On November 3, 2005, the IRS announced that the voluntary compliance program (VCP) for cleaning up errors in withholding taxes on payments to foreign persons would be extended to March 31, 2006.1 At the same time, the IRS announced its intention to audit 100 percent of Form 1042/1042S filers. The articulated position is that the terms of clean up under the VCP will be kinder and gentler than audit resolutions.
Originally designed for financial institutions, the VCP was created pursuant to Rev. Proc. 2004-59, and has been used by non-financial institutions to resolve historical non-compliance with the rules. The withholding rules are found in Section 1441 and 1442, and apply to taxes imposed on non-U.S. persons earning U.S. source fixed, determinable, annual or periodic income (FDAP) that is not connected to a U.S. business.2 Many non-financial institutions are, or should be, Form 1042/1042S filers. Private equity and venture funds should also be specifically concerned about the application of the rules.
Are you a Form 1042/1042S filer? You have the exposure if you pay U.S. source FDAP to non-U.S. persons. That type of income includes:
- payments for services rendered by an independent contractor or other non-employee while in the U.S.
- payments of licensing fees or royalties to non-U.S. persons
- payments of dividends from U.S. sources to non-U.S. persons
- payments of interest to non-U.S. persons.
With respect to the withholding on services, it is the place where services are rendered that controls, not the place of contract, the residence of the payee, or the place of payment. If you have relied on a contractor claiming treaty benefits to avoid the withholding tax, you should have received a Form 8233 from the contractor. That form has only a one-year validity. Be sure the forms you rely on are up-to-date and have the required TIN. Also, determine whether your company pays non-U.S. Board members for attending meetings in the U.S. If so, your company should be withholding the appropriate tax (after application of any treaty).
Royalties are frequently a problem if the license is for global usage - you should be withholding on the portion that is attributable to the right to use in the U.S. and contracts are frequently not written to support that action.
For private equity funds, given the recent rise in leveraged dividends, the withholding on dividends is a considerable issue. The withholding needs to occur at 30 percent, unless the payor can reasonably associate the payment with the right of a partner to utilize a tax treaty or other exemption. Recently, we reviewed a group of forms collected for this purpose by an investment fund, and we found that more than 90 percent were not correctly completed and could not be relied upon to reduce the withholding tax. Failure to timely withhold the tax and pay it to the IRS leaves the withholding agent liable for the amount of the tax, interest and penalties. The penalty for failure to timely deposit can be quite high.
Under the VCP, the taxpayer essentially self-audits its withholding obligations, and discloses pursuant to the terms of the revenue procedure. While the taxpayer must pay the under-withheld tax and interest the IRS is taking a liberalized approach to penalty relief and is also allowing remediation - getting the right forms, having the taxpayer ID number provided to make the form complete, etc. Thus, under audit the IRS will not be as accepting of bad forms and lack of compliance.
Pepper Perspective
Consider whether your company or client makes payments of the types described above, and if so, review your procedures for complying with the withholding tax rules. If you find errors, the VCP may be the right approach for you.
ENDNOTES
1 Rev. Proc. 2005-71.2 The taxes are imposed under Section 871 and Section 881.
Joan C. Arnold
