The Hiring Incentives to Restore Employment (HIRE) Act of 2010 imposes significant new burdens on foreign financial institutions and other foreign investors with US investments. These new rules will affect every foreign entity which receives payments of US source income - they will have to determine whether to comply with the new reporting requirements or pay a 30% withholding tax. The withholding tax provisions of the HIRE Act will likely override existing provisions of US income tax treaties, resulting in the imposition of a 30% withholding tax in many situations.
Significant press coverage on the issue of unreported foreign financial accounts by US taxpayers over the past year has led to the introduction of the Foreign Account Tax Compliance Act of 2009, as well as the inclusion of similar provisions in the Tax Extenders Act of 2009 and President Obama's 2011 Budget. The HIRE Act continues this trend of focusing on foreign financial accounts owned by US taxpayers by seeking to impose significant new information gathering obligations on foreign entities to identify US account holders. Depending on how the Secretary acts to implement the provisions of the HIRE Act, many foreign entities may choose to no longer invest in US stock or securities.
For these purposes, the term "foreign financial institution" is defined broadly as any foreign entity which (1) accepts deposits in the ordinary course of banking or a similar business, (2) holds financial assets for the account of others as a substantial portion of its business, or (3) is engaged primarily in the business of investing, reinvesting or trading securities, partnership interests, commodities or any interest (including futures and forward contracts) on the preceding assets. This includes banks and similar deposit taking institutions, and it appears that it will also include foreign private equity funds and foreign hedge funds since they are primarily engaged in investing in securities, partnership interests and/or commodities.
A "financial account" includes deposit and custodial accounts maintained by a financial institution and any debt or equity interests in a financial institution. A partnership or other equity interest in a foreign hedge fund would be considered a "financial account" for these purposes.
Payments to Foreign Financial Institutions
Under new Section 1471, a withholding agent will be required to withhold US tax at the rate of 30% on a withholdable payment to a foreign financial institution unless certain information reporting requirements are met with respect to that payment.
Withholding agents are all persons, in whatever capacity they act, who have control, receipt, custody, disposal, or payment of a withholdable payment. If the IRS interprets this term consistently with the provisions of Section 1441, then the term includes both US and foreign persons. Accordingly, if a foreign person sold stock of a US corporation to a foreign financial institution, that transaction would be subject to withholding under new Section 1471 unless certain reporting requirements are satisfied, even though the gain would otherwise be exempt from US tax under the provisions of an applicable income tax treaty.
A number of foreign financial institutions may already be treated as Qualified Intermediaries (QI) for purposes of Section 1441; the rules discussed above are in addition to those QI rules and must be complied with separately.
A "withholdable payment" includes any payment of interest, including OID, dividends, rents, salaries, wages, premiums, annuities, compensation, remunerations, emoluments and other fixed or determinable annual or periodic gains, profits, and income from sources within the US. It also includes gains from the sale of any property which can produce interest or dividends from sources within the US. However, income which is effectively connected with a US trade or business and taken into account under Sections 871(b)(1) or 882(a)(1) is not included.
In order to avoid the new withholding tax, the foreign financial institution must have an agreement in place with the IRS defining procedures to identify, and provide substantial information regarding US account holders. The foreign financial institution must agree to (1) obtain information from each holder of each account to determine whether the accounts are US accounts, (2) comply with any verification and due diligence requirements the Secretary may require with respect to the identification of US accounts, (3) report to the IRS on an annual basis, (4) deduct and withhold a payment of 30% on any passthru payments made to a recalcitrant account holder or another foreign financial institution which does not also meet these requirements, (5) comply with requests from the Secretary for additional information with respect to any US account, and (6) obtain a waiver from the account holder if any foreign privacy or other law would otherwise prevent the disclosure of the above information.
"US account" refers to financial accounts held (1) by one or more specified US persons or (2) by US owned foreign entities. Unless the foreign financial institution elects otherwise, the term “US account” does not include accounts held by a person where the aggregate of all accounts held by that person with the institution does not exceed $50,000. The Secretary may provide that members of the same expanded affiliate group shall be treated as a single institution for this purpose; if the Secretary does so, this exception will not be of much help for large multinational institutions with operations in multiple countries. A "specified US person" is any US person other than (1) a corporation whose stock is regularly traded on an established securities exchange, and any member of its expanded affiliated group, (2) an entity exempt from tax under Section 501(a), (3) the United States itself, (4) any State or the District of Columbia, (5) any bank, (6) any real estate investment trust, or (7) certain other trusts.
