Tax Reform Updates Withholding Rules for Foreign Investors in U.S. Businesses (article)
U.S. companies have unique withholding requirements when they have foreign individual investors. The withholding requirements are designed to capture taxes from international activities that have a U.S. presence and ensure international compliance with U.S. tax laws. Recent changes from the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) will affect withholding requirements for these companies. Entities will need to be prepared for the impact the updates will have on their 2018 tax reporting.
Withholding Rules Refresher
To understand the withholding provisions, it is important to have a general knowledge of how the U.S. tax system taxes U.S. source income of foreign persons, including nonresident aliens and foreign corporations. The key elements to this system are:
- Foreign persons are taxed at graduated rates on the net amount of income effectively connected with the conduct of a trade or business within the U.S.
- Foreign persons are taxed on the gross amount of their U.S. source investment type income at a flat rate of 30 percent.
- Income tax treaties often reduce the withholding rate on interest, dividend, and royalty income to 15 percent or less.
- There is a broad statutory exemption for portfolio interest income. In general, portfolio interest is most U.S. source interest that meets certain requirements in order to protect against the unauthorized use of the portfolio interest exemption by U.S. persons.
- Capital gains from sales of stocks or bonds by foreign persons are generally exempt from U.S. taxation.
- Special rules apply to gains from the sale of U.S. real property.
The tax system employs a withholding regime to collect taxes from passive offshore investors. This withholding obligation is imposed on any person (generally the last U.S. person in a chain) who has control, receipt, custody, disposal, or payment of an item of U.S. source income to a foreign person. In addition to the penalty provisions noted above, a withholding agent that fails to withhold is liable for the uncollected tax, i.e. the economic burden is shifted from the recipient of the income to the payor of the income.
To determine the relevant withholding provisions that apply, it is necessary to ascertain the following:
- The type of income, e.g., investment income, effectively connected income.
- The recipient of the income, e.g., foreign individual, corporation, or flow through entity and if the recipient is compliant with the Foreign Account Tax Compliance Act (FATCA).
- Tax treaty provisions or statutory exemptions that apply, if any.
Withholding on U.S. Source Investment Type Income
In general, withholding is required on the gross amount of any income that is fixed or determinable, annual, or periodic (FDAP Income) and that is derived from sources within the United States. The following rules (described in more detail in Internal Revenue Code [IRC] Chapter 3) apply in most cases:
- Withholding tax rate – 30 percent, unless there is a lower treaty rate. This rate applies regardless of whether the ultimate beneficial owner of the income is a foreign individual or foreign corporation.
- Statutory exemptions – Portfolio interest exemption, and income derived from the sale in the United States of personal property, most notably U.S. stocks and securities.
- IRS reporting – Entities with FDAP income must file Forms 1042 and 1042-S.
- Timing of deposits – Deposits may be made quarterly or monthly, and for purposes of Section 1446 withholding, is required regardless of whether the income is distributed.
Once the appropriate amount of U.S. taxes is withheld, the passive foreign investor generally has no further U.S. tax obligations; however, a tax return reflecting limited information may be required if a treaty or code exemption is being claimed.
If foreign entities are also subject to FATCA withholding under IRC Chapter 4, the FATCA withholding takes precedence over the FDAP (Chapter 3) withholding rules. The withholding agent for the FATCA-eligible entity has to ensure the Form 1042-S includes both a Chapter 3 and Chapter 4 classification code for each investor (more details on this are found in the 1042-S instructions).
A foreign taxpayer identification number (FTIN) is required for a foreign person claiming a reduced rate of, or exemption from, tax under a tax treaty between a foreign country and the U.S. if such person did not provide a U.S. TIN and the income is not the type for which an exemption from the TIN requirement applies. Please note, any Form W-8BEN-E is required to have a foreign TIN if signed after Jan. 2, 2018, unless the foreign person is in a jurisdiction that does not assign them (i.e. Cayman Islands).
All Form W-8BENs signed on or after Jan. 1, 2018 also require reporting of a date of birth, a field that is also reported on the Form 1042-S. Form W-8BEN-Es signed during 2017 must contain the date of birth only with respect to payments made on or after Jan. 1, 2019.
Effectively Connected Income
In general, a foreign person that is engaged in a U.S. trade or business is subject to U.S. tax on the income effectively connected with the conduct of that U.S. trade or business. One the ways that foreign individuals determine if they have U.S. effectively connected income is through the application of two tests: “the asset use” test and the “business activities” test, to determine whether an item of income is effectively connected with their U.S. trade or business. Usually, trading income that the foreign business taxpayer receives from the U.S. activities or branches will constitute effectively connected income (ECI).
A foreign person’s ECI is subject to withholding tax if the foreign person is a partner of a U.S. partnership. Foreign investors of U.S. partnerships with ECI should note that their withholding tax rates will be changing as a result of the TCJA. Corporate foreign investors will be paying a tax equal to the new corporate tax rate—21 percent. Foreign investors in U.S. pass-through entities will pay a top withholding tax rate of 37 percent.
