Friday, August 22, 2014

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.

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