If a foreign financial institution has one or more US accounts, and has entered in an agreement with the Secretary, then the institution must provide the following information annually to the IRS;
- name, address, and TIN of each account holder who is a specified US person or of each substantial US owner of a US owned foreign entity;
- the account number;
- the account balance or value
- the gross receipts and gross withdrawals and payments from the account, except as provided for by the Secretary.
The requirement to provide information as to the gross receipts and gross withdrawals and payments will probably make it necessary for many institutions to develop computer programs specifically to comply with these new US reporting requirements.
The HIRE Act has a broad definition of US owned foreign entity, which will increase the amount of information a foreign financial institution will have to request from a new account holder in order to determine whether the account constitutes a US account. For these purposes, a US owned foreign entity is any foreign entity which has one or more substantial US owners. A substantial US owner is one who owns more than 10% of the stock of a foreign corporation, or more than 10% of the profits, interests or capital interests of a foreign partnership or certain foreign trusts with either a US owner or a greater than 10% beneficial interest. However, in the case of an entity which qualifies as a foreign financial institution by virtue of being engaged in the business of investing, reinvesting or trading securities, partnership interests or commodities, the threshold is 0% rather than 10%. This means that any foreign private equity fund or hedge fund with one or more US investors, regardless of how little they own of the fund, will count as a US owned foreign entity.
Alternatively, a foreign financial institution can elect to provide the same information that a US financial institution would be required to provide to the IRS if the account holder were a US person. This effectively substitutes the Form 1099 filing requirements for those discussed above.
The Secretary is authorized to treat a foreign financial institution as satisfying the HIRE Act reporting requirements if the institution ensures that it does not maintain US accounts, and meets other requirements regarding accounts maintained with that institution by other foreign financial institutions. In that case, the 30% withholding tax would not apply to withholdable payments to foreign financial institutions.
One issue raised by the HIRE Act is whether existing Know Your Client (or KYC) rules adopted by foreign financial institutions will be sufficient to satisfy these requirements. The IRS has issued conflicting statements on this matter. At a recent conference involving foreign financial institutions, the IRS advised that the KYC rules would probably be sufficient. However, they also informally stated at a conference of tax lawyers and accountants that the issue was under consideration and that the KYC rules may not be sufficient to satisfy the requirements. Given the expansive definition of US account, the decision of the Secretary on exactly what information must be obtained and maintained will have a huge impact on the record keeping and account opening procedures of foreign financial institutions.
The big question now is whether banks in Switzerland and other locations with strong banking secrecy regulations will be inclined (or even permitted) to seek a waiver of applicable privacy laws. However, it is known that these new rules do not apply to payments to foreign governments, any international organization or agency, any foreign central bank, or any other class of person identified by the Secretary as posing a low risk of tax evasion.
Payments to Non-financial Foreign Entities
Similar withholding tax provisions under new Section 1472 apply to withholdable payments made to a non-financial foreign entity. Withholding can be avoided if (1) the beneficial owner provides either a certification that the non-financial foreign entity has no substantial US owners, or the name, address and TIN of each substantial US owner, (2) the withholding agent does not know or have reason to know that any information under (1) is incorrect, and (3) the withholding agent reports the information to the IRS in the manner outlined by the Secretary.
There are exceptions where the beneficial owner is (1) a corporation whose stock is regularly traded on an established securities market, (2) a member of an expanded affiliated group whose parent qualifies under (1), (3) certain corporations organized in a US possession , (4) any foreign government or agency, (5) any international organization or agency, (6) a foreign central bank, or (7) any class of person identified by the Secretary. There is also an exception for any class of payments identified by the Secretary as posing a low risk of tax evasion.
The above new rules will apply to payments made after December 31, 2012. There is an exception for certain grandfathered obligations which are outstanding 2 years after the date of enactment of the HIRE Act.