What's Mine is Mine, and What's Yours is Also Mine - Withholding Under the Code

Withholding Under IRC Sections 871/881 and 1441/1442

In the previous post, I began to talk about the withholding regime imposed by the IRC on income earned in the U.S. as it is moved outside the country. I mentioned that IRC Section 871(a) imposes a tax of 30% on the gross amounts of certain items of income, primarily consisting of what I think of as 'passive' income. The formal term for the type of income which is taxed under this section is "fixed, determinable, annual and periodical" income, or FDAP. This category includes, amongst other things, interest, dividends, rents, and royalties as the most frequent categories. It notably does not include capital gains, which although they are frequently the result of an investment held passively for a period of time before being sold, is not "annual" or "periodical" in the same way that, for example, interest or rental income generally would be. 

"Annual" in this context means that it is generally paid at least on an annual or more frequent basis. This is pretty self-explanatory. "Periodical" means that the income pertains to the use of something for a specified period of time. On the example of interest, the interest income here is "periodical" because you receive it for allowing the borrower to use your cash in a loan agreement for a period of time and are compensated at a rate depending on the length of that period. Capital gains, which are generated by the one-time sale of an asset, are not annual because they only happen once and they are not periodical because they represent a sale of something whose value isn't measured by reference to a specific period or periods of time.

Bucking the assertion that IRC Section 871(a) is concerned with passive income, FDAP income here also includes compensation for services. Thinking about the terms "annual" and "periodical" again, this makes sense when you think about typical employment and the form that the compensation for services usually entails. Services are most often compensated by paying wages to an employee. The amounts paid are measured on a regular (usually far more frequently than annual) basis and are determined by reference to a period of time over which the service is provided by the employee. As such, compensation for services, both as an employee and as a third-party contractor, are sufficiently "annual" and "periodical" and are therefore included under the FDAP taxing regime.

For all these types of income, IRC Section 1441 authorizes and requires the payors of such income to undertake the role of the withholding agent. Each such payor who makes FDAP payments to a foreign person is required to withhold based on IRC Section 871 and remit the withholding amount to the IRS.

How does the withholding agent know who is a foreign person from whom they need to withhold? For every person to whom they make a FDAP payment, all payors must request a signed withholding certificate which represents to them that the person is either a U.S. person (and therefore not subject to withholding) or a foreign person. The withholding certificates are forms published by the IRS and are called Form W-9 (for U.S. persons) and Forms W-8 (for foreign persons, and there are lots of types of Form W-8 depending on the type of recipient).

There are a number of types of foreign persons who are exempt from the tax imposed by IRC Section 871. Specific exemptions can be found throughout the Code but examples include recipients of effectively connected income with a U.S. trade or business (ECI), foreign governments, and recipients of portfolio interest income, amongst many other types of exemptions.

In addition to the exemptions provided by the Code, the U.S. has entered into a large number of tax treaties which provide residents of the counterparty country with either exemptions or reduced withholding under the treaty. Each treaty's terms are different to varying degrees and it is necessary to check each treaty to determine the extent of any benefits (and whether the recipient qualifies for benefits under the treaty). But it is common under these treaties for reductions (though not usually complete eliminations) in the rates of withholding for interest, dividends and royalties. It is also common for such treaties to generally eliminate entirely the withholding on compensation for services and rents, subject to certain limitations on the involvement of the foreign resident in the U.S. All these treaties generally provide similar benefits in both directions, meaning, foreign residents will benefit for income earned in the U.S. and U.S. persons will benefit for income earned in the foreign country.

An Example of Some Tax Planning

I've been speaking very generally until this point about withholding and laying a lot of groundwork so the unfamiliar reader can understand the basics (and there is plenty that I haven't even touched on). But let's skip ahead for a moment and take a look at a relatively common type of planning that derives from the rules we discussed above. Let's think about a business that sells a new type of medical device it invented in its country of origin (hereafter "Country X") and now wants to sell in the U.S., putting aside the regulatory hurdles that such entrance generally entails. 

The business wants to consider what would be the best way to structure its operations to minimize and/or delay its tax liability as long as possible. We will assume the business has a large number of employees in Country X who are actively involved in a range of activities, from sales to R&D to manufacturing to management. In order to get the U.S. business off the ground, the company will want to have some employees doing sales in the U.S.

Under the facts above, we have a few basic challenges to overcome. First, we have the problem that the U.S. generally taxes at a higher corporate rate than most other countries (and might tack on a branch profits tax on top of the normal corporate tax), but we'll put that aside. Assuming the company decides to create a U.S. subsidiary to handle it's U.S. sales, it will want to use the knowledge and intellectual property of its parent which are a necessary part of the medical devices that the company creates. Now, it could decide to pay the parent for the right to use the intellectual property and then go ahead and sell the devices. But this would result in withholding tax on those payments, which are royalties and therefore FDAP. While many treaties reduce the 30% withholding, they usually don't eliminate it entirely. So you may be stuck with, for example, an additional 15% withholding on such payments (which may or may not be creditable in Country X depending on several considerations). So what might we be able to do to avoid this?

Well, one viable option is to change the terms by which the U.S. subsidiary and the parent in Country X do business together and in the U.S. We had previously assumed that the U.S. would be selling the devices on its own and for its own benefit. It would then pay a royalty fee to the parent (which it has to do or the taxing authorities will get very upset if it gets the use of the intellectual property for free). So what can it do instead which will substantially result in the same business arrangement but eliminate the need to withhold on royalty payments? 

