IRS to limit refunds and credits of foreign withholding payments

The IRS announced in a notice that it intends to amend its regulations to prevent taxpayers subject to withholding under chapter 3 or 4 of the Code from obtaining refunds or credits of withheld tax where a withholding agent failed to deposit the amounts required under Sec. 6302. Chapter 3 (Secs. 1441 through 1443) requires withholding on certain payments of U.S.-source fixed or determinable annual or periodical income to foreign persons, and chapter 4 (Secs. 1471 and 1472, provisions of the Foreign Account Tax Compliance Act (FATCA)) generally requires withholding on certain payments to nonparticipating foreign financial institutions and certain nonfinancial foreign entities that do not provide information regarding their substantial U.S. owners.

If the IRS allows a refund or credit for an amount that a withholding agent has not deposited, it may have difficulty recovering that amount because the taxpayer and sometimes the withholding agent may be outside the United States. The current practice of allowing refunds or credits based on the amount reported as withheld on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, presents the risk that refunds or credits may be improperly granted for fictitious withholding or amounts that have not been deposited.

In response, the IRS intends to amend Regs. Secs. 1.1464-1(a) and 1.1474-5(a)(1) to allow a refund or credit to a taxpayer for an overpayment only to the extent the withholding agent has deposited (or otherwise paid over) the amount withheld and the amount exceeds the taxpayer’s tax liability, except as otherwise provided by Sec. 6401(b)(2). Also, the IRS will issue regulations under Sec. 33 and amend Regs. Secs. 1.1462-1(a) and 1.1474-3(a) to provide that a credit is available to a taxpayer only to the extent that the withholding agent has deposited (or otherwise paid) the amount withheld.

The IRS will also issue rules adopting a pro rata method for allocating partial payments among taxpayers and procedural rules for reporting information to claimants and withholding agents in connection with the allocation rules, as described in the notice. The Service stated it considered permitting the use of a tracing or specific identification method for partial payments but rejected it as too burdensome. The IRS also stated in the notice that it is considering whether there should be exceptions to the proposed rules, for example, for a de minimis amount or where a withholding agent has a history of complying with the withholding rules. The exceptions would treat a claimant that is the beneficial owner of the withheld payment as if a full deposit had been made, but only for purposes of a claim for refund or credit of an amount withheld under chapter 3 or 4.

The IRS is requesting comments on the feasibility of developing and implementing a more precise methodology than the pro rata allocation method for partial payments at some future date, on the procedural rules in connection with the allocation rules, and on possible exceptions to the rules.

These regulations will apply to claims for refund or credit for amounts withheld for the 2015 calendar year and later.

• Notice 2015-10

—By Sally P. Schreiber, J.D., a JofA senior editor.