The President recently signed into law the Hiring Incentives to Restore Employment (HIRE) Act (Public Law 111-147). While intended as a jobs incentive bill, a key revenue offset of the Act is a new reporting and disclosure regime for foreign financial institutions and individuals with foreign accounts that generally takes effect after December 31, 2012. The Act incorporates provisions of S. 1934, the previously introduced Foreign Account Tax Compliance Act of 2009, and is intended to curb offshore tax abuse by forcing foreign financial institutions and other foreign entities to disclose information about their U.S. account holders and owners. These measures are widely viewed to be the most comprehensive change to our information reporting and withholding rules since 2001. A general summary of the Act’s key reporting and withholding provisions follows:
Foreign Financial Institutions
- Under new Internal Revenue Code Section 1471, foreign financial institutions (“FFIs”) will be subject to a 30% U.S. withholding tax on U.S.-source income (e.g., interest or dividends but excluding any income which is effectively connected with a U.S. trade or business) and the gross proceeds from the sale of property that produces U.S.-source interest or dividends (e.g., stock or debt of domestic companies), whether or not beneficially owned by the FFI, unless the FFI agrees in writing with the Treasury Department to disclose certain information about financial accounts held by U.S. persons (or U.S.-owned foreign entities) and to report annually on the account balance, gross receipts, and gross withdrawals and payments from such account. (Alternatively, the FFI may elect to comply with IRS Form 1099 reporting as if the FFI were a U.S. person and each such account holder was a U.S. individual—meaning that payments to U.S. corporations which are otherwise generally exempt from reporting on Form 1099 must be reported and both U.S.- and foreign-source income and gross sales proceeds would be subject to reporting.)
- FFIs are broadly defined to include banks, brokers, mutual funds, hedge funds and private equity funds. (According to the Joint Committee on Taxation, a FFI “may include . . . investment vehicles such as hedge funds and private equity funds.”) Payments beneficially owned by foreign governments, foreign central banks, and international organizations are excluded from the 30% withholding tax.
- Certain U.S. persons with accounts are excluded, including publicly-traded corporations, banks, RICs, REITs, tax-exempt organizations, individual retirement plans, U.S. government entities, certain charitable trusts, and individuals whose total depositary accounts with the foreign financial institution do not exceed $50,000.
- A U.S.-owned foreign entity for this purpose is generally a foreign entity that is more than 10% owned by a U.S. person or, in the case of a foreign investment fund, that has any U.S. owner.
- If foreign privacy laws prevent reporting, the FFI must attempt to obtain a waiver from each U.S. account holder and, if a waiver is not obtained within a reasonable period of time, must agree to close the account.
- Under this rule, the 30% U.S. withholding tax at source applies to all withholdable payments (as described above) made to the FFI and not just to payments whose beneficial owners are U.S. persons.
- FFIs must also agree to act as withholding agent by deducting and withholding 30% from any “passthru payment” (i.e., a withholdable payment as described above or other payment to the extent attributable to a withholdable payment) made to a “recalcitrant account holder” (i.e., any account holder who fails to comply with reasonable requests for disclosure of information or fails to waive foreign privacy or confidentiality laws that would otherwise prevent reporting) or another FFI that does not have a similar agreement with the Treasury Department. (Alternatively, a FFI may shift its obligation to withhold on recalcitrant account holders and nonparticipating FFIs by electing to have the person making the payment to the FFI withhold instead on the portion of the payment allocable to recalcitrant account holders and nonparticipating FFIs, in which case, the FFI must also waive any treaty rights with respect to such amounts deducted and withheld.)
- If a FFI is a qualified intermediary (QI), the foregoing rules apply in addition to the requirements under the existing QI regime.
- Generally, any beneficial owner of a withholdable payment could file a claim for refund of the withheld amount if, for example, the beneficial owner is entitled to an exemption from or reduced rate of withholding under a tax treaty or if payment of an amount is not otherwise subject to U.S. tax (e.g., if a payment is eligible for the portfolio interest exemption or represents gross proceeds from the sale of a capital asset.) Where the FFI is the beneficial owner of a payment that is withheld upon, the FFI is only entitled to file a claim for refund (without any interest component) if it is entitled to a reduced withholding rate by reason of an applicable tax treaty.
- A FFI may be deemed to satisfy all reporting requirements (i.e., without having to enter into an agreement with the Treasury Department) if it complies with such procedures as the Secretary prescribes to ensure that it does not maintain any U.S. accounts.
- Under a grandfathering rule, the 30% withholding tax will not apply to payments on, or the gross proceeds from the disposition of, obligations outstanding on March 18, 2012.
