On March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment (HIRE) Act, H.R. 2847. The HIRE Act contains incentives for businesses to hire unemployed workers and extends Section 179 expensing, among other provisions intended to accelerate the economic recovery. But it also contains offsets that target a wide range of foreign investment vehicles and U.S.-based multinationals.
Under the new pay-as-you-go (PAYGO) deficit-reduction rules, the price tag for the incentives under the HIRE Act must be offset. With U.S. taxpayers facing a challenging business climate, raising taxes is likely to be unpopular. Moreover, certain recent proposals in the international tax arena have invoked the ire of corporate taxpayers (e.g., pooling of foreign tax credits and earnings, deferral of deductions for foreign-related expenses, taxes on offshore transfers of intellectual property, etc.). Therefore, for its first set of significant revenue offsets in 2010, Congress has chosen a more unsympathetic target: U.S. individuals hiding behind offshore accounts, foreign trusts and other foreign entities. Unfortunately, the class of persons that will bear the cost of implementing these measures extends far beyond these U.S. tax cheats or those investment houses and advisors facilitating their actions.
Foreign financial institutions, foreign nonfinancial entities and U.S.-based multinationals will face significant new burdens as a result of the U.S.’s newly adopted withholding and reporting regime. Remember the scramble required of foreign banks and brokerages in late 1990s and early 2000s to implement the proper infrastructure and procedures to adhere to the then new nonresident withholding tax and qualified intermediary (QI) regime? Recall that the effective date of these regulations was twice delayed. With this new scheme — we call it QI redux — expect similar complications, unreasonable deadlines and heavy compliance demands. Only this time around, the rules will encumber far more than just foreign banks and brokerages. Issuers of U.S. securities and foreign investment vehicles of all stripes will be required to change the way they do business in the United States and abroad. Alternatively, the affected class of foreign investors may avoid U.S. investments (and U.S. investors) altogether. Ironically, this may work at odds with the legislation’s express purpose of job creation, making the U.S. a less desirable investment destination, reducing credit in the system and thus further perpetuating the sense of economic uncertainty that has stymied job growth.
The international offsets contained in the HIRE Act were first introduced as part of the Foreign Account Tax Compliance Act of 2009 (known as FACTA), and were also considered as part of the Obama 2011 budget proposal. In a previous edition of , we anticipated that these provisions were likely to be enacted in the near future. The future is now.
In this article, we will summarize the provisions applicable to foreign financial and non-financial entities, and comment on the possible direction of the forthcoming implementing regulations. We will also briefly cover new requirements for foreign bank account reporting, the narrowing of the portfolio interest exception, changes in the treatment of equity swap payments and new reporting for U.S. shareholders of passive foreign investment companies. Finally, the article includes the most relevant provisions applicable to U.S. individuals and foreign trusts.
Changes in the U.S. Withholding Tax Arena
At its core, the new regime requires all foreign intermediaries, foreign investment vehicles and other foreign entities to disclose their U.S. account holders and investors (both direct and indirect, i.e., looking through tiers of foreign entities) and provide certain information. Noncompliance will result in a 30 percent withholding tax on all U.S. dividends and interest payments, among others, as well as on the gross proceeds of any stock or security that produces such payments.
Compliance obligations differ depending on whether the recipient is a foreign financial institution (FFI) or a non-financial foreign entity (NFFE). FFIs must enter into an agreement with the IRS and be subject to external audit procedures (thus, the moniker “QI redux”). A NFFE need only provide either a certification that it has no substantial U.S. owners or information identifying such owners. These rules will be applicable for payments made after December 31, 2012.
Withholdable Payments to Foreign Financial Institutions
FFIs are broadly defined to include nearly all foreign investment vehicles, including hedge funds, private equity funds and even family offices, regardless of whether these entities have U.S. resident owners. More specifically, an FFI is an entity that:
- Accepts deposits in the ordinary course of banking or similar business;
- Holds financial assets on account for others; or
- Is engaged primarily in the business of investing, reinvesting and trading securities, interest in partnerships, commodities or any interest in such securities, partnerships interests or commodities.
