Additional Withholding on US Cross-Border Payments
By Kelly Kogan and John Marciano
US companies will have to withhold 30% of payments to foreign companies from US sources under agreements signed after 2013, even in cases where there would not otherwise be any withholding tax.
This new withholding regime, called FATCA, is a stick designed to force foreign financial institutions that receive payments to provide information about their US account holders to the US tax authorities. The stick is also supposed to force other foreign business entities to disclose any significant US partners or shareholders.
Modifying an existing loan, lease, technology license or other agreement requiring payments after 2013 would also bring FATCA into play.
The Internal Revenue Service issued final regulations to implement the new regime in mid-January.
The foreign financial institutions affected by FATCA withholding are not only foreign banks, but also foreign hedge and private equity funds and insurance companies. Non-financial foreign entities are also affected if they have at least one 10% or greater US owner, but not if they are publicly traded or earn most of their income from an active business (rather than from investments).
There are a number of ways to avoid FATCA withholding, all of which are based on why FATCA was enacted. Unlike other withholding rules that apply to payments by US persons to foreigners, the goal of withholding under FATCA is not to collect taxes, but to compel foreign recipients of payments to provide the US tax authorities information about their US account holders or US owners. Thus, to the extent a foreign payee provides this information either to the IRS or to the payor (who must then forward it to the IRS), it can avoid withholding. FATCA withholding can also be avoided if the IRS considers the foreign payee to have a low risk of enabling tax avoidance by US persons. The IRS regulations have a list of 22 possible exemptions.
Anyone claiming an exemption from withholding must provide an IRS exemption form to the US person making the payment. Exemption forms must be updated every three years.
The most common situation where FATCA withholding will apply is where a US project company borrows from a foreign lender. A US branch of a foreign bank is treated as a foreign lender for this purpose, unless it enters into an agreement with the borrower under which the US branch takes responsibility for paying any FATCA tax directly to the IRS. Any FATCA withholding would be on the interest payments and not principal repayments.
Lenders usually require borrowers to “gross up” debt service payments for withholding taxes.
The typical withholding tax indemnity agreement absolves the borrower from having to gross up in situations where the lender has the ability to avoid withholding, for example, by giving the borrower an IRS form claiming an exemption from US withholding taxes under a US tax treaty or on grounds that it is using a US affiliate to make the loan. Most loans would have been structured in the first instance so that there is no withholding. Thus, the gross up is most likely to come into play when withholding is triggered by a change in US law.
However, historically lenders have usually agreed to provide exemption forms for withholding obligations only if they could produce them economically and without any negative consequences. When FATCA was enacted in 2010, lenders did not know how cumbersome and expensive compliance with the new regime would be. Because of this uncertainty, they were unwilling to bear the risk that debt service might be reduced if eventually there was FATCA withholding on the payment.
Now that the global financial community has been preparing for FATCA for over two years, and the new final rules provide more certainty about its implementation, more recent deal documents put the FATCA risk back on the lender. They do this by requiring that the lender provide a timely and valid FATCA exemption form to the borrower. The lender would have to check a box on the form indicating that it has an agreement in place with the IRS to turn over information about US account holders to the IRS.
Alternatively, the lender could check a box on the exemption form indicating that its home country has signed an agreement with the US Treasury Department. Currently, three countries have signed such agreements — the United Kingdom, Mexico and Denmark — and the US Treasury Department is in the process of negotiating agreements with more than 50 other countries. Under these agreements, a resident financial entity provides information about its US account holders to the local tax authorities, who then forward that information to the IRS.
US borrowers should insist in loan documents that lenders provide FATCA exemption forms beginning in 2014. The exemption form is an IRS form W-8. There are various types of W-8 forms. Each has a different suffix, like W-8BEN or W-8IMY whose use depends on the type of payment and whether the payee is the owner of the income or is acting as an intermediary.
While the focus in the trade press has been almost entirely on payments to foreign financial institutions, the new rules cover more than just interest payments. They also cover rents and royalties paid for the use of property in the United States, compensation for labor performed in the United States, and dividends paid by US companies to foreign shareholders.
This means that US payors should not forget to require FATCA exemption forms from foreign payees of these items beginning in 2014, and they should also consider whether they are obligated to “gross up” their payments if the payee fails to provide the form. Lenders are familiar with FATCA, but foreign payees of these other items probably are not.
Starting in 2017, the new rules will require a US company to withhold 30% of the full amount of any payment to a foreign person to redeem stock in the US company or debt of the US company.
Withholding will also be required on the gross purchase price by any buyer of stock in or debt of a US company from a foreign seller.
Withholding can be avoided in both situations if the foreign payee provides the US payor an IRS form providing a basis for an exemption: for example, that the foreign person is publicly-traded or that it earns most of its income from an active business.
FATCA does not apply to payments for which the payee must itself report the payment on a US tax return and pay US income taxes, such as earnings from engaging directly or through a partnership or US branch in a US trade or business.
It also does not apply to foreign entities that are owned by a foreign government, such as an export credit agency.
In either case, the payee must claim the exemption by providing the payor with a W-8ECI or W-8EXP, respectively.
FATCA also does not apply to payments that do not have a source in the US, such as where the borrower is a Puerto Rico project company. There are complicated rules under US tax law for determining the “source” of a payment. For example, interest is considered to have its source where the borrower is located. Compensation has its source where the services are performed. No Form W-8 is needed to claim this exemption.
From the standpoint of a US developer, the focus should be on trying to get a foreign lender or other payee to provide proof that it is exempted from FATCA withholding. This is best done by including in the deal documents a requirement that a payee provide an exemption form to the US developer before the first payment is due. This requirement must leave as little discretion as possible to the foreign payee.
Keep in mind that FATCA withholding obligations are ongoing, so the payee should be required to update any exemption form to the extent the facts change or the IRS requires that a new form be provided. Also, if at any point, the foreign payee is not able to provide the exemption form, consider who should be burdened with the FATCA withholding tax.
For its part, the foreign payee will need to confirm its
eligibility for a FATCA exemption and be prepared to provide the US developer with the relevant form before the first payment.
If a US developer does not receive an exemption form from a payee exempting the payment from FATCA withholding in a timely manner, then the US developer must withhold the FATCA tax and forward it to the IRS. A US payor that fails to withhold the FATCA tax and remit it to the IRS becomes liable for it.