Businesses with foreign investors should note that compliance with ECI requirements does not end with determining the tax rates that apply. Foreign partners with ECI must also file a nonresident U.S. income tax return (Form 1040-NR in the case of individuals and Form 1120-F for corporations). In general, the following rules apply:
- Withholding tax rate – The maximum U.S. tax rate applicable to individuals in the case of a non-corporate partner or the maximum U.S. tax rate applicable to corporations in the case of a corporate partner. As noted, as a result of the TCJA, the maximum tax rate for individuals is 37 percent and corporations is 21 percent.
- Timing of deposits – In general, required on a quarterly basis regardless of whether the income is distributed.
- IRS reporting – The individual will be required to file relevant IRS Forms, including Forms 8804, 8805, and 8813.
Keep in mind that in case of foreign corporation, the Branch Profits Tax may apply but is not subject to withholding.
TCJA Changes for ECI
Prior to the TCJA, the Tax Court ruled in the Grecian Magnesite case that non-resident partners did not pay withholding when they realized dispositions from their U.S. partnerships, except to the extent that the partnership owned a U.S. real property interest (USPRI). The TCJA overruled the Grecian decision and enacted IRC Section 864(c)(8). Under Section 864(c)(8), gain or loss resulting from the sale or an exchange of a foreign partner’s interest in a U.S. partnerships is considered ECI. Late in 2018, the IRS issued proposed regulations to clarify some of the Section 864(c)(8) provisions, including the effective date. Section 864(c)(8) rules will affect foreign partner sale or exchange transactions that occur on or after Nov. 27, 2017, unless the IRS finalizes any part of the proposed regulations before June 22, 2019, in which case the rule change would apply to sales or transfers occurring on or after Dec. 27, 2018.
Transferees of foreign partner’s interest will have withholding obligations under Section 1446. A detailed set of interim rules under Section 1446(f) can be found in IRS Notice 2018-29, which will remain in effect until additional regulations are issued under Section 1446(f). The interim Section 1446(f) regulations include a coordination rule that is the opposite of the coordination rule in the proposed Section 864(c)(8) regulations.
U.S. Real Property Interests
Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange, or other disposition of a U.S. real property interest are taxed in the same manner as income effectively connected with the conduct of a U.S. trade or business. FIRPTA also applies to the sale of stock in certain domestic corporations if the fair market value of the corporation’s real estate holdings equals or exceeds 50 percent or more of the net fair market value of the corporation’s total assets.
Withholding also applies to certain types of distributions of U.S. real property interests, even if the distribution does not constitute a sale or exchange.
Foreign investors with U.S. real property interests will generally apply the following rules to determine their withholding compliance under FIRPTA:
- Withholding tax rate – 15 percent of the amount realized by the foreign person unless reduced by a withholding certificate issued by the IRS.
- Withholding agents – Purchasers of the real estate and entities making a distribution subject to FIRPTA withholding are generally withholding agents. The purchaser of real estate will need to find out if the seller is a foreign person and if so it will need to withhold. If the purchaser fails to withhold it may be liable for the tax. An entity making a distribution subject to FIRPTA withholding will need to confirm who is receiving the distribution and withhold appropriately on any foreign persons.
- Timing of deposits – In general, at the time of sale or distribution.
- IRS reporting – IRS Forms 8288 and 8288-A will need to be completed.
Identification of the Recipient of the Income
Another key element to the tax withholding system is the proper identification of the beneficial owner of the income. This is important to ensure that the ultimate recipient is a foreign person, the applicable tax rate that applies, and the relevant tax treaty, if any. Identification is accomplished based upon documentation that the buyer must provide to the payor. U.S. persons must provide Form W-9. Foreign persons must file a type of W-8, the most common of which is Form W-8BEN, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting, and Form W-8BEN-E, Certificate of Entities Status of Beneficial Owner for United States Tax Withholding and Reporting.
When the recipient of the income is itself a foreign pass-through entity, a complex set of reporting rules and associated documentation is used to identify the beneficial owner. Furthermore, the withholding agent can be either the foreign pass-through entity if it is a “qualified intermediary” or a “withholding foreign partnership” or a domestic pass-through in the case of nonqualified intermediaries. A qualified intermediary is one that has qualified and registered with the IRS to be responsible for withholding. A withholding foreign partnership has entered into a WP agreement with the IRS and is acting in that capacity.
Withholding Takes Careful Analysis
As the U.S. and foreign countries continue their efforts to reduce profit shifting and base erosion, withholding requirements and rates may continue to change. Working with your international tax advisor can help your organization and its shareholders keep on top of the latest developments. For more information about the TCJA’s effects on withholding, please contact us.
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