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Blake Christian
Blake Christian

Foreign Tax Withholding and Reporting — FATCA Update

How it impacts CPAs.

September 29, 2011
by Blake Christian, CPA/MBT

The Hiring Incentive to Restore Employment Act (HIRE Act, P.L. 111-147), established Chapter 4 of Subtitle A and enacted new reporting requirements for foreign financial institutions (FFIs) and nonfinancial foreign entities (NFFEs) referred to as FATCA (Foreign Account Tax Compliance Act). Basically, for FFIs that do not meet the requirements of Sec. 1471(b), the withholding agent will be required to withhold a 30-percent tax from payments of certain U.S. source gross income. An FFI can meet the Sec. 1471(b) reporting requirements and avoid the 30 percent withholding requirement by entering into an agreement with the Internal Revenue Service (IRS) in which the FFI agrees to obtain information for each holder, to comply with verification and due diligence procedures, to report on an annual basis information regarding its U.S. account holders (i.e. account holder information, account number, account balance, etc.) and to comply with IRS requests for additional information. These rules are generally applicable beginning in 2013.

On July 14, 2011, the IRS and Treasury Department released guidelines (Notice 2011–53) regarding phased in reporting and withholding requirements associated with FATCA. This notice provides phased-in compliance rules to allow withholding agents, FFIs and the IRS adequate time to develop internal reporting systems to ensure full compliance with the complex FATCA rules.

Notice 2011–53 provided the following timeline to implement the FATCA requirements:

  • An FFI must enter into an agreement with the IRS by June 30, 2013 to ensure that it will be identified as a “participating FFI” in sufficient time to allow withholding agents to refrain from withholding beginning on January 1, 2014.
  • Withholding on U.S. sourced “fixed, determinable, annual or periodic payments” (FDAP) payments to non-participating FFIs will begin on Jan. 1, 2014 and withholding on gross proceeds that produce U.S. source dividend and interest income (generally, not currently taxable to foreign persons) will begin on January 1, 2015.
  • Completion of due-diligence procedures for both pre-existing and new account holders are phased-in depending on the type of account.
  • For purposes of the Notice, “high risk accounts” include private banking accounts with balances equal or greater than $500,000.

Notice 2010–60 and 2011–34 provided preliminary guidance regarding the implementation of the FATCA rules and additional guidelines, including regulations, are expected to provide more guidance as the financial services industry raises additional issues.

U.S. Withholding Overview

Any U.S. person who makes a payment of U.S. source income to a foreign person must generally withhold tax of 30 percent on U.S. source FDAP gross income distributed to the foreign person. This is to ensure that the U.S. federal government receives their share of income up front.

A foreign person is defined as a nonresident alien individual, foreign corporation, foreign partnership, foreign trust, a foreign estate and any other person who is not a U.S. person. In order to be subject to the withholding requirements, items of income must be FDAP. It is worth noting that FATCA has expanded the scope of income subject to withholding to include gross proceeds that produce U.S. source dividend and interest income in addition to U.S. source FDAP income.

The U.S. person or the withholding agent may be an individual, corporation, partnership, trust, association, nominee and any other entity including any foreign intermediary, foreign partnership or U.S. branch of certain foreign banks and insurance companies. An intermediary can also act as a custodian, nominee or as an agent on behalf of the U.S. and/or foreign persons.

The 2010 HIRE Act added IRC Sections 1471 through 1474 to implement the FATCA reporting requirements and also added IRC Section 6038D related to reporting of foreign financial assets in excess of $50,000 and IRC Section 1298(f) related to expanded reporting of interests in PFICs. The new rules under IRC 6038D and 1298(f) are generally effective beginning in 2011.

Exemptions

Treaty Exemptions. An income tax treaty is the principal exemption available to taxpayers. A lower withholding rate is often available, provided that exemption is specified in the applicable tax treaty between the U.S. and a specified country. For certain U.S. income tax treaties, a reduced or a zero-withholding rate is available for certain related party and other fixed-interest payments. A reduced rate on portfolio dividends of 15 percent may also be provided. For direct investment dividends paid to a 10 percent or greater shareholder, the rate may be reduced to five percent. A U.S. Taxpayer Identification Number (TIN) for the foreign person is required to include on a Form W-8 to claim the exemption or lower rate of withholding.

