Editor: Valrie Chambers, Ph.D., CPA
Foreign Income & Taxpayers
Most CPAs are familiar with the offshore asset disclosure provisions of the Foreign Account Tax Compliance Act (FATCA). Beginning with 2011 tax years, Sec. 6038D requires the annual disclosure on Form 8938, Statement of Specified Foreign Financial Assets, of an individual’s specified foreign financial assets when their aggregate value exceeds certain thresholds. In addition, many CPAs are aware of the disclosure rules FATCA applies to foreign financial institutions regarding their U.S. depositors.
What many CPAs may not be aware of, however, is FATCA’s impact on domestic withholding agents. Beginning July 1, 2014, U.S. taxpayers that have nothing to do with financial services will be required to collect, analyze, document, and report information regarding payments to both foreign financial institutions and nonfinancial foreign entities (NFFEs). The effective date for FATCA withholding was originally scheduled to be Jan. 1, 2014. On July 12, 2013, the IRS issued Notice 2013-43 to extend the effective date to July 1, 2014. CPAs should use the additional six months wisely to educate themselves and their clients.
The FATCA definition of a withholding agent is drafted broadly, and it requires any person, acting in any capacity, having the control, receipt, custody, disposal, or payment of an item of income that is subject to FATCA withholding to have appropriate documentation. Withholding agents that fail to obtain this documentation are required to withhold 30% on the gross payment. As a result, all U.S. persons (individuals, businesses, trusts, retirement plans, tax-exempt organizations, etc.) are potentially affected. Many will find complying with this part of FATCA to be very time-consuming and will need to put into place new policies and procedures in their accounts payable function.
This item examines the portion of FATCA that relates to payments to NFFEs and why it is important for most CPAs to advise their clients on what withholding agents must do to be ready on July 1, 2014.
FATCA was signed into law in March 2010 as a “revenue raiser” that was part of a much larger bill, the Hiring Incentives to Restore Employment (HIRE) Act, P.L. 111-147. FATCA was also a response to the revelation that the Swiss investment firm UBS had been actively helping its clients evade U.S. taxes by establishing foreign bank accounts, moving funds into those accounts, and not reporting the income earned. In August 2009, the Swiss government agreed to abandon its historical protection of the identity of depositors and turned over the names of 4,450 U.S. nationals who had a total of $18 billion in assets on deposit with UBS.
FATCA’s multipronged approach to identifying unreported offshore income includes the provisions regarding NFFEs that force U.S. payers to identify and document the nature of certain foreign payees with which they conduct business. Failure to go through this process could be very risky. FATCA introduces chapter 4 withholding, a documentation regime in addition to the existing chapter 3 withholding on certain payments to foreign payees. Chapter 4 withholding should be viewed as a penalty imposed when a payment is made and the payer does not have adequate documentation regarding the foreign payee. If chapter 4 withholding is applicable, the payer must withhold 30% of the payment. Importantly, FATCA imposes secondary liability on the U.S. payer.
Chapter 4 withholding is required for payments made after June 30, 2014, when the following conditions are all present:
- The payee is foreign.
- The payment is not a specifically identified exempt payment—in other words, it is a “withholdable payment.”
- The payer is not in possession of a Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities), that certifies that either:
- The foreign payee is excepted;
- The foreign payee has “substantial” U.S. owners and these owners are disclosed; or
- The foreign payee has no substantial U.S. owners.
The first step in the chapter 4 withholding process is to determine whether a payee is foreign or domestic. Currently, U.S. payees generally provide Form W-9, Request for Taxpayer Identification Number and Certification, and foreign payees generally submit Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding. The second step is to determine whether the payment is specifically exempt from chapter 4 withholding. In addition to foreign-source income, payments of interest or original-issue discount on a short-term obligation, and payments of income effectively connected with a U.S. trade or business, where a treaty exemption is claimed, the following “excluded nonfinancial” payments are exempt from chapter 4 withholding:
- Services (including wages and other employee compensation, such as stock option income);
- Use of property;
- Office and equipment leases;
- Software licenses;
- Transportation and freight;
- Gambling winnings, awards, prizes, and scholarships; and
- Interest, but only if it is related to accounts payable arising from the acquisition of goods or services.
