When payments leave U.S., kiss most of the tax revenue goodbye
Brexit. BEPS. EU State Aid. Inversions. These are all items that have occupied the financial, tax and mainstream press in the past year.
And the impact from all of them may change international tax policy in the future.
The current presidential campaign also has included discussion on taxes and what changes should be made to transform the U.S. into a more competitive tax system. International taxation and the U.S. tax treatment of certain income, transactions and structures has been part of this discussion.
The Internal Revenue Service periodically releases statistics regarding the information it gathers from income and other tax return filings. Recently it issued its analysis of the income earned and taxes paid by foreign recipients of U.S.-source income in 2012.
Much of this income is paid in the form of interest, dividends and royalties. Under U.S. domestic tax law, most of these types of income are subject to withholding taxes, often at the 30 percent statutory rate. However, there are certain exceptions to the withholding requirements in domestic tax law, as well as tax treaty reductions or exemptions on certain U.S.-source income paid to foreign recipients.
The IRS statistics released in recent weeks tell some interesting stories. In 2012, nearly $673 billion was paid out by U.S. payers to foreign recipients in the form of interest, dividends, royalties and other income. The total 2012 amount was approximately $90 billion higher than 2011. This income is not reported on a Form 1099. It is reported on Form 1042-S. The Form 1042-S reports both the income paid and any tax withheld.
The IRS statistics provide data by country of residence of the recipient. Four of the top five countries are the typical suspects: major U.S. trading partners the United Kingdom, Japan, Germany and Canada.
The payments to residents of each country totaled more than $50 billion apiece, with the UK leading the list at nearly $92 billion. The other member of the top five may surprise many readers.
It was the Cayman Islands.
The Caymans actually received more payments than Canada or Germany. Last time I checked, the Caymans were not a major trading partner of the U.S.
However, many funds (including hedge funds and private equity funds) use Cayman structures for foreign investors and U.S. tax-exempt investors.
The Cayman recipients had approximately $1.5 billion of U.S. tax withheld from $51 billion in payments. This represents an effective tax rate of 3 percent.
This compares to the 30 percent headline rate under the IRS code mentioned earlier.
The U.S. has no income tax treaty that provides for reduced withholding taxes with the Cayman Islands.
For comparison, the UK recipients were subject to U.S. withholding of approximately $800 million on the $92 billion, for an effective withholding tax rate of less than 1 percent. This result is likely appropriate because the UK tax treaty with the U.S. provides for a zero rate of withholding on interest, royalties and on some dividend payments for qualified recipients.
China was the biggest mover on the IRS list. China occupied the No. 10 spot on the list, and Chinese recipients received more than $24 billion in 2012. This was triple the amount received in 2011.
The U.S. tax withheld on these payments in 2012 was a mere $41 million, which represented an effective tax rate of approximately two-tenths of 1 percent. Many other countries also had low rates of withholding tax.
The low rate of withholding tax is the result of domestic tax law and tax treaties that have provisions that provide low or no withholding rates on payments to foreign recipients.
The largest share of payments in 2012 was for interest. In addition, interest paid is a tax deduction in most instances to the U.S. payer. As a result, many foreign investors coming into the U.S. market typically favor debt over equity in capitalizing their operations. The use of certain tax planning strategies can often result in low or no taxes on interest income in the country of the foreign recipient.
Such tax planning is one reason for the recent Base Erosion and Profit Shifting (BEPS) efforts by the developed world. The use of such planning may be more limited in the future for many reasons.
The first reason is the BEPS action plans include recommendations for limitations on related-party interest deductions as well as limits on the use of certain instruments that are treated as debt in one jurisdiction and equity in the other jurisdiction. Many countries have adopted or announced plans to adopt some of the recommendations in the BEPS action plans in their domestic law.
Additionally, the U.S. has taken some action. Earlier this year the Treasury Department announced a new Model Tax Treaty as its base document for future treaty negotiations with treaty partners. The Model Treaty provisions will have — if implemented in new or revised tax treaties — the impact of tightening the ability to claim treaty benefits. Since tax treaties are bilateral documents, our treaty partners will need to agree to any changes in tax treaties.
And last but not least, in April the IRS and the Treasury Department, in connection with the release of inversion regulations, proposed tax regulations that impact the characterization of instruments as debt and equity for related-party situations.
If the regulations are finalized and adopted in their current form, the amount of payments treated as deductible interest expense may be reduced. The regulations may result in more payments of interest being treated as dividends and possibly being subject to higher rates of withholding tax in addition to not being deductible to the payer in the U.S.
The combination of deduction limitation and higher withholding may assist in increasing U.S. tax receipts.
What to tax and how much to tax are questions without precise answers. It will be interesting to track the impact of the recent BEPS and U.S. tax developments on payments to foreign recipients when the 2017 or 2018 statistics are released in years to come.
Bill Roth is a tax partner with the local office of international accounting firm BDO USA LLP. The views expressed above are the author’s and not necessarily those of BDO.