It has been well publicized that both Congress and the Internal Revenue Service (“IRS”) in their ongoing effort to raise revenues have focused on international tax compliance. This is evidenced by the recently enacted Hiring Incentives to Restore Employment Act (“HIRE”), the Foreign Account Tax Compliance Act of 2009 (“FATCA”) and other measures such as the recently announced 2011 Offshore Voluntary Disclosure Initiative (“OVDI”). In general, these changes attempt to increase international tax compliance through a combination of additional reporting requirements imposed upon U.S. persons, enhanced penalties for noncompliance, and other measures such as extending the statute of limitations for failure to file certain forms. Therefore, it is more important than ever to understand and comply with the various reporting requirements, filings, etc.
This article specifically addresses the withholding provisions applicable to U.S. pass-through entities with foreign investors. To understand the withholding provisions, it is important to have a general knowledge of how the U.S. tax system taxes U.S. source income of foreign persons, including nonresident aliens and foreign corporations. The key elements to this system are:
- Foreign persons are taxed at graduated rates on the net amount of income effectively connected with the conduct of a trade or business within the United States.
- Foreign persons are taxed on the gross amount of their U.S. source investment type income at a flat rate of 30 percent.
- Income tax treaties often reduce the withholding rate on interest, dividend, and royalty income to 15 percent or less.
- There is a broad statutory exemption for portfolio interest income. In general, portfolio interest is most U.S. source interest that meets certain requirements in order to protect against the unauthorized use of the portfolio interest exemption by U.S. persons.
- Capital gains from sales of stocks or bonds by foreign persons are generally exempt from U.S. taxation.
- Special rules apply to gains from the sale of U.S. real property.
The tax system employs a withholding regime to collect taxes from passive offshore investors. The withholding obligation is imposed on any person (generally the last U.S. person in a chain) who has control, receipt, custody, disposal, or payment of an item of U.S. source income to a foreign person. In addition to the penalty provisions noted above, a withholding agent that fails to withhold is liable for the uncollected tax, i.e. the economic burden is shifted from the recipient of the income to the payor of the income.
To determine the relevant withholding provisions that apply, as to the timing, amount, reporting and withholding forms, it is necessary to ascertain the following:
- The type of income, e.g., investment income, effectively connected income.
- The recipient of the income, e.g., foreign individual, corporation, or flow through entity.
- Tax treaty provisions or statutory exemptions that apply, if any.
Withholding on U.S. Source Investment Type Income
The chart at the end of this article provides a summary of the various withholding rules. In general, withholding is required on the gross amount of any income that is fixed or determinable, annual, or periodic (“FDAP” Income) and that is derived from sources within the United States. The following rules apply in most cases:
- Withholding Tax Rate - 30 percent, unless there is a lower treaty rate. This rate applies regardless of whether the ultimate beneficial owner of the income is a foreign individual or foreign corporation.
- Important statutory exemptions - Portfolio interest exemption, and income derived from the sale in the United States of personal property, most notably U.S. stocks and securities.
- Relevant IRS reporting forms - Forms 1042 and 1042S.
- Timing of deposits - In general, required on a quarterly basis and regardless of whether the income is distributed or not.
Once the appropriate amount of U.S. taxes is withheld, the passive foreign investor generally has no further U.S. tax obligations; however, a tax return reflecting limited information may be required if a treaty or code exemption is being claimed.
Effectively Connected Income (“ECI”)
In general, a foreign person that is engaged in a U.S. trade on business is subject to U.S. tax on the income effectively connected with the conduct of that U.S. trade or business. ECI earned by a foreign person is subject to ordinary tax rates. Therefore, the basic purpose behind the “effectively connected” concept is to give direction to taxpayers in determining whether or not income received from U.S. sources (and from certain foreign sources) is taxable at the flat 30 percent or lower treaty rate, or at the normal rate applicable to U.S. citizens and residents. Usually, trading income that the foreign business taxpayer receives from the U.S. activities or branches will be income from his business and thus constitute ECI. Therefore, in many cases the character of the income (investment or ECI) will be obvious. The Internal Revenue Code and Regulations establish two tests, referred to as “the asset use” test and the “business activities” test (beyond the scope of this article), to determine whether an item of income is effectively connected with the taxpayer’s U.S. trade or business.
