What’s New in Withholding on Foreign Taxpayers?

Foreign persons such as non-resident aliens and foreign corporations are generally taxed in the same manner as a U.S. citizen or domestic corporation on all income that is effectively connected with the conduct of a trade or business in the United States. If any U.S. source income received by a foreign person is not effectively connected with a U.S. trade or business, then it will be taxed at a flat 30-percent rate or a lower rate permitted under a tax treaty.

Comment

U.S. source income received by a foreign person that is not effectively connected with a U.S. trade or business is generally fixed, determinable, annual, or periodical income. This can include interest, dividends, rents, salaries, wages, or other items of annual or periodic income, profit, or gain.  Since the foreign person is outside of U.S. jurisdiction, the IRS collects federal income tax by requiring withholding on payments made to the foreign taxpayer. This article focuses on recent changes to foreign taxpayer withholding and reporting requirements, including withholding under the Foreign Account Tax Compliance Act.

Interest Paid to Non-Resident Aliens

The IRS issued final regulations in 2012 that impose new reporting requirements for commercial banks, savings institutions, credit unions, securities brokerages, and insurance companies. Beginning on or after January 1, 2013, the entities are required to report on Form 1042-S any deposit interest of $10 or more paid to certain non-resident aliens. The regulations require reporting even though the interest income is not subject to U.S. taxes and there is no withholding requirement.

Under prior regulations, there was no reporting required for interest paid on a deposit maintained at a bank’s U.S. office, if the income was not effectively connected with a U.S. trade or business. There was an exception for deposit interest of $10 or more paid to a Canadian resident who is not a U.S. citizen. The final regulations have extended reporting to interest earned by residents of other foreign countries.

Reporting of deposit interest is required if the recipient is a non-resident alien who resides in a foreign country that has agreed to exchange tax information with the United States under a tax treaty or tax information exchange agreement. For administrative convenience, a financial institution may elect to report interest paid to all non-resident aliens, so that it will not have to determine whether a non-resident alien lives in a country with a tax agreement.

Comment : Rev. Proc. 2012-24, 2012-20 IRB 913, lists 78 countries that have TIEAs with the U.S. There is also one country that exchanges information automatically with the IRS: Canada.

Comment  : The final regulations are extremely controversial. Banks and other financial institutions have told the IRS that the reporting requirement will cost them business and will discourage foreign individuals from making U.S. deposits. The IRS, however, has long contemplated this reporting and finalized the regulations after FATCA was enacted. Under FATCA, foreign institutions, assisted by foreign governments, will be required to report to the IRS information about their accounts belonging to U.S. taxpayers. To encourage cooperation by foreign governments, the IRS wanted to be able to exchange corresponding information about the accounts of foreign taxpayers with their home governments.

Portfolio Interest

Interest from U.S. sources paid to foreign persons is generally subject to withholding. Thus, withholding agents must withhold interest on bonds, debentures, notes, government obligations, and other debt of U.S. obligors. Withholding is based on the gross amount of stated interest payable, even if a portion of the payment is a return of capital.

Interest and original issue discount that qualify as portfolio interest, however, are not subject to withholding. To qualify as portfolio interest, the interest must be paid to a foreign person on obligations issued after July 18, 1984, and be otherwise subject to withholding.

The rules for determining whether interest is portfolio interest have changed for obligations issued after March 18, 2012. Before March 19, 2012, exempt portfolio interest included interest on certain registered and non-registered (bearer) bonds. For obligations issued after March 18, 2012, exempt portfolio interest does not include interest paid on debt that is not in registered form.

An obligation is considered in registered form if either (1) the beneficial owner has provided the withholding agent with Form W-8 or other statement certifying that the beneficial owner is not a U.S. person, or (2) the IRS has determined that such statement is not required. A registered bond issued after March 18, 2012, and before January 1, 2014, is also in registered form if it is targeted to foreign markets.

Comment

An obligation is not in registered form if it can be converted at any time into a non-registered obligation.

U.S. Real Property Interest

The gain or loss derived by a non-resident alien or foreign corporation from the sale, exchange, or other disposition of a U.S. real property interest is treated as gain or loss effectively connected with a conduct of a U.S. trade or business. In order to ensure that a foreign investor will pay taxes on gain realized on the sale or disposition of a U.S. real property interest, the transferee is generally required to withhold and deduct a tax equal to 10 percent of the amount realized on the disposition. The withholding rate may be as high as 35 percent, however, in the case of a distribution made by a qualified investment entity.

A qualified investment entity for this purposes includes any real estate investment trust, and any regulated investment company (mutual fund) that is a U.S. real property holding company. The look-through rule for a RIC was slated to expire at the end of 2011 but has been extended through 2013 by the American Taxpayer Relief Act of 2012, P.L. 112-240.

For this purpose, a U.S. real property interest includes an interest, other than as a creditor, in real property (including an interest in a natural deposit) located in the United States or the U.S. Virgin Islands. It includes personal property associated with the use of the real property, such as farm machinery. It also means an interest in a U.S. corporation, unless the corporation was not a U.S. real property holding corporation for a specified period (five years or the holding period for the interest in the corporation, whichever is less).

Dividends Paid to Foreign Persons

A regulated investment company (mutual fund) can designate all or part of a dividend paid to a non-resident alien or foreign corporation as an interest-related dividend. As such, the dividend is exempt from 30-percent withholding. An interest-related dividend is limited to the RIC’s qualified net interest income. This income is the RIC’s U.S. source income from bank deposits, exempt short-term OID, interest on an obligation in registered form, and interest-related dividends from another RIC.

The RIC can also report all or part of the dividend as a short-term capital gain dividend. The amount designated as a short-term capital gain dividend cannot exceed the qualified short-term capital gain for the year, equal to the excess of the RIC’s net short-term capital gain over its net long-term capital loss. Short-term gains include short-term capital gain dividends from another RIC.

The American Taxpayer Relief Act of 2012, P.L. 112-240, extended the exemption from 30-percent withholding for two years, through 2013, for RIC dividends that are paid to non-resident aliens or foreign corporations and are interest-related or short-term capital gain dividends. The dividends must be reported by the company in a written statement to its shareholders. The exemption does not apply if the non-resident alien is present in the United States for 183 days or more during the tax year.

Partnership Withholding Rate

A foreign or domestic partnership that has income effectively connected with a U.S. trade or business must pay a withholding tax on the effectively connected income that is allocable to foreign partners. A partnership that must pay the withholding tax but fails to do so may be liable for the payment of the tax and any penalties and interest.

For 2013, the rate of withholding on non-corporate partners has increased to 39.6 percent. For corporate partners, the rate remains at 35 percent. The partnership may, however, withhold at the highest rate that applies to a particular type of income, if properly documented.

Comment

This withholding rate does not apply to income that is not effectively connected income. That income (for example, FDAP) is subject to withholding tax on non-resident aliens and foreign corporations.

The partnership must determine whether the partner is a foreign partner. A foreign partner can be a non-resident alien individual, foreign corporation, foreign partnership, foreign estate or trust, foreign tax-exempt organization, or foreign government. A partner that is a foreign person should provide the appropriate Form W-8 to the partnership.
Reference: PTE §37,301