Foreign Income & Taxpayers
In the more than 100 years that U.S. withholding tax has been imposed on payments of U.S.-source income to foreign persons, the definition of a "withholding agent" has remained virtually unchanged. The current definitions (located in Secs. 1441(a) and 1473(4)) are the continuation of a definition that first appeared in the Revenue Act of 1913, ch. 16, 38 Stat. 114, and they generally include "all persons, in whatever capacity acting, having the control, receipt, custody, disposal, or payment" of an item of income subject to withholding (Sec. 1473(4)). The key phrasing—"control, receipt, custody, disposal, or payment"—has remained fixed even as new principles have been incorporated into the Internal Revenue Code, and the global banking landscape has evolved dramatically. More than 100 years after the definition was introduced, application of that key phrasing produces results that might best be described as predictably complex, particularly in relation to common transactions such as modern debt issuances.
Example: Issuer, a U.S.-based firm engaged in the global services business, plans to issue obligations with a fixed interest rate exclusively to foreign customers. The obligations will be represented by a global note (Global Note) deposited with Clearing Organization, a foreign (non-U.S.) limited trust company that operates an electronic book-entry securities clearing and settlement system. Global Note will be serviced by Paying Agent, a U.S. bank that also is Issuer's banking service provider.
Economic and other rights in Global Note will be conferred exclusively on registered owners recorded in Clearing Organization's electronic book-entry system (Holders). Paying Agent will service the Global Note under the following terms:
One business day before the due date of the principal, premium, if any, and interest on the Global Note, Issuer shall deposit with Paying Agent U.S. dollars sufficient to pay the amounts becoming due. Paying Agent shall make available the payment in a timely manner to Holders via Clearing Organization on the relevant due date for payment.
In the example, Issuer is not independently keeping track of Holders, is not positioned to determine if withholding applies or the appropriate rate at which to withhold, and cannot perform reporting obligations without requesting details that Issuer may hope could be left to Clearing Organization and Paying Agent. The question arises whether, if Issuer remits cash only to Paying Agent, has Issuer made any payment to a foreign person triggering a withholding and reporting requirement?
Treasury regulations provide that a "payee is the person to whom payment is made, regardless of whether such person is the beneficial owner of the amount" (see, e.g., Temp. Regs. Sec. 1.1441-1T(b)(2)(i)). As discussed further below, Issuer's ability to rely on Paying Agent as a "payee" depends on the level of activity undertaken by Paying Agent, as well as the contractual arrangements between the parties. There may be scenarios in which Paying Agent is not a "payee."
Issuer's duty to withhold and report may be satisfied when an agent of Issuer, or another party in the chain of payment, performs withholding and reporting (i.e., under a services agreement). However, Issuer will continue to be liable in the event of noncompliance. The Tax Court interpreted the statute this way in Casa De La Jolla Park, Inc.,94 T.C. 384 (1990), indicating that interposing a third party between the payer and the payee will not relieve the payer's liability when the third party made the payment at the payer's direction and from the payer's funds.
The regulations allow a payer making a payment to a U.S. financial institution that is an agent of the payee to treat the U.S. financial institution as the payee if the payer does not have reason to know the U.S. financial institution will not satisfy its compliance obligations (see, e.g., Regs. Sec. 1.1441-1(b)(2)(ii)). In the example, Paying Agent is an agent of Issuer (the payer). Could Paying Agent be the agent of both Issuer and Holders, allowing Issuer to rely on the rule in the regulations? Paying Agent must be an agent of Holders to rely on this particular exception, and it appears that, without undertaking substantial additional activities (and potentially entering into formal legal agreements establishing agency), Paying Agent likely would not be the type of agent referenced in this exception.
Furthermore, Clearing Organization is solely responsible for recording ownership interests in Global Note using its electronic book-entry system, an attractive arrangement for Holders because it enhances privacy. If the terms of Global Note suggest that Paying Agent does not know the identity of Holders, Issuer may be deemed to have "reason to know" that Paying Agent is unable to satisfy its withholding obligations. This potential hurdle may be overcome if Paying Agent can demonstrate it collected the necessary documentation from Clearing Organization, or if Paying Agent will apply 30% withholding to all payments. Each of these solutions, however, will also result in additional costs.
There are additional regulatory provisions for payments to certain "intermediaries" and "authorized agents" that could reduce or eliminate Issuer's exposure for liability as a withholding agent. However, these provisions also require Issuer and Paying Agent to undertake additional steps that may include collection of withholding certificates and/or entering into additional legal arrangements.
Status as Withholding Agent
Based upon the foregoing, there may be scenarios in which Issuer retains liability as a withholding agent regardless of having hired Paying Agent. However, there is no limit to the number of withholding agents associated with a payment, and each party in the chain of payment may fit the statutory definition. Is Paying Agent also a withholding agent?
Paying Agent's status as a withholding agent may depend on the level of activity undertaken. In Bank of America NT & SA v. Chaco,No. 77-00038 (D. Guam 2/14/79), the court determined that a bank honoring deposit and withdrawal instructions under a contract covering a customer's account, "[w]ithout a showing of more active involvement and control," was not within the statutory definition of a withholding agent. The regulations address facts similar to Bank of America by providing exceptions from the duty to withhold when the payer does not have sufficient knowledge, control, or custody of the payment to perform withholding. An example of the exception in Regs. Sec. 1.1471-2(a)(4)(i)(B) indicates that a bank honoring the wire transfer instructions of its customer without further knowledge is not required to withhold. The example's facts and conclusion seem similar to the holding in Bank of America, which is welcome relief as taxpayers continue to work toward implementing the Foreign Account Tax Compliance Act's many reporting requirements.
The foregoing discussion demonstrates the potential for inadvertent noncompliance taxpayers face in applying the definition of a withholding agent to the various participants in common transactions. The current definition can result in duplicative documentation efforts among taxpayers who are not always well-positioned to comply. However, by diligently documenting when a payment is made, and to which payee, a taxpayer may successfully navigate this increasingly complex web of compliance requirements.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 202-414-1048 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.