Thursday, March 17, 2011

IRS Pub On Withholding For Payments To Foreign Persons Incorporates 2010 HIRE Act Changes

Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities (Feb. 2011)

IRS recently released Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities. It reflects a number of important changes made by the “Hiring Incentives to Restore Employment Act of 2010” (HIRE Act, P.L. 111-47, 03/18/2010).

Background. Publication 515 describes who is responsible for withholding (withholding agent), the types of income subject to withholding, and the information and tax return that must be filed with regard to payments to foreign persons, including nonresident aliens, foreign corporations, foreign partnerships, foreign trusts, foreign estates, foreign governments, and international organizations.

Generally, payments made to foreign persons of fixed or determinable annual or periodical (FDAP) income from U.S. sources are subject to a 30% U.S. withholding tax, unless the beneficial owner qualifies for an exemption or a reduced withholding rate under an income tax treaty. FDAP income includes interest and dividends but not gains on sales of property.

In addition to encouraging companies to hire and retain unemployed workers by creating an employer “payroll tax holiday” and providing an employer tax credit if the new hires were retained for a year, the HIRE Act included a comprehensive set of measures to reduce offshore noncompliance by giving IRS new tools to detect, deter and discourage offshore tax abuses. These provisions were included in the HIRE Act's revenue raising provisions—the Foreign Account Tax Compliance Act (FATCA). In particular, for payments made on or after Sept. 14, 2010, the HIRE Act provides that substitute payments and dividend equivalents are sourced as direct dividends for certain purposes, including the U.S. withholding tax rules applicable to foreign persons.

What's new in withholding for foreign persons. Publication 515 highlights some of the changes that are effective for withholding in the 2011 tax year, including:

Dividend equivalent payments. Beginning Sept. 14, 2010, a dividend equivalent is treated as a U.S-source dividend. A dividend equivalent is a payment that, directly or indirectly, is contingent on, or determined by reference to, the payment of a dividend from U.S. sources. It includes:

1. A substitute dividend made under a securities lending or sale-repurchase transaction involving a U.S. stock. A substitute dividend is any payment made in a securities lending or sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources in the U.S.;

2. A payment made under a specified notional principal contract; and

3. Any payment determined by IRS to be substantially similar to a payment in (1) or (2), above.

Specified notional principal contracts. Beginning Sept. 14, 2010, a payment made under a specified notional principal contract is treated as a dividend equivalent. A specified notional principal contract is any notional principal contract that satisfies one or more of the following.

... In connection with entering into the contract, any long party to the contract (i.e., a party that is entitled to receive payment under the contract that is contingent on or determined by reference to the payment of a U.S.-source dividend on the underlying security) transfers the underlying security to any short party to the contract (i.e., a party other than a long party).

... In connection with the termination of the contract, any short party to the contract transfers the underlying security to any long party to the contract.

... The underlying security is not readily tradeable on an established securities market.

... In connection with entering into the contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract.

... IRS identifies the contract as a specified notional principal contract.

Guarantees of indebtedness. Certain amounts paid, directly or indirectly, for the provision of a guarantee of indebtedness issued after Sept. 27, 2010, are from U.S. sources. The amounts must be paid by one of the following: (1) a noncorporate U.S. resident or a U.S. corporation for the provision of a guarantee of the resident or corporation; or (2) any foreign person for the provision of a guarantee if the payment is connected with income that is effectively connected, or treated as effectively connected, with the conduct of a U.S. trade or business.

Automatic extension for filing certain Forms 1042 and 1042-S. If a taxpayer paid substitute dividends after Sept. 13, 2010, it has an automatic extension of up to six months to file Form 1042-S, Foreign Persons U.S. Source Income Subject to Withholding, for such substitute dividend payments.

Exemption from withholding for payments to qualified securities lenders. If a withholding agent made U.S.-source substitute dividend payments after Sept. 13, 2010 to qualified securities lenders (QSLs), and these payments were part of a chain of substitute dividend payments, it may be exempt from withholding tax on the payments. The withholding agent should treat the QSL as the recipient. The withholding agent is not required to withhold if it receives, at least annually, a certificate from the QSL that includes a statement that: (a) the recipient of the substitute dividend is a QSL; and (b) with respect to the substitute dividend it receives from the withholding agent, the QSL states that it will withhold and remit the proper amount of U.S. gross-basis tax.

Extension requests. Requests for extensions to provide statements to recipients of more than 10 withholding agents must be submitted electronically. A withholding agent can get an automatic 6-month extension of time to file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, by filing Form 7004, Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns. Form 7004 is to be filed on or before the due date of Form 1042. It doesn't extend the time for payment of tax.

Deposit coupons eliminated. Beginning Jan. 1, 2011, a withholding agent must deposit all withheld taxes by electronic funds transfer. Forms 8109 and 8109-B, Federal Tax Deposit Coupon, can't be used after Dec. 31, 2010. Generally, electronic funds transfers are made using the Electronic Federal Tax Payment System (EFTPS). If a withholding agent doesn't want to use EFTPS, it can arrange for its tax professional, financial institution, or other trusted third party to make deposits on its behalf. Also, a withholding agent can arrange for its financial institution to initiate a same-day wire payment on its behalf.

Penalties increased. The penalties have increased if a withholding agent fails to file Form 1042 or provide Form 1042-S to the recipients or IRS or if the withholding agent provides incorrect or incomplete information. The penalty for not filing Form 1042 when due (including extensions) is usually 5% of the unpaid tax for each month or part of a month the return is late, but not more than 25% of the unpaid tax.

References: For tax on U.S. source income not effectively connected with a U.S. business, see FTC 2d/FIN ¶O-10201; FTC 2d/FIN ¶O-10301; United States Tax Reporter ¶8714.02; TG ¶30091.

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