Withholding for the millennium

Attorney-CPA, The, 2001 by Muina, Margarita P

Under Final Treas. Reg. 1.1441-1(b)(1), a withholding agent must withhold 30 percent of the amount of each payment made to a foreign payee unless it can "reliably associate" the payment with documentation upon which it can rely to treat the payment as made to a beneficial owner that is: (1) a U.S. person or (2) a foreign person1 entitled to a reduced rate of withholding2. A withholding agent cannot just rely on the documentation if it is aware of information contrary to that provided in the documentation.

For instance, a withholding agent must withhold even if the documentation shows the payee to be a U.S. person if the withholding agent knows the payee is an agent of a foreign person. However, the withholding agent may treat the payment as made to a U.S. person if the U.S. person is a financial institution, such as a bank, and the withholding agent has no reason to believe that the financial institution will not comply with its obligation to withhold. If, under certain circumstances, the withholding agent fails to withhold 30 percent of the payment when required, the agent will be held liable for the tax due, together with interest and penalties. No withholding is required for payments made to qualified intermediaries who are primarily responsible for the withholding tax under their agreement with the IRS.

To date, the regulations are effective for payments made as of Jan. 1, 2001(1). The IRS is now revising the rules and procedures under which it will recognize certain "qualified intermediaries". Currently, the IRS is also devising prototype agreements to expedite the qualification process for intermediaries from the geographic areas with the same or similar "know your customer rules" and enforcement policies. Qualified intermediaries may be entitled to rely on a "blanket" disclosure statement for all its foreign account holders or partners without having to disclose information for each account holder or partner. In exchange, the IRS would charge the qualified intermediary with primary liability for the tax due, hence no withholding is required.

Under the rules, 30% withholding is required each time a payment of FDAP (fixed or determinable, annual or periodical) income is made. FDAP income is defined in IRC Sec. 871(a) and 881(a) (for individuals and corporations, respectively) to include certain types of passive income derived from U.S. sources. The duty to withhold on such U.S. source FDAP income is imposed under IRC Sec. 1441(b) and 1442(b), again for individuals and corporations, and is based on the practical premise of collecting the tax before the income leaves the payor's hands. A payment is considered made when a cash basis taxpayer would recognize it in income. Withholding may be required for constructive payments but only if the payor has custody of property belonging to the payee or ultimate beneficiary or if the payor and the payee are related in the IRC Sec. 482 sense.

IRC Sec. 871(a) and 881(a) define FDAP income as "interest (other than OID), dividends, rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable annual or periodical gains, profits, and income. . ." not effectively connected with a U.S. trade or business6. FDAP income also includes the taxable portion of scholarships and grants received by holders of certain student visas (not deemed compensation) and withholding is required at a 14 percent rate.

The final regulations enlarge FDAP income to include all income included in gross income under IRC Sec 61 (including original issue discount), unless the item is excluded from gross income under another code section regardless of the recipient's status. The Regs. cite as an example interest from state or local bonds excluded from gross income under IRC Sec. 103. Such interest cannot be FDAP income even if received by a foreign person and hence no documentation is required since no obligation to withhold exists. A similar argument exempts from withholding any item of gross income excluded pursuant to IRC Secs. 101 through 138. If, however, the interest is excluded because the recipient was entitled to claim the benefits of an income tax treaty excluding such interest from U.S. taxation, then the payor would have to reliably associate the payment of interest with documentation evidencing the recipient's entitlement to claim treaty benefits and the exclusion of the interest payment from U.S. income taxation. Otherwise, the payee would have to withhold at a 30% rate, since the interest is clearly FDAP income.

Treas. Reg. 1.1441-1(b)(4) lists income exempt from withholding, even if the income is clearly not FDAP income and no duty to withhold exists. For instance, arguably effectively connected income should not be included in the list since it is not FDAP income. Still, the Treas. Reg. enlarge the definition of FDAP income as "all income unless otherwise exempt " as defined above. Income is exempt from withholding if it otherwise qualifies under the Code as: portfolio interest5; bank deposit interest6; interest from foreign branch of a U.S. bank; interest from short-term (less than 183 days) obligations 7; income from sources without the U.S.; distributions from certain domestic corporations; dividends from foreign corporations if less 25 percent is effectively connected income8; effectively connected income9; compensation for services performed in the U.S.10; annuities from certain qualified plans; payments to foreign governments; interest paid to a foreign central bank; foreign central bank acceptances; payments to international organizations; treaty exemptions or reductions from 30 percent withholding; taxable portion of scholarship and grants that do not represent compensation; amounts paid to a foreign tax exempt organization; per them amounts for certain U.S. non-resident aliens; and certain kinds of gambling winnings. The Treas. Reg. concludes by cautioning that any payments not otherwise mentioned shall be subject to withholding at the rate of 30 percent, unless exempt under future IRS guidelines.