Some try to renounce it; others aim to prove it—what is it?
U.S. tax residency.
U.S. businesses operating internationally can incur significant foreign tax liabilities, adding to their overall cost of doing business. A network of tax treaties between the United States and other countries serves to address this problem. In fact, reduced rates of tax as well as outright tax exemptions are available under such treaties with the caveat that treaty benefits are reserved for “residents,” a status that must be proved. Doing so becomes critically important as it can shield U.S. businesses from foreign tax and improve cash flow. The Internal Revenue Service (“IRS”) provides the requisite proof in the form of U.S. residency certificates upon request, but, as might be expected, not instantaneously (indeed, the process can be notoriously slow, taking 10 weeks or more). U.S. businesses are therefore well advised to seek the certifications in advance and to apply for their 2019 certificates when the IRS begins accepting applications on December 1 of this year.
Taxpayers who enjoy filling out tax forms and the conversational banter with IRS revenue agents are directed to exemplar 8802 in the IRS forms library and its illuminating instructions. We welcome inquiries from those less administratively inclined.
Many types of income including dividends, interest and royalties as well as business profits and services payments benefit from treaty relief. Treaties play an important role in avoiding double taxation in all of these cases. But, take as an illustrative example, a U.S. consulting business that provides services to a client in a foreign country.
The work performed might be in the nature of architectural, consulting, data processing, engineering, legal, medical, scientific or a myriad of other professional services. Suppose further that the consultant does most of her work behind a desk in Chicago, Illinois (or anywhere else on U.S. soil for that matter). Some countries will nevertheless attempt to tax the consultant’s services income. Frequently this tax will be enforced by requiring the consultant’s foreign client to withhold a percentage (e.g., 20 percent) of the payments made for the services it received.
If the rate of foreign withholding tax is low enough, the consultant might think that the U.S. foreign tax credit will make her whole. Afterall, the purpose of the foreign tax credit is to mitigate international double taxation. However, there is an important limitation—colloquially referred to as, “the limitation”—which provides that the foreign tax credit cannot exceed the U.S. tax that would be imposed on the consultant’s “foreign source income.” In the case of services income, the place where the services are performed (as opposed to where the work product is enjoyed) determines its source. A consultant working from an office in Chicago therefore has U.S. (as opposed to foreign) source income even though she serves clients who are resident abroad. Because her activity generates no foreign source income, her foreign tax credit is “limited” to zero. Without recourse to another remedy, the consultant will pay foreign tax at a rate of, say, 20 percent (collected through withholding by her client) and U.S. tax at the marginal tax rate applicable to her business, resulting in international double taxation.
Fortunately, U.S. tax treaties overcome this unwelcome result by stipulating that certain services income (or business profits, dividends, interest, etc.) of U.S. residents is taxable only by the United States and not by the foreign country. The treaty benefit shields U.S. residents from foreign tax. However, many U.S. treaty partners require proof of U.S. residency before granting the tax exemption and request the U.S. IRS to certify that the person claiming treaty benefits is in fact a resident of the United States. The IRS provides this residency certification on Form 6166. The “form” is actually a letter printed on U.S. Department of Treasury stationery certifying that the individuals or entities listed are residents of the United States.
Obtaining Residency Certification
U.S. residents may obtain the residency certification by filing an application on Form 8802 (i.e., “Application for United States Residency Certification”), paying a user fee and waiting at minimum 30 to 45 days. However, processing times of 10 weeks or longer have been noted in the past. A foot fault in making the submission can result in further delays. These processing times obviously affect cash flow, so U.S. enterprises with international clients should consider proactively securing residency certificates ahead of time, something the IRS accommodates by beginning to process Forms 8802 on December 1 for the succeeding year. It is conceivable that a foreign country may also require the residency certificate to be apostilled before giving it effect.
It’s worth noting that U.S. fiscally transparent entities like partnerships and S corporation, as well as disregarded entities (e.g., single member LLCs), are not themselves U.S. tax resident, because of their “flow through” tax status. However, these entities may apply for residency certifications in their own names on the basis that their interest holders are U.S. tax resident. Multimember entities must secure appropriate “penalties of perjury” statements from all members and designated officers in support of the application. Enterprises with concerns over a potentially time consuming and administratively burdensome application process might consider subcontracting engagements with foreign clients to affiliated domestic C-corporations. C-corporations are generally U.S. resident in their own right without reference to their interest holders and function as “blockers” against imposition of income taxes on their individual interest holders.
Once secured, proof of U.S. residency can have the additional salutary effect of exempting its beneficiary from value added taxes (“VAT”). This effect is achieved not under a tax treaty but simply by virtue of proving under the domestic law of a member state of the European Union, for example, the non-EU residence of the payee.
For U.S. businesses operating internationally, having proof of U.S. tax residence on hand can reduce foreign income tax, eliminate VAT and improve cash flow.