Non-Financial Foreign Entites
- Under new Internal Revenue Code Section 1472, any foreign entity that is not a FFI will be subject to a 30% U.S. withholding tax on withholdable payments (as described above) unless the beneficial owner (i.e., the foreign entity itself or indirectly any other non-financial foreign entity) or payee certifies to the withholding agent that the beneficial owner has no substantial U.S. owners or provides certain identifying information about each such substantial U.S. owner and the withholding agent does not know or have reason to know that the information provided is incorrect. This provision does not apply to payments beneficially owned by certain excluded entities, such as publicly traded companies (or their corporate affiliates), foreign governments, or foreign central banks.
Other International Tax Provisions
- The Act repeals certain exemptions for foreign-targeted bearer bonds (i.e., bonds designed to be issued solely to non-U.S. persons) by denying a deduction for interest paid on such bonds and providing that such interest is ineligible for the portfolio interest exception to withholding. This provision is generally effective for bearer debt issued after March 18, 2012. Under current law which remains unaffected by the Act, bearer debt that is (i) is issued by a natural person; (ii) matures in one year or less; or (iii) is not of a type offered to the public will continue to be eligible for such exemptions. Moreover, the Act does not affect the portfolio interest exemption as it applies to registered debt obligations.
- Effective for tax years beginning after March 18, 2010, U.S. individuals with an interest in a “specified foreign financial asset” (such as financial accounts maintained by a FFI or any stock or security issued by a non-U.S. person) will have new reporting requirements if the aggregate value of such assets exceeds $50,000. Increased penalties will also apply to individuals who fail to make the requisite disclosures. This requirement is in addition to any foreign bank and financial account (“FBAR”) filing requirements under current law.
- Effective as of March 18, 2010, U.S. shareholders of a passive foreign investment company (“PFIC”) will be required to file annual information returns with the IRS “as the Secretary may require”. In Notice 2010-34, however, the IRS recently stated that a shareholder of a PFIC will not be required to file an annual return for tax years beginning before March 18, 2010 (as a result of this new provision).
- Effective for payments made on or after September 14, 2010, “dividend equivalent” payments (e.g., payments in connection with a securities lending transaction that are contingent on, or determined by reference to, the payment of a dividend from U.S. sources) to non-U.S. persons will be subject to a 30% withholding tax (or a lower applicable treaty rate).
- The Act imposes increased reporting requirements and penalties with respect to foreign trusts.
Ramifications of New Reporting and Withholding Rules and Repeal of Certain Bearer Bond Exceptions
The new reporting and withholding rules for FFIs and non-financial foreign entities are likely to create significant burdens for foreign entities. Because these rules are written broadly, a FFI that takes no action (i.e., does not enter into the above agreement with the Treasury or does not comply with procedures designed to ensure that it has no U.S. accounts) may be subject to a 30% withholding tax on all withholdable payments even if the FFI currently has no U.S. account holders.
These rules would also impose significant due diligence obligations on both U.S. withholding agents which have to determine whether a payee is a FFI (and, if so, whether it has entered into the above agreement with the Treasury) and on FFIs which have to determine whether account holders are U.S. persons, non-U.S. entities with substantial U.S. owners, or participating or nonparticipating FFIs (as defined under these rules). A FFI must also comply with an open-ended requirement to provide any additional information as the Secretary requests. One example of the burdens of these rules is where a widely-held foreign investment fund has an account at a FFI. The account would be a U.S. account subject to these rules if the fund has any interest holder that is a U.S. owner. As a result, the FFI would be required to obtain identifying information for each owner in the investment fund in order to determine which accounts are U.S. accounts even though the FFI has no direct relationship with the fund’s owners.
Non-U.S. persons must also change their mindset about U.S. withholding taxes. Whereas portfolio interest and capital gains were generally exempt from U.S. withholding tax under pre-Act law, such amounts may be subject to a 30% U.S. withholding tax under these rules unless an agreement with the Treasury Department is entered into. Moreover, although non-U.S. persons previously enjoyed reduced or zero U.S. withholding tax on certain payments under applicable tax treaties, these rules may impose a full 30% withholding tax at source at the time of payment (despite the application of a U.S. tax treaty) and require that a claim for refund of excess withholding tax be filed instead.
Finally, the repeal of certain exceptions for foreign-targeted bearer bonds could negatively affect the ability of U.S. issuers to raise capital because this rule effectively eliminates the use of bearer bonds as a viable financing alternative. (The Act does provide, however, that debt held through a dematerialized book entry system will be treated as being in registered form and thus not treated as bearer debt for this purpose.) Nevertheless, this new rule may have the effect of preventing U.S. issuers from accessing foreign debt markets where it is either not feasible or permissible to obtain IRS Forms W-8 from investors.
IRS Circular 230
For purposes of complying with IRS Circular 230 Standards of Practice, we advise you that any U.S. federal tax advice contained herein is not written to be used for, and the recipient and any subsequent reader cannot use such advice for, the purpose of avoiding any penalties asserted under the Code.