IRS data and analysis of Form 1042-S filings of interest
Over the past year we have seen many reports on international taxation. From inversions to Double Irish tax structures, mainstream media has become interested in tax policy. The news even grabbed the attention of my middle school children who were informed on the Burger King – Tim Horton transaction, thanks to CNN’s Student News.
Foreign investment in the U.S. has increased in recent years as evidenced by recently released statistics from the IRS, which periodically releases statistics and analysis regarding the various tax filings it receives. The data is often two or three years old when released; however, it is helpful in understanding what is occurring.
The most recent analysis was released a few weeks ago. It includes information regarding payments by U.S. businesses and other entities to foreign investors including interest, dividends and other payments. The February report provides details and analysis of 2011 filings of Form 1042-S, the sister form to Form 1099. Form 1042-S is used to report payments made to non-U.S. recipients. Form 1042-S reporting is due to the IRS by March 15 of the year following the year of payment. So, the IRS has received the 2014 reporting in recent days.
I recently pulled IRS data from 1995 so I could compare the reporting in 1995 and 2011 and note the changes over the past 16 years. The historical Form 1042-S data indicates that in 1995, $95 billion was paid to foreign recipients in U.S. source payments. By 2011, this had grown to $568 billion, a nearly six-fold increase. Interest payments are the largest component of total amounts, growing from $60 billion in 1995 to $279 billion in 2011.
Dividends paid to foreign investors grew from approximately $18 billion in 1995 to $109 billion in 2011. This likely reflects the growth in corporate profits and the increased foreign investment in U.S. business during this period. The payments (interest, dividends, etc.) to foreign investors are subject to U.S. withholding tax, though many U.S. tax treaties reduce or eliminate the withholding tax requirement. If excess tax is withheld, a foreign investor may request a refund of the overpaid tax, typically by filing a U.S. tax return.
The countries with the largest receipts of Form 1042-S payments 2011 were (in order): United Kingdom, Japan, Cayman Islands, Canada, Germany, Switzerland, France and Luxembourg. The first two countries may not surprise anyone given their relative size and the significant investment by companies in those countries in the United States. Surprisingly, China wasn’t in the top 10.
The third spot, Cayman Islands, may surprise some readers. Nearly 9 percent of all payments to foreign recipients reported on Form 1042-S and other U.S. international forms was attributable to entities formed or organized in the Cayman Islands. Further, 15 percent of all withholding taxes on those payments to foreign recipients in 2011 was attributable to entities formed or organized in the Cayman Islands.
It is somewhat surprising that payments to Cayman Islands entities were more than payments to Canadian or German entities, both of which have significant investment in the U.S.
Of the nearly $51 billion in 2011 payments paid to Cayman entities, $43 billion was interest and $4 billion was dividends. More than 92,000 Forms 1042-S were issued to Cayman recipients. The U.S. withholding tax averaged less than 3 percent of the total income received, far below the 30 percent U.S. statutory withholding rate since the U.S. does not have a tax treaty with reduced withholding with the Cayman Islands. The low amount is likely the result of the interest qualifying for a special provision under U.S. tax law that exempts certain interest from withholding tax when paid to foreign holders of debt instruments.
The appearance of Cayman Islands is not the result of the Caymans being a trading partner with the U.S. It is, in part, due to its use in international legal and tax structures. Foreign investors and U.S. tax-exempt investors often use Cayman entities to hold interests in private equity funds and hedge funds that may have U.S. investment. These are often referred to as Cayman blockers: The Cayman corporation blocks any U.S. taxation at the owner level of the Cayman blocker. The blocker corporation pays any U.S. tax due. The Cayman blocker is often leveraged with debt that meets the special exception in the tax code that avoids withholding tax. In addition, in recent years there has been an increased use of Cayman entities by many Asian-based investors for investment into the U.S. and elsewhere.
What does this historical Form 1042-S data tell us? It is likely foreign investment in the U.S. by foreign businesses has used a higher proportion of debt rather than equity to fund their U.S. operations. This may, in part, be due to many U.S. tax treaties that provide for a zero rate of withholding on interest payments to qualified residents of a tax treaty country. Since interest is deductible and dividends are not deductible for U.S. tax purposes for a U.S. business, U.S. subsidiaries of foreign businesses are often funded largely with debt instead of equity. It should be noted the U.S. has limitations on how much interest can be claimed as a deduction in a given tax year, based on a mechanical calculation of the business’s cash flow.
Many of the widely reported inversion transactions use debt and interest deductions to reduce their U.S. tax liability. Several inverted companies from inversions in the 1990s have reported large proposed adjustments by the IRS relating to these companies’ interest expense deductions. The interest expense deduction in the U.S. (at a high corporate tax rate) is interest income in a low tax jurisdiction and thus this tax arbitrage provides tax savings. These distortions are what have caused concern for officials in Washington.
The recent IRS reports and analysis of Form 1042-S filings show significant payments being made to non-U.S. entities. These payments reflect the dramatic increase in foreign investment in the U.S. The data also shows evidence of the tax planning foreign investors use to reduce U.S. withholding tax as well as U.S. corporate tax liabilities. Whether this data impacts the Washington tax debate, only time will tell.
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 of BDO. The comments are general in nature and not to be considered specific tax or accounting advice. Readers are advised to consult their professional advisers before acting on items discussed.