U.S.-Source FDAP Income Compliance Designated as Tier 1 Issue

By Daniel Faulk, CPA, MBA, San Jose, CA

Editor: Mark G. Cook, CPA, MBA

The IRS has designated the obligation of U.S. withholding agents to report and withhold on U.S.-source fixed or determinable annual or periodic (FDAP) income as a Large and Mid-Size Business (LMSB) Division Tier 1 issue. Tier 1 issues are issues of high strategic importance to the LMSB and have a significant impact on one or more industries. The IRS is concerned that some taxpayers have used strategies to minimize withholding taxes, such as securities lending, payments to foreign vendors, and potential use of total return swaps. The IRS is also focusing on the quality of the overall reporting and withholding systems and procedures of the withholding agents to ensure proper classification of payments, sourcing, and validity of documentation of foreign persons.

Background

Generally, foreign persons are subject to federal income tax on their U.S.-source income under the following rules:

  1. Income that is effectively connected with a U.S. trade or business is taxed on a net basis at U.S. graduated tax rates; and
  2. FDAP income is subject to gross taxation at a flat 30% tax rate if it is derived from U.S. sources and is not taxable as U.S. effectively connected income under rule (1). (Note that a tax treaty may reduce or eliminate the flat 30% tax rate.)

FDAP income is all income except for gains from the sale of property (including market discount and option premiums but not including original issue discount) and items of income excluded from gross income without regard to the owner’s U.S. or foreign status, such as tax-exempt municipal bond interest and qualified scholarship income. Examples of FDAP income include compensation for personal services, dividends, interest, original issue discount, pensions and annuities, alimony, real property income (such as rents) other than gains from the sale of real property, royalties, taxable scholarship and fellowship grants, and commissions.

Withholdings on FDAP income

Generally, a withholding agent must withhold 30% tax on FDAP income unless the agent can reliably associate the payment with documentation that the payment is made to (1) a payee that is a U.S. person or (2) a foreign beneficial owner who is eligible for a reduced rate of withholding. (The documentation process is sometimes referred to as “self-certification.”) Withholding is not required, however, when a foreign person assumes withholding responsibility as a qualified intermediary.

A withholding agent is a person who is required to deduct and withhold taxes under the provisions of Secs. 1441, 1442, 1443, or 1461. A U.S. or foreign person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding is a withholding agent. Several persons may be withholding agents for a single payment, but the full tax is required to be withheld only once. Generally, the U.S. person who pays an amount subject to withholdings is the person responsible for the withholdings; however, other persons may be required to withhold. For instance, a payment made by a nonqualified intermediary that knows or has reason to know that the full amount was not withheld by the person from which it received payment is required to do the appropriate withholdings.

Withholding agent liable for tax: A withholding agent is personally liable for any tax that is required to be withheld. The withholding tax liability is independent of the tax liability of the foreign person to whom the payment is made. Accordingly, if a withholding agent fails to withhold a tax and the foreign person does not satisfy its U.S. tax liability, both the withholding agent and the foreign person are liable for tax, interest, and penalties on the outstanding balances due.

Common Types of FDAP Income

Interest: With specific exceptions, such as portfolio interest, taxes must be withheld on interest from U.S. sources paid to foreign payees (interest income is sourced according to an individual obligor’s residence and a corporate obligor’s place of incorporation). Domestic corporations must withhold on interest credited to foreign subsidiaries or foreign parents. A treaty may permit a reduced rate or exemption for interest paid by a domestic corporation to a controlling foreign corporation. The interest may be on any type of debt, including open or unsecured accounts payable, notes, certificates, bonds, or other evidence of indebtedness.

Dividends paid by U.S. corporations: Generally, a U.S. corporation making a distribution with respect to its stock is required to withhold on the entire amount of the distribution. However, a distributing corporation may elect not to withhold on the part of the distribution that:

  • Represents a nontaxable distribution payable in stock or stock rights;
  • Represents a distribution in exchange for stock;
  • Is not paid out of current or accumulated earnings and profits; or
  • Represents a capital gain dividend.

Royalties: Royalty income is sourced where the property is used. Income from the sale of intangible property is treated as royalty income if the amount received is contingent on productivity, use, or disposition of the property. A 30% tax on U.S.-source income applies to the extent that the royalty income is not effectively connected with the conduct of a trade or business within the United States.

Potential Impact of Fiscal Year 2010 Revenue Proposals

The Obama administration’s fiscal year 2010 revenue proposals include recommended changes to withholdings on payments of FDAP income. According to the General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals, “The Administration is concerned that some persons that are not entitled to an exemption from withholding tax or a reduced rate of withholding tax may attempt to avoid U.S. tax by arranging to receive payments through foreign intermediaries that are not qualified intermediaries (nonqualified intermediaries)” (Department of the Treasury (May 2009), p. 43, www.ustreas.gov/offices/tax-policy/library/grnbk09.pdf).

The administration proposes making the following change: “Any withholding agent making a payment of FDAP income to a nonqualified intermediary would be required to treat the payment as made to an unknown foreign person (and therefore to withhold tax at a rate of 30 percent)” (id.). The rationale for this proposed change is that it “would discourage U.S. and foreign persons from attempting to avoid U.S. tax or to obtain a lower rate of withholding tax by providing incorrect self-certification or otherwise relying on the lack of information reporting associated with using nonqualified intermediaries” (id.). The proposal would be effective for payments made after December 31 of the year of enactment.

Conclusion

Foreign persons are subject to U.S. tax on their U.S.-source FDAP income. If the FDAP income is not U.S. effectively connected income, the income is subject to withholding at a flat rate of 30% by the U.S. withholding agent, unless the flat 30% tax rate is reduced or eliminated under a tax treaty.

As evidenced by the IRS’s designation of potential underreporting and withholding on U.S.-source FDAP income as a Tier 1 compliance issue, and the Obama administration’s proposed changes to require a withholding agent making a payment of FDAP income to a nonqualified intermediary to treat the payment as made to an unknown foreign person (and therefore to withhold tax at a rate of 30%), it is clear that there will be increased scrutiny of FDAP reporting and withholding requirements in the future.

The withholding agent is personally liable for any tax required to be withheld. If the withholding agent fails to withhold and the foreign payee fails to satisfy its U.S. tax liability, both the withholding agent and the foreign payee are liable for tax, interest, and penalties. Accordingly, U.S. payers of FDAP income need to understand the reporting and withholding requirements related to FDAP income to minimize their audit risk and their personal tax liability for missed withholdings.


EditorNotes

Mark Cook is a partner at Singer Lewak LLP in Irvine, CA.

Unless otherwise noted, contributors are members of or associated with Singer Lewak LLP.The editor would like to offer a special thanks to Jennifer Allison, J.D., for her assistance with this column.

For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or mcook@singerlewak.com.

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