In addition to identifying exempted payments, the FATCA regulations specifically identify payments considered withholdable:
- Lending transaction payments, including loans of securities;
- Forward, futures, options, or notional principal contracts;
- Investment advisory fees;
- Custodial fees;
- Bank or brokerage fees;
- Premiums for insurance or annuity contracts; and
- Cash-value insurance or annuity payments.
From the above lists, it is clear that FATCA targets payments that are more financial in nature, as opposed to those routinely made by nonfinancial entities.
If it is determined that a payment is not exempt and is a withholdable payment, the U.S. payer will be required to withhold 30% unless the payer first has in its possession a properly executed Form W-8 from the payee. Although there are several types of Form W-8, the most commonly used version will be Form W-8BEN-E (currently in draft form).
In addition to an exemption for certain types of payments from chapter 4 withholding, certain types of entities are also excepted from chapter 4 when the withholding agent has been provided with a completed Form W-8BEN-E. With regard to excepted NFFEs, otherwise withholdable payments are not subject to chapter 4 withholding. The regulations, by creating these broad classes of excepted NFFEs, have significantly reduced the FATCA burden on payers who conduct business with these types of entities. Excepted NFFEs include:
- Publicly traded corporations and affiliated entities.
- Active NFFEs, those that meet both of the following criteria:
- Less than 50% of their gross income for the prior calendar year is passive; and
- Less than 50% of their weighted average assets are held for the production of passive income (such as dividends, interest, nonactive rents and royalties, annuities, and passive gains).
- Territorial entities (wholly owned by one or more bona fide residents of a U.S. territory under the laws of which the entity is organized).
When a foreign payee that is not an excepted NFFE has substantial U.S. owners, U.S. payers will not only be required to obtain a completed Form W-8BEN-E but also to use the information provided on the Form W-8BEN-E to complete Form 8966, FATCA Report. Form 8966, a draft version of which the IRS released on Aug. 15, will be submitted to the IRS annually. Form 8966 will provide the IRS the name, address, and tax identification number of each substantial U.S. owner of the NFFE, and the total payments made to the NFFE.
A substantial U.S. owner is defined for these purposes as a U.S. person who owns, directly or indirectly, more than 10% of:
- The stock of a payee corporation, by vote or value;
- The profits interests or capital interests of a payee partnership; or
- The beneficial interest in a foreign trust (or is treated as the owner of a foreign grantor trust).
A substantial U.S. owner of a foreign trust also includes a U.S. person who is an owner of any portion of that trust under the grantor trust rules
Two draft versions of Form W-8BEN-E have been issued: a six-page, 25-part version on May 31, 2012, and an expanded eight-page, 27-part version in May 2013. CPAs already receive many inquiries from clients regarding the completion of existing Form W-8BEN. That version, which will not be usable starting on July 1, 2014, is only one page and has four parts.
Even if a payment to a foreign payee is otherwise withholdable, no 30% chapter 4 withholding will be required, provided that the foreign payee has properly prepared and submitted a Form W-8BEN-E to the U.S. payer. However, it is fair to say that the new, much more lengthy, Form W-8BEN-E will represent a complex challenge for many foreign payees to complete, and CPAs should expect many more requests for assistance from clients. As such, CPAs should familiarize themselves with Form W-8BEN-E and Form 8966 once they are finalized.
In addition to the challenges presented by the new Form W-8BEN-E, U.S. payers will need to institute new procedures in their accounts payable departments to properly identify potentially withholdable payments and foreign payees from whom Form W-8BEN-E must be obtained. Implementing these new procedures will take time.
CPAs who advise clients with potential chapter 4 withholding obligations would be well-served to begin to notify such clients immediately of this part of FATCA. Clients will look to CPAs to provide such information, particularly in view of the secondary liability of U.S. payers for the chapter 4 penalty withholding.