CPAs with clients whose responsibilities include withholding and remitting taxes on payments to foreign individuals and entities can help those clients understand guidelines and institute sound practices. Often, these “withholding agents” are financial institutions, but they can include any individual, business or other entity paying U.S.- source income to a foreign individual or entity in exchange for services.
The stakes are potentially high: The withholding agent can be liable to the IRS for the amount of tax required to be withheld, as well as for interest and penalties. A new Internal Revenue Manual section highlights this area as one of heightened scrutiny by the Service. Its provisions can also be useful to CPAs in advising their clients, since they offer a glimpse into how IRS examiners will audit these withholding obligations.
GENERAL REPORTING RULES
U.S. taxpayers must file information forms reporting certain payments to foreign corporations, foreign individuals, partnerships, and certain fiduciaries, trusts and estates. See IRC §§ 1441 and 1442 and Treas. Reg. §§ 1.1441-1 through -9. Generally, every U.S. person who makes a fixed or determinable payment of annual or periodic income (FDAP payment) from U.S. sources must withhold tax—generally 30%—and remit it to the IRS. A “person” in this sense includes U.S. citizens and residents, domestic partnerships and corporations, and certain estates and trusts. They must also file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and information return Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding.
The 30% withholding rate can be reduced by various exceptions provided in the statute or by a reduced rate of tax under a tax treaty (Treas. Reg. § 1.1441-6). For certain types of payments, treaty-reduced withholding rates are available, but only if the beneficial owner of the payment provides the withholding agent with a withholding certificate that includes a taxpayer identification number. This requirement should be carefully complied with by the withholding agent, given the potential liability by the agent for taxes, penalties and interest.
NEW IRM SECTION
In July, the IRS issued Internal Revenue Manual section 4.10.21, “U.S. Withholding Agent Examinations—Form 1042,” that instructs IRS examiners to more closely examine and enforce the statutory requirements for withholding and the related compliance reporting of FDAPs to foreign persons.
The IRM notes that withholding agent audits are likely to be of U.S. financial institutions required to report and withhold tax on behalf of nonresident aliens (NRAs) in connection with the institutions’ custodial or brokerage activities. But audits could also be of nonfinancial entities paying foreign persons for services, it states.
INSTRUCTIONS TO WITHHOLDING AGENT EXAMINERS
Withholding agent examiners should consider Form 1099 reporting and backup withholding as part of an integrated audit, the new IRM section states. In addition, when auditing Form 1042, the examiner is supposed to ascertain the statute of limitations on the audit years for both Form 1042 and Form 945, Annual Return of Withheld Federal Income Tax. The IRM instructs the examiner to obtain and have executed, if applicable, Form 872, Consent to Extend the Time to Assess Tax, and Form SS-10, Consent to Extend the Time to Assess Employment Taxes, to protect the statute of limitations on such forms.
RELIANCE ON WITHHOLDING CERTIFICATE
The IRM provides guidance to withholding examiners with respect to reliance on a withholding certificate (Form W-8) that is part of the review process of Form 1042 and Form 1042-S. A U.S. withholding agent can generally rely on a properly completed withholding certificate to establish foreign status or claim treaty benefits. The withholding certificate must be completed with respect to any item that is relevant to a claim for treaty benefits.
The IRM instructs the withholding agent to request for each account under review withholding certificates, other evidence for offshore accounts, and account information needed to administer and open the account (that is, addresses, account holder’s status and other account instructions). The examiner also is instructed to ask for an explanation of the withholding and reporting procedures for real estate investment trust (REIT) distributions, original issue discount (OID) transactions, and security lending transactions.
By Philip T. Pasmanik, CPA, MST, a senior manager at Rothstein, Kass & Co. PC in Roseland, N.J. He is a member of the AICPA International Tax Technical Resource Panel and chair of its Forms 1120F/5472/1042 Task Force. His e-mail address is email@example.com.