayment of any required withholding on the payments to a foreign recipient.
The IRS also has indicated it will step up its review of taxpayers for Form 1042 filings, documentation and any withholding tax payments. Businesses should review their internal procedures (typically in accounts payable) to identify foreign payees and to have the appropriate documentation in hand before making any payments to foreign payees. This attention to detail will help a business avoid or mitigate any possible liabilities for under-withheld or late-paid withholding taxes and any associated interest or penalties resulting from an underpayment.
Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author and not necessarily those of BDO. The comments are not to be considered as specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties.