The Internal Revenue Service continues to ramp up its enforcement of cross-border withholding taxes for foreign nationals working in U.S. companies. Corporate tax departments should be ready for the challenges and changes ahead.
The IRS, which has been boosting its enforcement priorities in cross-border withholding for several years, formally designated the issue as a Tier 1 audit concern (a label the IRS applies to high priorities) in December 2008. It has also placed greater focus on training and hiring more agents to examine withholding issues.
During a March 30 Webcast on the subject, John Mattos, an international tax partner at PricewaterhouseCoopers, said he’s already seeing “significant audit activity” in the withholding area on the West Coast, and no single industry is a target. “It’s become a standard matter on all [IRS] exams,” he said.
At issue is Section 1441 of the tax code, which stipulates that certain payments—dividends, interest, royalties, payment cards purchases, legal expenses, to name a few—made to a foreign citizen for services performed in the United States may be subject to cross-border withholding. What’s more, the Hiring Incentives to Restore Employment Act, signed into law on March 18, includes yet more provisions for cross-border withholding likely to complicate companies’ efforts to comply with the tax code.
Specifically, the HIRE Act adds a new Chapter 4 to the tax code that requires a 30 percent withholding tax on any “withholdable payment” made to a foreign financial institution—such as foreign banks, private equity and hedge funds, and qualified intermediaries—or a non-financial foreign entity. A “withholdable payment” is defined to include not only most U.S. payments subject to withholding under current law, but also the gross proceeds from the sale of any property that can produce U.S. source interest or dividends.
“The more robust your internal procedures are, the less likely the IRS will do a deep dive during an examination on these matters.”
—Maria Murphy,
Director,
PricewaterhouseCoopers
The rules are generally effective for payments made starting in 2013.
Passage of the new law means that withholding agents—that is, the taxpayer making the payment—must now beware of two withholding regimes: Chapter 3 and Chapter 4. “The Chapter 4 rule will have to be applied first, and then if there is no withholding there, withholding agents will still have to look to Chapter 3 to see if withholding [on non-resident aliens] will be applicable,” explained Maria Murphy, a director at PwC who also spoke on the Webcast.
The IRS has identified several industries as having more exposure to the risk of cross-border withholding exposure, including the tech, pharmaceutical, and professional services sectors, as well as businesses with a heavy focus on intellectual property, Murphy noted.
Withholding Exemptions
Under certain circumstances, the IRS may exempt certain companies or investments from Chapter 4 withholdings. Murphy said the IRS is likely to grant exemptions once it determines that a company poses a low risk of being a vehicle for tax evasion.
The 30 percent withholding also doesn’t apply to any foreign financial institution that enters into an agreement with the IRS and satisfies certain reporting requirements. These include:
Obtaining information from U.S. account holders to determine which are U.S. accounts;
Complying with any required due diligence or verification procedures;
Deducting and withholding a 30 percent tax on any “pass-thru payment” to “recalcitrant account holders” or other foreign financial institution that don’t comply;
Complying with IRS information requests; and
Attempting to obtain a waiver of applicable bank secrecy or other information disclosure limitations or close the U.S. account.
Under the IRS agreement, the foreign financial institution must also agree to report annually:
IRS GETS BUSY
The following excerpt is from the PwC Webcast and explains what steps the IRS has taken in regard to Section 1441:
What has the IRS Been Doing?
Designated “withholding” as a Tier 1 issue.
Learned how and where to look for noncompliance from Section 1441
Voluntary Compliance Program (“VCP”).
Published Internal Revenue Manual for Form 1042 Examinations to
ensure quality and consistency in enforcement.
Training more agents to examine withholding issues.
Cross-checking the information reporting it currently receives and
enhancing its use of that information (Forms 1042-S, 5471, 5472)
Focused on Accounts Payable/Vendor Payments
What has the IRS Been Doing–General Observations
Looking beyond what’s reported on Forms 1042 and 1042-S
Applying a “strict liability” approach to all Forms W-8
The persons directly responsible for collecting documentation, reviewing documentation, and processing invoices may not be well versed in the NRA rules
Section 1441 examinations are subject to standard examination timeframes. It is unlikely additional time will be allowed to remediate documentation failures discovered during the examination.
What has the IRS Been Doing-Why Should You Care?
Significant potential exposure, especially with respect to having “valid”
Forms W-8:
(1) Generally 30 percent withholding where forms are invalid.
(2) Withholding agent is liable for the amount of tax that should have
been withheld, plus penalties and interest
Areas most susceptible to errors are frequently those out of the direct
control and jurisdiction of the tax department.
Source
PwC Webcast: Compliance Health Check (March 30, 2010)
The name, address, and taxpayer identification number (TIN) of each account holder that is a specified U.S. person;
The name, address, and TIN of each substantial U.S. owner of any account holder that is a U.S. owned foreign entity;
The account number;
The account balance or value; and
The gross receipts and gross withdrawals or payments from the account.
Best Practices
Corporate legal departments can take several steps prior to an IRS examination to help reduce exposure for withholding taxes, interest, and penalties.
Generally, Mattos said, the IRS provides a three-step examination process. First, it reviews the withholding agent’s written processes and procedures. Then it identifies non-resident alien account holders or vendors, and lastly it looks to the U.S. sourcing of those payments.
To determine the source of income, look to the payment being made, explained Dominick Dell’Imperio, another PwC partner. Consider the following payments and their sources:
Interest: residence of the payor.
Dividends: where the corporation is organized.
Personal services: the place where the services are performed.
Licenses, royalties, patents, and copyrights: where the property is used.
Rent: where the property is located.
Pension payments: where services were performed while a resident alien.
Keep in mind that some payments can be mixed sources, Dell’Imperio said. “When in doubt, treat it as a U.S. source.”
Wrongfully filling out Forms W-8 are also an area where common pitfalls are seen. Dell’Imperio warned against falling victim to these commonly made errors:
Invalid documentation;
Conflicting information in files or Systems;
Failure to obtain documentation;
Presumption rules incorrectly applied—relying on presumption rules alone may increase risk of exposures for under withholding or backup withholding; Failure to identify payments subject to withholding; and
Controlled foreign corporations not compliant with information reporting rules, especially for U.S. payees.
Some companies, for instance, make the mistake of not having an original signature on their Form W-8, which is “even more relevant in today’s electronic storage medium, where many documents are stored electronically. What we’re really saying is you have to keep a hard copy of each W-8 continued in the file,” said Mattos.
Most importantly, don’t wait for the IRS examination to find and fix problems, said Murphy. Instead, she said, do a mock internal compliance health check.
Review internal procedures and training manuals. If you don’t have any with respect to withholdings, it’s a good time to start thinking about it, Murphy said, “because the more robust your internal procedures are, the less likely the IRS will do a deep dive during an examination on these matters.”
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