The Internal Revenue Service (IRS) recently announced that it is modifying certain of its tax forms, known generally as Form W-8s, used by foreign individuals and entities (“Foreign Parties”) to claim a reduction or exemption of withholding taxes on payments from U.S. sources (“U.S. Payors”). Payments subject to withholding include interest, rents, dividends and partnership distributions, all of which are extremely relevant to U.S. real estate activities. These new Form W-8s are scheduled to be finalized in December 2012 and available for use starting in 2013. If you are a U.S. Payor making payments to any Foreign Party in connection with your business activities, or if you are a Foreign Party receiving U.S.-sourced income, it is important that you are aware of the revisions to the Form W-8s to avoid any unintended tax withholding liabilities.
Background on Foreign Tax Withholdings
U.S. tax laws impose withholding tax obligations on any individual or entity making certain payments from U.S. sources to any Foreign Party, including payments of interest, dividends, rents, royalties and partnership distributions. Unless there is an exemption or reduction in the withholding tax rate, the withholding tax rate on these payments is generally a flat 30% of the payment (except in the case of partnership distributions, where the withholding tax rate is the highest rate applicable to the type of income allocated by the partnership). A Foreign Party may be eligible to claim a reduced rate of withholding under one of several exemptions, and, as discussed below, such exemptions are claimed by filing the Form W-8 for the applicable exemption.
Compliance with the U.S. withholding tax rules is critical for both U.S. Payors and Foreign Parties. If a U.S. Payor fails to make the proper withholding, the U.S. Payor is personally liable to the U.S. Treasury for any taxes not withheld from the payments to the Foreign Party. This liability can be particularly costly to the U.S. Payor if there is a longstanding payment history between the parties. However, receipt by a U.S. Payor of a Form W-8 from a Foreign Party that reduces or eliminates the applicable withholding taxes protects the U.S. Payor from any liability for not withholding taxes in excess of the reduced rate. Similarly, if a Foreign Party fails to provide the proper documentation to claim a reduction or exemption from the withholding tax, the Foreign Party is required to pay the 30% withholding tax rate. This mistake can be costly, because once withholding tax is paid, it is difficult to obtain a refund.
Changes to the Form W-8
Currently, there are four basic categories of Form W-8: (1) Form W-8BEN (Certificate of Foreign Status), (2) Form W-8ECI (Certificate of Claim that Income is Effectively Connected with Conduct of U.S. Trade or Business), (3) W-8EXP (Certificate of Foreign Government), and (4) Form W-8IMY (Certificate of Foreign Intermediary). The IRS last published these forms in 2006.
In May 2012, the IRS began publishing revised drafts for all of the Form W-8s. Based on the published drafts, the proposed changes to Form W-8ECI and Form W-8EXP are not substantive. However, the proposed changes to the Form W-8BEN and Form W-8IMY are significant. These changes are described below.
Revised Form W-8BEN
The 2006 Form W-8BEN is widely used in connection with real estate transactions, and it is the form used by Foreign Parties who can claim the benefit of a tax treaty between their country of residence and the U.S. to reduce the applicable withholding tax on their U.S.-sourced income. The U.S. has many tax treaties in place with other countries, which reduce the withholding tax rate in general to 15-20% depending on the type of income and, in many cases, even eliminate the withholding tax entirely. The 2006 Form W-8BEN is a single-page form in which the Foreign Party provides certain identification information (e.g., name, type of entity, address) and certifies that it is a resident of a particular country. The proposed 2012 Form W-8BEN is now split into two separate forms, a W-8BEN and a W-8BEN-E. The 2012 W-8BEN is similar in content to the 2006 Form W-8BEN, except only foreign individuals can use this form. All foreign entities, including corporations, partnerships, trusts, tax-exempt organizations and financial institutions, now must use the new Form W-8BEN-E.
As compared to the single-page 2006 Form W-8BEN, the 2012 Form W-8BEN-E is expanded to six pages. The reason for this increased complexity is that this new form is expanded to accommodate foreign financial institutions that are subject to the Foreign Account Tax Compliance Act (FATCA). Under FATCA, foreign financial institutions are subject to a 30% withholding tax on certain U.S.-sourced income unless the foreign financial institutions are registered with the IRS. It appears that the IRS created the new W-8BEN-E form with the purpose of having a single form applicable to all foreign entities subject to U.S. tax withholdings, including foreign financial institutions. A foreign entity completing this form will now be required to categorize itself by selecting only one of the over 20 possible categories for its type of entity. Fortunately, once this categorization is made, only the portions of the form that are applicable to the selected type of entity need to be completed.
Revised Form W-8IMY
The 2006 Form W-8IMY is the form used by Foreign Parties who are foreign intermediaries (including foreign banks, partnerships and trusts) to evidence that they are not acting for their own account and that they are taking responsibility for withholding and collecting the withholding certificates from the ultimate Foreign Party beneficiaries. The 2006 Form W-8IMY is a two-page form in which the Foreign Party provides certain identification information (e.g., name, type of entity, address) and certifies that it is either a qualified intermediary, nonqualified intermediary, U.S. branch or foreign partnership or trust.
As compared to the 2006 Form W-8IMY, the proposed 2012 Form W-8IMY is lengthened to seven pages. The reason for this increased complexity again is that the 2012 form is expanded to deal with foreign financial institutions that are subject to FATCA. As with the 2012 W-8BEN-E, a foreign entity filling out Form W-8IMY is required to categorize itself by selecting only one of the over 20 possible categories for its type of entity. Similarly, once this categorization is made, only the portions of the form applicable to the specific type of entity need to be completed.
Challenges of the New W-8 Forms
The increased complexity of the new 2012 Form W-8BEN-E and the new 2012 Form W-8IMY create a number of challenges for U.S. Payors and Foreign Parties completing these forms. Notably, a Foreign Party will be required to make a number of additional determinations before it can properly complete the form. In addition, the new complexities of the 2012 W-8 Forms likely will make it more difficult for U.S. Payors and Foreign Parties to determine the applicable withholding tax rate that applies to any payments to Foreign Parties. To avoid any unintended tax withholding liabilities on payments to Foreign Parties, U.S. Payors and Foreign Parties should carefully review the documents governing U.S.-sourced payments (e.g., loan agreements, leases, partnership agreements) to make sure that the parties are adequately protected against any inadvertent liability resulting from improper withholdings.