We can set up the following arrangement: Instead of selling the devices directly and for its own benefit, INC will provide "marketing and pre-sale" services to the parent. All sales will occur between the parent in Country X and the customer in the U.S. directly (and as a legal matter). The parent will then compensate INC for its services by paying for its costs plus a small percentage so it can have a profit (this is important for a separate requirement of the Code under IRC Section 482 called the "arm's length principle", also known as the topic of transfer pricing).

What will be the net result? We will have all the same employees on the ground in the U.S. helping to make sales for the company. We will avoid the need for paying a royalty from INC to the parent because INC isn't actually selling the device; rather, the parent is. And there may be other benefits as well such as moving a substantial amount of the income which might have otherwise been taxed in the U.S. to Country X, which likely has a lower corporate tax rate (most countries around the world have lower corporate tax rates than the U.S.)

There may be other considerations that would make this proposed solution undesirable. In general, it's important to fully understand the needs of each client in order to come up with solutions to these types of challenges. But the underlying principle here is that with proper planning and management of the facts surrounding a business's structure, you can achieve substantial tax benefits and reduce your tax burden from what it might otherwise have been in the absence of such thoughtful planning.

So You're Thinking About Expanding Into the U.S...... (or Vice-Versa)

While I plan to eventually delve into more specific cases and scenarios that I am experiencing in my practice, I want to hold off on that for the next few posts in order to look at the topic of tax advising on cross-border transactions and businesses from a bird's eye view. Thus, for this post I want to speak more generally about some of the common pitfalls and challenges which are introduced when a company enters the U.S. market from a foreign country or vice versa. My discussion will highlight the fact that most of the issues imposed on such companies by the Code have fairly reasonable and intuitive rules. An important step towards mastering the rules and especially being able to speak generally about the rules with clients is understanding the goals which motivate each rule and developing your intuition until you can frequently guess what the tax treatment is likely to be under the Code.

So let's lay some basic groundwork about the international tax system before getting into specific rules. I should clarify the previous sentence; when I say "international tax system", I am referring to the U.S. system for taxing international transactions. The U.S. has a very elaborate system in place (and is probably the most aggressive country in this regard) of taxing cross-border and even foreign transactions where it believes it is entitled to tax.

It is worth highlighting that the goal of the U.S. tax system is ultimately to collect taxes. There are many specific rules which attempt to make the collection of such taxes either more "fair" or are an attempt to engineer certain non-tax outcomes. But ultimately the tax system is an extremely important source of revenue for the U.S. government and the rules reflect this priority of the tax system.

Taxing foreigners is hard. The basic problem of taxing foreigners is that, unlike U.S. persons, foreigners are harder for U.S. authorities to reach. This challenge for the U.S. tax system comes down to the fact that, when all is said and done, a judge cannot simply send a marshal to a delinquent's house and bang on their door to get them to pay up. Nor is this person likely to have assets in the judge's jurisdiction (i.e., the United States) that a marshal can seize. This sort of concern is what led to the system of withholding put in place by the U.S. for types of income that might be received by someone who will never be heard from again. Instead of waiting for the recipient to acknowledge their obligation to pay taxes on income sourced in the United States (what income is sourced in the U.S. is a separate and involved question), IRC Section 871(a) imposes a gross tax of 30% (by default, but frequently reduced by treaty) on primarily passive types of income such as interest, dividends, royalties, rents and others. Furthermore, IRC Section 1441 creates joint and several liability for "withholding agents" who are obligated to withhold and remit the tax liability created by this regime and insures compliance with the tax. The income taxed under these rules is commonly referred to as FDAP income (Fixed, determinable, annual and periodical income; this essentially means passive income such as what I listed above)

Thus, if you are a foreign person interested in opening a business or otherwise earning money in the U.S., you need to consider the impact of the withholding regime on your bottom line and plan accordingly. You can start to consider the relative merits of many types of tax planning depending on your needs and expectations. For example, you can create a U.S. domestic corporation to receive the income and keep it in the U.S. This at least delays the imposition of withholding tax. Or you can structure your contracts to have your business provide certain services or goods which have preferential treatment based on rights derived through mutual tax treaties between the U.S. and your country of residency. But one thing is certain; you do not want to simply ignore the possibility of 30% gross withholding on your income from the U.S., which is likely far higher than the tax you will be required to pay in your country of residence and may therefore result in more tax credits than you can utilize locally.

There are other ways that the U.S. can tax you as a foreigner. Keeping in mind the consideration above about the difficulty of reaching foreign recipients of U.S. income, what if you are a foreigner that has a more permanent presence in the U.S.? The withholding regime mentioned above is rather draconian in that it doesn't give you any benefit for the expenses you incurred in earning the income, something most tax systems will generally try to do. Most businesses would prefer to net their revenues against their expenses and pay tax on the net (even if the rate is higher at 35%, the effective tax rate is still lower). So the U.S. rule under IRC Section 871(b) (for individuals) and 882 (for corporations) is to tax this income like any other business income in the U.S. Why is this situation different from the way they tax (mostly) passive income mentioned above? Because the presence of a trade or business operating in the U.S. gives enough assurance that you have a continuous presence in the U.S. that the IRS can go after if you don't pay your taxes and take the income outside of the country.

What I have discussed above is just the tip of the iceberg and there are many other specific regimes used by the U.S. to tackle the challenges outlined above (and other challenges related to cross-border transactions). To a practitioner, it feels like an endless list of specific and seemingly unique considerations which come into play depending on the facts of a case. But as you, a tax practitioner or other party involved in tax, start to encounter these specific rules and regimes, you will develop a feel for when a transaction 'feels' like the U.S. will want to tax it in a special or specific way and when other more 'default' rules might apply.