Under the new regime, a withholding agent must deduct and withhold a tax equal to 30 percent on any “withholdable payment” made to an FFI, unless the FFI enters into a contractual agreement with the Treasury. The provisions in the HIRE Act operate independently of, and are in addition to, the withholding procedures for payments to nonresident aliens and foreign corporations pursuant to Code Section 1441 and 1442 (i.e., Chapter 3 withholding). As written, therefore, the new Chapter 4 rules do not replace current QI agreements.
A Chapter 4 agreement (or QI redux) would require the FFI to obtain information and identify through verification and due diligence each account of the FFI that is a U.S. account. A U.S. account is defined as any financial account held by one or more specified U.S. persons or U.S.-owned foreign entities maintained by the FFI and any equity or debt interest in an FFI (other than publicly traded interests). On an annual basis, the FFI would also be required to disclose the name, address and taxpayer identification number (TIN) of each direct or indirect 10 percent U.S. owner, as well as the account balance and the gross receipts and gross withdrawals or payments from the account. In the case of a trading or investment entity, the FFI is required to report with respect to a U.S. person holding any level of interest, no matter how insignificant the percentage or minor the value. An FFI need not report information about publicly traded corporations, tax-exempt organizations, regulated investment companies (RICs) or real estate investment trusts (REITs), among others. Further, information about certain small depository accounts (less than $50,000 aggregate value) held by natural persons is also exempt from reporting.
In the event foreign secrecy laws prevent the reporting of such accounts, the FFI must obtain a waiver from the account holder. If the waiver is not obtained within a reasonable time, the FFI must close the account.
Finally, the FFI must agree to withhold 30 percent from any passthrough payment — a withholdable payment or other payment attributable to a withholdable payment — made to (a) recalcitrant account holders or another FFI that does not enter into an agreement, or (b) an FFI that has elected to be withheld upon rather than to withhold account holders described in (a) above.
As an alternative to the QI redux agreements, an FFI may elect to apply the withholding requirements applicable to domestic payers of dividends, interest, gross sales proceeds, etc. Under this election, the FFI must provide full Form 1099 reporting for all payments to specified U.S. persons. As a result, both U.S. and foreign-source amounts (including gross proceeds) would be subject to reporting.
While fairly detailed, these rules still leave many unanswered questions that must be resolved by the administrative guidance that will be required to implement the Chapter 4 withholding regime. Such guidance presumably will address how to identify U.S. persons, what due diligence procedures would be deemed to satisfy the FFI’s obligations under the “reason to know standard” and the extent of the audit requirements. More problematic will be the practical issues that FFIs will face in order to comply, including how to navigate the legal impediments to obtaining information about U.S. status for existing account holders, how to share information among business divisions and how to close accounts of recalcitrant account holders.
Note that the Chapter 4 rules apply to accounts opened anywhere in the world, not just in the United States, or by U.S. branches of the FFIs. Further, the infrastructure needed to collect and verify such information is certain to prove complex and expensive, and most likely beyond the tolerance of many smaller FFIs. Moreover, FFIs with relatively small U.S. investments may elect to divest, as the cost of compliance may be significantly higher than the benefits related to the U.S. activity.
Withholdable Payments to Other Foreign Entities
Similar to withholdable payments to FFIs, the Chapter 4 regime requires withholding agents to deduct and withhold a tax equal to 30 percent of any withholdable payment made to an NFFE if the beneficial owner of such payment is an NFFE that does not meet the reporting requirements. To meet the requirements, the beneficial owner needs to provide a certification that the foreign entity does not have a substantial U.S. owner or provide the contact information including TIN of each substantial U.S. owner. These provisions do not apply for publicly traded corporations and members of their affiliated group, entities organized in a U.S. possession and owned by residents of the U.S. possession, foreign governments, international organizations, foreign banks or any other person that the Treasury considers has a low risk for tax evasion.
NFFE are entities that do not fall under the definition of FFI described above. Without clear guidance, it will be difficult to determine FFI or NFFE status. However, the technical explanation to the HIRE Act provides that the Treasury may exclude from FFI status entities such as certain holding companies, research and development subsidiaries, or financing subsidiaries within an affiliated group of non-financial operating companies.
Other Relevant Provisions
In addition to the new withholding regime, the HIRE Act includes several other revenue offsets.