ECI Exemption. Another exemption is the valid claim in which income is effectively connected with a foreign person’s conduct of a U.S. trade business (ECI). In this case, the withholding agent must provide the foreign person’s U.S. TIN on a Form W-8ECI (PDF).

Other Exemptions:

  • An interesting exemption that appears to be the result of effective lobbying from the gaming industry — Income from nonresident gambling winnings from the games of blackjack, baccarat, craps, roulette or big-6 wheel (as exempted under Code Sec. 871(j)) until the IRS determines that collection is practical. Code Sec. 1441(c)(11); Reg. §1.1441-1(b)(4)(xx).
  • A variety of other exemptions apply as outlined in Reg. Section 1.1441 and IRC Sections 871, 872 and 1442, the most prevalent being the portfolio interest exemption.

Tax Compliance Reporting and Required Forms

Payments of U.S. source FDAP income to a foreign person must be reported by a withholding agent on an Annual Withholding Tax Return for U.S. Source Income of Foreign Persons (Form 1042 (PDF)) by March 15th of the succeeding calendar year. As of January 1, 2011, withholding agents are required to make all deposits on withheld taxes by electronic funds transfer (ETF) through the U.S. Department of Treasury’s Federal Tax Payment System (EFTP). Visit the EFTPS website for more information.

The withholding agent is generally personally liable for any tax that is required to be withheld. The IRS may come after the withholding agent, foreign person or both and access interest and penalties. For the 2010 tax year, the penalty for failure to file Form 1042 (PDF) on a timely basis is five percent of the unpaid tax for each month or part of a month the return is late and up to a maximum of 25 percent of the unpaid tax. The penalty for late payment of tax is half of one percent of the unpaid tax for each month or part of a month the tax is unpaid, up to a maximum of 25 percent of unpaid tax. The penalty for failure to make a tax deposit by EFTPS is 10 percent of the total tax. 2011 penalty rates have not yet been issued.

In addition, a withholding agent is required to file a Foreign Person’s U.S. Source Income Subject to Withholdings (Form 1042-S (PDF)) information return for each recipient, in order to report amounts of income paid that are subject to withholding. Note that withholding agents are still required to file Form 1042-S (PDF) even if no amount was withheld because of a treaty, a Code exception or if the tax withheld was repaid to the payee. Form 1042-S (PDF) is due by March 15 of the succeeding calendar year and may only be extended for a maximum of 30 days (except for cases of extreme hardship).

Escalating penalties are imposed on the withholding agent or intermediary who fails to timely file a correct and complete Form 1042-S (PDF). For the 2011 tax year, penalties for late filed forms begin at $30 per form up to $100 per form for forms filed after August 1st of the reporting year.

Other Forms to Consider:

  • Form W-8BEN (PDF). Provided to a withholding agent by a foreign person to confirm the recipient’s non-U.S. status and beneficial owner of the income. Also used to claim withholding related treaty benefits.
  • Form W-8IMY (PDF). Provided to a withholding agent by a foreign person who is an intermediary or flow-through entity, rather than the beneficial owner of the income.
  • Form W-8ECI (PDF). Provided to a withholding agent by a foreign person who is the beneficial owner of a reportable amount, when the income is effectively connected income (ECI) that will be reported on a U.S. tax return (i.e., Form 1120F or Form 1040NR).
  • Form W-8EXP (PDF). Provided to a withholding agent by a foreign person who is the beneficial owner of the income and is a tax-exempt entity, including foreign government entities exempt under IRC Section 892.
  • Form W-9 (PDF). This form is used for certifying a recipient’s status as a U.S. person. No nonresident alien (NRA) withholding and reporting is required in such cases.
  • Form 8233 (PDF). A nonresident person attaches this form to the tax return to invoke an income tax treaty position to override U.S. tax law.
  • Form 945 (PDF). This form is used to report withheld federal income tax from certain non-payroll payments, including gambling, IRAs and pensions. Backup withholding is required when a Form 1099 (PDF) is missing a tax identification number (TIN) or contains an incorrect TIN with respect to a reportable payment.

Conclusion

These withholding rules will continue to evolve in the coming years as the financial industry, CPAs and attorneys continue to weigh in on the practicality (and impracticality) of these complex rules.


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Blake Christian, CPA, MBT is a tax partner in the Long Beach, California-based office of Holthouse Carlin & Van Trigt LLP and is co-founder of National Tax Credit Group, LLC. He can be reached at (562) 216-1800.