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New Withholding Tax Regime will result in Heavy Burden on Non-US Entities with US Investments

29 Mar 2010

On 18 March 2010, President Obama signed into law the Hiring Incentives to Restore Employment (HIRE) Act. Foreign financial institutions, foreign non-financial entities, and US based multinationals will face significant new burdens as a result of the US's newly adopted withholding and reporting regime. At its core, the new regime requires all foreign intermediaries, foreign investment vehicles and other foreign entities to disclose their US account holders and investors (both direct and indirect, i.e., looking through tiers of foreign entities) and provide certain information. Non-compliance will result in a 30 percent withholding tax on all US dividends, interest payments and gross proceeds from the sale of certain stock and securities.

Taxand US examines the statutory changes and identifies the compliance challenges non-US firms will face as the law requires that foreign entities make changes to the way they operate in the United States and abroad.

The HIRE Act contains a number of incentives for businesses to hire unemployed workers and the extension of Section 179 expensing, among other provisions intended to accelerate the economic recovery. The price tag for these incentives must be offset. Unfortunately, the class of persons that will bear the cost of implementing these measures extends far beyond those investment houses and advisors facilitating US tax cheats.

Foreign financial institutions, foreign non-financial entities, and US based multinationals will face significant new burdens as a result of the US's newly adopted withholding and reporting regime. Remember the late 1990/early 2000's scramble required of foreign banks and brokerages to implement the proper infrastructure and procedures to adhere to the then new non-resident withholding tax and Qualified Intermediary (QI) regime? Recall that the effective date of these regulations was twice delayed. With this new scheme ("QI Redux") expect similar complications, unreasonable deadlines and heavy demands of compliance. Only this time around the rules will encumber far more than just foreign banks and brokerages. Issuers of US 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 US investments (and US investors) altogether. Ironically, this may work at odds with the legislation's express purpose of job creation; making the US a less desirable investment destination, reducing credit in the system and thus further perpetuating the sense of economic uncertainty that has stymied job growth.

Changes in the US Withholding Tax Arena

At its core, the new regime requires all foreign intermediaries, foreign investment vehicles and other foreign entities to disclose their US 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 US 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). FFI's must enter into an agreement with the IRS and be subject to external audit procedures (thus, the moniker "QI redux"). While a NFEE need only provide a certification that it has no substantial US owners or identifying information regarding 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 US 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 a FFI, unless the FFI enters into a contractual agreement with the Treasury. A withholdable payment includes payments of US 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 US source interest or dividends. The provisions in the Hire Act operate independently of, and are in addition to, the withholding procedures for payments to non-resident aliens and foreign corporations pursuant to Code Section 1441 and 1442 (i.e., Chapter 3 withholding).

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 US account. A US account is defined as any financial account held by one or more specified US persons or US owned foreign entities maintained by the FFI and any equity or debt interest in a 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 US 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 US person holding any level of interest, no matter how insignificant the percentage or minor the value. An FFI need not report information regarding publicly traded corporations, tax exempt organisations, RICs and REITs, among others. Further, information regarding certain small depository accounts (less than $50,000 aggregate value) held by natural persons are also exempt from reporting.

In the event foreign secrecy laws prevent the reporting of such account, the FFI must obtain a waiver from the account holder; and, 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 (i.e.withholdable type 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., i.e., Form 1099s.

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 US 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 regarding US status for existing account holders, sharing information among business divisions and closing 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 US 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 US investments may elect to divest as the cost of compliance may be significantly higher than the benefits related to the US 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 a NFFE if the beneficial owner of such payment is a NFFE that does not meet the reporting requirements. In order to meet the requirements, the beneficial owner needs to provide a certification that the foreign entity does not have a substantial US owner or provide the contact information including TIN of each substantial US owner. These provisions do not apply for publicly traded corporations and members of their affiliated group, entities organized in a US possession and owned by residents of the US possession, a foreign government, international organisation, foreign bank 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 provide 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 additional revenue offsets.

Repeal of the Foreign Targeted Exception

Notably, the new law would prevent the US 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 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 US withholding tax. By including an exception to the general sourcing rule for notional principal contracts, the provision will consider such income to be from US sources, to the extent that the swap payment is attributable to US 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, US 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 US 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.

Taxand's Take

The information to be gathered by foreign financial institutions is extensive and will present significant compliance challenges for non-US 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 impacted operations are viable in light of the new US reporting and information gathering obligations or determine the policies that will need to be implemented to assist in the data gathering and compliance.

Your Taxand contacts for further queries are:

Doug Wibbing
T: +1.415.490.2141

Lisa Askenazy Felix
T: +1.415.490.2149

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