Changes to Bearer Bonds and Repeal of the Foreign Targeted Exception
Notably, the new law would prevent the U.S. Treasury from issuing bearer bonds and would make interest on any privately issued bearer bonds generally nondeductible. In addition, interest paid on state and local bonds not issued in registered form may not qualify for tax exemption. With respect to the portfolio interest exemption from Chapter 3 withholding tax, the HIRE Act eliminates the exception for foreign targeted obligations. Thus, the portfolio interest exemption is now available only in the case of registered obligations.
Substitute Dividends and Dividend Equivalent Payments
With respect to equity swaps, current regulations sourced swap income by the place of residence of the recipient. Thus, dividend equivalent payments to a foreign recipient were foreign-source income not subject to U.S. withholding tax. By including an exception to the general sourcing rule for notional principal contracts, the provision will consider such income to be from U.S. sources, to the extent that the swap payment is attributable to U.S. dividends paid by a domestic corporation. This proposal specifically seeks to curtail withholding tax avoidance in securities loan and sale-repurchase (repo) transactions.
Passive Foreign Investment Company (PFIC) Reporting
Before the HIRE Act, U.S. PFIC shareholders did not have an annual reporting requirement except upon the occurrence of certain triggering events. The HIRE Act codifies a 1992 proposed regulation that would require U.S. PFIC shareholders to make annual reports. Future regulations are expected to eliminate the potential for duplicative reporting, as PFIC shares also may be covered by the reporting requirements for individuals’ foreign financial assets.
Delay in the Application of Worldwide Interest Allocation
The HIRE Act has further delayed the application of worldwide interest allocation rules from 2018 until 2021.
Foreign Account Reporting Requirements for U.S. Individuals
Any U.S. individual who holds an interest in a foreign financial account, in a foreign entity or in any financial instrument/contract held for investment issued by a foreign person would be required to file an information return with his or her U.S. income tax return if the aggregate value of such assets exceeds $50,000. This reporting would be in addition to the obligation to file Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR).
The proposal would double the accuracy-related penalty to 40 percent in the case of foreign financial asset understatements. Moreover, the statute of limitations would be extended to six years after the required return was filed if the taxpayer omits from gross income more than $5,000 that is attributable to one or more foreign financial accounts.
Relevant Provisions Applicable to Foreign Trusts
If a U.S. person transfers property to a foreign trust, the trust would be presumed to have a U.S. beneficiary for purposes of the grantor trust rules unless the U.S. transferor demonstrates that (1) no part of income or corpus may be paid or accumulated during the year for the benefit of a U.S. person; and (2) if the trust were terminated, no part of the income or corpus could be paid to or for the benefit of any U.S. person. If a foreign trust permits the use of trust property (other than cash or marketable securities) by a U.S. grantor or beneficiary, the fair market of the use of such property may be treated as a distribution unless the U.S. grantor or beneficiary pays for the use of the property at arm’s length. Similar provisions apply for loans.
The penalty for noncompliance was amended to be the greater of $10,000 or 35 percent of the gross reportable amount (if known).
Alvarez & Marsal Taxand Says:
The information to be gathered by foreign financial institutions is extensive and will present significant compliance challenges for non-U.S. banks, brokerages, hedge funds and other investment vehicles. To avoid the hefty 30 percent withholding penalty, foreign financial institutions will be required to change the way they operate in the United States and abroad. As a first step, financial institutions need to review these rules in detail and assess the impact of the various provisions to their operations. Financial institutions can then decide whether the affected operations are viable in light of the new U.S. reporting and information gathering obligations and whether new policies are needed to assist in the data gathering and compliance.
The Pay-As-You-Go Act of 2010, H.J.Res. 45, 111th Cong. (2010) increases the public debt limit from $12.394 trillion to $14.294 trillion, and establishes a statutory pay-as-you-go procedure that requires that new non-emergency legislation affecting tax revenue or mandatory spending cannot increase the federal deficit.
For these purposes, a withholdable payment includes payments of U.S. source interest (including OID), dividends, rents, salaries, premiums, annuities, and other fixed or determinable, annual or periodical (FDAP) income, and any gross proceeds from the disposition of property that can produce U.S. source interest or dividends.
Lisa Askenazy Felix, Senior Director, contributed to this article
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