Finally, in the case of ECI, even if the appropriate amount of tax is withheld, the recipients of the income are required to file a nonresident U.S. income tax return (Form 1040-NR in the case of individuals and Form 1120-F for corporations). In general, the following rules apply:
- Withholding Tax Rate - The maximum U.S. tax rate applicable to individuals in the case of a noncorporate partner or the maximum U.S. tax rate applicable to corporations in the case of a corporate partner. Presently, the maximum tax rate for both individuals and corporations is 35 percent, so this rate applies regardless of whether the beneficial owner of the income is an individual or a corporation. In addition, in the case of a foreign corporation, the “Branch Profits Tax” (beyond the scope of this article) may apply but is not subject to withholding.
- Timing of deposits - In general, required on a quarterly basis regardless of whether the income is distributed.
- Relevant IRS Forms - Forms 8804, 8805, and 8813.
U.S. Real Property Interests
First imposed by the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange, or other disposition of a U.S. real property interest are taxed in the same manner as income effectively connected with the conduct of a U.S. trade or business, i.e., taxed at graduated rates. In addition to direct ownership in real property, FIRPTA applies to the sale of stock in certain domestic corporations. In general, it applies if the fair market value of the corporation’s real estate holdings equals or exceeds 50 percent or more of the net fair market value of the corporation’s total assets.
Withholding also applies to certain types of distributions of U.S. real property interests, even if the distribution does not constitute a sale in exchange. In general the following rules apply:
- Withholding Tax Rate - 10 percent of the amount realized by the foreign person unless reduced by a withholding certificate issued by the IRS.
- Withholding agent - purchaser of the real estate or entity making a distribution subject to FIRPTA withholding.
- Timing of deposits - In general, at the time of sale or distribution.
- Relevant IRS Forms - Forms 8288 and 8288-A.
Identification of the Recipient of the Income
Another key element to the tax withholding system is the proper identification of the beneficial owner of the income. This is important to ensure that the ultimate recipient is a foreign person, the applicable tax rate that applies, and the relevant tax treaty, if any. Identification is accomplished based upon documentation that the buyer must provide to the payor. U.S. persons must provide Form W-9. Foreign persons must file a type of W-8, the most common of which is Form W-8BEN, Certificate of Foreign Status of Beneficial Owner.
In the case of foreign intermediaries, (i.e., the recipient of the income is itself a pass-through entity) a complex set of reporting rules and associated documentation is used to identify the beneficial owner. Furthermore, the withholding agent can be either the foreign pass-through entity if it is a “qualified intermediary” or the domestic pass-through in the case of nonqualified intermediaries. A qualified intermediary is one that has qualified and registered with the Internal Revenue Service to be responsible for withholding.
Recent Legislative Developments
In March, 2010 Congress enacted FATCA, the Foreign Account Tax Compliance Act of 2009. The apparent purpose of the Act was to impose various reporting requirements on offshore banks and foreign financial institutions. There are numerous reporting provisions in the new law. However, with respect to withholding, FACTA requires a 30 percent withholding tax on any “withholdable payment” made to a foreign financial institution or certain other entities if they fail to comply with new reporting, disclosure and related requirements. These rules are to go into effect on January 1, 2013. We will keep you apprised of developments as guidance is issued.
In summary, the tax withholding rules are complex and noncompliance can result in significant penalties. If you control an entity with foreign investors or owners, or to ensure that the proper procedures are being followed, you should consult your CBIZ Tofias Tax Advisor, or you may contact us here.
Summary of Withholding Rules Applicable to Foreign Persons Investing in the U.S. through Pass-Through Entities
Type of Income
Type of Foreign Partner
Subject to U.S. Tax?
Tax Return Required?
Withholding Tax Rate
|Effectively Connected Income||Individual||Yes||Yes||Individual Partners||Graduated||Yes||35%|
|Corporation||Yes||Yes||Corporate Partners||Graduated and possibly subject to Branch Profits Tax||Yes||35%|
|U.S. Source Dividends||Individual||Yes||Possibly, if a treaty or Code exemption is claimed||Yes||30% or lower treaty rate|
|Corporation||Yes||Possibly, if a treaty or Code exemption is claimed||Yes||30% or lower treaty rate|
|Portfolio, Trading, Foreign Source and other generally non-taxable sources of income||Individual||No||Possibly, if a treaty or Code exemption is claimed|
|Corporation||No||Possibly, if a treaty or Code exemption is claimed|