If not, perhaps you should. The IRS has announced plans to audit 100 percent of all taxpayers that file forms 1042 – the forms that evidence payment of U.S. source fixed, determinable annual, periodic income (FDAP) to non-U.S. persons. The first batch of audit letters has been sent out to 5,000 taxpayers. Such payments are generally subject to a 30 percent withholding tax, unless there is an applicable treaty or statutory exemption. In order to claim the benefits of a treaty, or some of the statutory exemptions, the payor must have on file properly executed documentation. Absent having the documentation, the 30 percent rate applies. While the tax is the liability of the foreign person, if the US payor fails to withhold, the U.S. payor is liable for the full amount of the taxes and associated penalties.
More Than Just a Financial Institutions’ Concern
The withholding rules are often thought of a problem for the banks – regular payors of FDAP type income. The concern, however, is not restricted to financial companies. The IRS instituted a voluntary compliance program in September 2004, which ended in June 2006. Approximately 1/3 of those who entered the program were non-financial multinationals.
Royalties, Interest, Dividends and Consulting Fees
What type of payments may be at risk? Does your company pay cross border royalties for the use of property in the U.S.? Those are subject to the withholding tax, unless a treaty applies. Many treaties will reduce the tax to zero. But, if you do not have on file the correct documentation, withholding at 30 percent is required. Does your U.S. company pay interest on a loan from a non-U.S. related party? The interest payments are subject to the 30 percent withholding tax unless a treaty reduces or eliminates the tax. Again, in order to claim the treaty benefits, the proper documentation is needed. Did your U.S. company pay a dividend to non-U.S. shareholders? The dividend is generally subject to a 30 percent withholding tax unless an applicable treaty reduces the rate. Did your U.S. company pay a non-U.S. consultant for work done in the U.S.? You guessed it – those payments are generally subject to the 30 percent withholding tax unless you have on hand appropriate documentation to claim an exemption.
Sufficient Documentation
Appropriate documentation is generally one of the Forms W-8, or for the consultant claiming benefits of a tax treaty, a Form 8233.
Many of the types of payments that are subject to the withholding tax are handled in a mechanical manner by the administrative units responsible for processing invoices. Experience is showing, however, that they may not have been given sufficient guidance on how to apply the withholding tax.
Failure to have systems in place to assess the need to withhold is becoming an issue under the Sarbanes-Oxley Act. In addition, once you do find out there is an issue, the exposure needs to be considered in light of FIN 48, as the tax is an income tax.
Pepper Perspective
The IRS expects to impose rigorous audit standards; partially completed forms or mis-completed forms will not be acceptable. Penalties are being emphasized. Taxpayers would be well advised to clean up before the IRS knocks by determining:
- if the taxpayer is making payments of FDAP to non-U.S. persons
- if the proper forms are being obtained, and they are correctly filled out
- if withholding has occurred were needed
- if Forms 1042 and 1042-S have been filed
- if withheld taxes have been timely deposited with the IRS.
If there is an issue, there is still some benefit to voluntary disclosure, but the time for that is now, not after the audit notice is received.
Joan C. Arnold
