Under current law, payors of U.S. source interest, services fees, royalties, and dividends are obligated to withhold 30 percent tax (unless exempt or reduced by treaties) pursuant to Section 14411 and report them on Form 1042. The Internal Revenue Service (IRS) is aggressively pursuing audits in this area. Many non-financial institutions have found that their accounts payable departments are challenged in complying with such rules. Under the Foreign Account Tax Compliance Act (FATCA), additional compliance burdens will be imposed, starting in 2013, and companies need to start thinking now about how FATCA will affect them.
This article introduces the basic issues for payors that are nonfinancial institutions that will be caught in the FATCA maze. It is the first article of many, as the rules are being developed. Stay tuned for the updates.
FATCA provides for the following basic rules:
- “Witholdable” payments made to a foreign financial institution (an FFI) are subject to the 30 percent FATCA withholding tax unless the FFI has entered into an agreement with the IRS that will require reporting of all U.S. account holders of the FFI, or another exemption applies. Section 1471.
- “Witholdable” payments made to a non-financial foreign entity (a NFFE) are subject to the 30 percent FATCA withholding tax unless the NFFE (i) does not have substantial U.S. owners, or (ii) provides the payor with the detailed information on its substantial U.S. owners. Section 1472.
- Witholdable payments include U.S. source interest, dividends, royalties, rents, and other fixed determinable and periodic income AND gross proceeds from the disposition of property that can produce interest or dividends. The latter category is not subject to the Section 1441 withholding regime.
It’s important to note that the FATCA withholding is in addition to and not a substitute for the Section 1441 withholding. For example, if the U.S. company is paying a U.S. source royalty to a foreign corporation, it is subject to the 30 percent Section 1441 withholding, and the FATCA withholding, unless exemptions are managed. In many situations the Section 1441 withholding may be avoided if the payee provides a properly completed Form W-8BEN on which it claims the benefits of a treaty to reduce the rate to zero. Even assuming that the form is received, and it’s accurately completed, it will not preclude the rules of FATCA (unless subsequent guidance so permits). If both FATCA and Section 1441 withholding apply, the payments could be reduced by 60 percent.
The goal of FATCA is to provide transparency, so that U.S. persons cannot inappropriately hide income and assets behind foreign entities. Given that goal, at least in the context of NFFEs, there is not a great deal of avoidance that should occur, and the government is looking at potential exemptions that would reduce the FATCA burden. The initial guidance is found in Notice 2010-60. The Notice provides for certain exemptions, and asks for comments on potential exemptions from FATCA for payments to NFFEs. The relevant provisions are:
- Payments to holding companies that are principally involved in holding investments in operating (non-financial) companies are expected to be FATCA-free.
- Payments to companies that operate as finance centers for the affiliated group are expected to be FATCA-free.
- Should payments made in the ordinary course of the payor’s business be exempt? The devil will be in the details of defining ordinary course payments. For example, royalty payments made by a software company to a third-party developer should be expected to be in the ordinary course. Payments to vendors for goods should be ordinary course. What if a payment is late, and interest is also charged – is that an ordinary course payment?
- Should payments made to payees that are in an active trade or business be exempt? How would that be defined and how would it be proven – will certification from the payee be sufficient?
Payments made to public companies that are not FFIs are statutorily exempt from FATCA withholding, but as of yet there is no guidance on how to prove the status of the payee as publicly traded, and there is no definition of publicly traded.
Numerous questions abound. For example, in the holding company exemption, does it matter if the shareholders of the company are themselves FFIs? For the finance center, are payments it makes subject to FATCA, even though the payments are foreign-source?
A number of these possible exceptions were the subject of a FATCA presentation made at the International Fiscal Association USA meeting on February 25, 2011. A link to the presentation can be found at http://www.pepperlaw.com/pdfs/Intl_Fiscal_Assoc_USAMeeting_Arnold_022511.pdf.
While the FATCA rules are still in the development stage, companies need to start considering what they may need to do to bring their accounts payable and treasury functions into compliance. A good starting point would be a review of the Section 1441 procedures in place to test for the strength of those procedures, and to understand what challenges may be faced in achieving FATCA compliance. We’ll be following up with more on this topic as guidance is developed.