New U.S. Withholding Rules for Hybrids and Passthroughs
New final regulations establish US withholding tax rules for pass-through entities, trusts, and hybrids. While maintaining its previously published positions -- arguably to prevent double taxation and double exemption -- the IRS has simplified the rules and added examples that should make the rules easier to apply.
The US Internal Revenue Service (the "Service") recently issued new final regulations relating to withholding taxes imposed on US source income paid to passthrough entities. Specifically, final regulations were issued under Internal Revenue Code(1) section 894(c), clarifying when treaty benefits will be available to reduce the withholding tax on payments of US source income made to "hybrid entities." Hybrid entities are treated as fiscally transparent in one jurisdiction but not fiscally transparent in another jurisdiction. These regulations will not apply to entities that are treated as fiscally transparent in both jurisdictions or in neither jurisdiction. The new regulations generally apply to items of income paid on or after June 30, 2000. Another set of recently issued final regulations amended the general withholding rules to clarify the rules that apply to payments of US source income to partnerships, trusts, and estates, effective generally on January 1, 2001. The Service has in the process also clarified some basic questions of whose law applies to determine beneficial ownership, status of an entity, and source and character of the payment.
Payments to domestic and foreign persons create a number of withholding and information-reporting obligations for both the payer and the recipient under various provisions of the Code. In the absence of timely and complete documents requesting exemption, the premise of the regulations is that a withholding agent will withhold tax on US source income. Thus, the burden is generally on the income recipient to provide proof that a withholding exemption applies. In order to overcome the presumption that an item is subject to full 30 percent withholding tax, the recipient must furnish sufficient documentation such that the withholding agent can reliably associate a payment to valid documentation, whereby a beneficial owner appropriately claims an exemption.
A withholding agent can reliably associate a payment with valid withholding documentation if, before the payment date, the agent (1) holds valid documentation, (2) can reliably determine how much of the payment relates to the documentation, and (3) has no actual knowledge of or reason to know that any of the information, assertions, or certifications contained in the documentation are incorrect.(2) Special rules apply to payments made to intermediaries, flowthrough entities, and certain US branches. These entities must provide not only a withholding certificate for themselves, but also withholding certificates, documentary evidence, or other information for the persons on whose behalf they are acting. In those situations, the agent must receive a valid non-qualified intermediary withholding certificate on Form W-8IMY;(3) it must be able to determine the portion of the payment that relates to valid documentation associated with Form W-8IMY from a payee (that is, a person other than a non-qualified intermediary, flowthrough entity, or US branch); and the nonqualified intermediary, flow-through entity, or US branch must have provided sufficient information for the withholding agent to report the payment on Form 1042-S(4) or Form 1099,(5) if such reporting is required.(6)
These final regulations also provide guidance on payments made to qualified intermediaries ("QIs").(7) In order to become a QI, a QI withholding agreement must be entered into with the Service. The objective of the QI withholding agreement is to simplify withholding and reporting obligations for payments of income made to an account holder through one or more foreign intermediaries. Rev. Proc 2000-12(8) provides guidance for entering into these QI withholding agreements. While the revenue procedure does not apply to a foreign partnership seeking to qualify as a withholding foreign partnership, the Service has announced that it will consider applying the principles of the QI withholding agreement provided in the revenue procedure to a foreign partnership acting on behalf of its partners in certain circumstances.
In determining whether to enter into a QI withholding agreement and the terms thereof, the Service has announced that it will consider factors including whether the foreign person agrees to assume primary withholding responsibility, the type of local "know-your-customer" laws and practices to which it is subject, the extent and nature of supervisory and regulatory control exercised under the foreign jurisdiction, the volume of investments in US securities, the financial condition of the foreign person, and whether the QI is a resident of a country with which the US has an income tax treaty.(9) So far, the countries with approved know-your-customer rules include Canada, Belgium, Denmark, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Singapore, Sweden, Switzerland, and the United Kingdom.(10) Hong Kong, Japan and Spain are some of the countries or jurisdictions currently in negotiatoins for approval of their know-your-customer rules.
Treaty Withholding Rules for Passthrough Entities
Internal Revenue Code section 894(c)(1) denies treaty benefits for certain US source payments made to hybrid entities. Under that rule, a foreign person is denied benefits under a US income tax treaty on an item of US income derived through an entity that is fiscally transparent if the item is not treated under the laws of the foreign jurisdiction as an item of income of the entity, the treaty does not specifically address the applicability of the treaty in the case of an item of income derived through a partnership, and the foreign jurisdiction does not impose tax on a distribution of an item of income from the fiscally transparent entity to the foreign person. Section 894(c)(2) authorizes "necessary or appropriate" regulations to further limit the availability of a treaty for hybrid entities. These regulations replace the temporary (and proposed) regulations issued on June 30, 1997 in TD 8722,(11) which were effective for amounts paid on or after January 1, 1998. Section 894(c) was added to the Code on August 5, 1997 as part of P.L. 105-34, Search7RH1054(a).(12)
On July 3, 2000(13), the Service issued final regulations under section 894(c). The new regulations provide significant clarification on the section 894(c) limitations described above. The rules apply on an item-by-item basis to income from US sources that is not effectively connected with the conduct of a US trade or business and is received by entities that are treated as fiscally transparent in either the US or one or more foreign jurisdictions. To determine whether an entity or its interest holders may be able to qualify for treaty benefits, the main focus of these regulations, then, is whether the entity is fiscally transparent. When an entity attempts to invoke treaty benefits, the issue whether the entity is fiscally transparent with respect to the specific item of income in question is to be determined under the laws of the jurisdiction of the entity. This is the jurisdiction where the entity is deemed resident for the purposes of invoking the benefits of an income tax treaty.(14) When an interest holder of an entity attempts to invoke treaty benefits, the issue whether the entity is fiscally transparent with respect to the income item is to be determined under the laws of the interest holder's jurisdiction (and it is irrelevant whether the entity is fiscally transparent under its own jurisdiction).(15)
An entity is defined for this purpose as any person that is treated by the US or an applicable treaty jurisdiction as other than an individual, including partnerships, disregarded entities, and single-member entities with individual owners.(16) Despite requests for application of treaty denial only in the presence of a significant tax-avoidance purpose, the final regulations maintain the objective approach of the temporary regulations in determining eligibility for treaty benefits on income paid to hybrid entities.
The regulations do not address payments made by a domestic US corporation that is treated as fiscally transparent in the interest holder's jurisdiction (referred to as a domestic reverse hybrid entity in the regulations).(17) The Service and the US Treasury Department have announced that they are aware of abusive structures that have been designed to take advantage of such entities and thus plan to issue guidance separately as to the treaty eligibility of payments made by such entities. The regulations do provide, however, that the US federal income tax on US source payments received by a domestic reverse hybrid entity cannot be reduced by a US income tax treaty, and that the foreign interest holders of such an entity are not entitled to any treaty benefits reducing the US tax on US source income that flows through to the entity.(18)
Under the final regulations, an item of income received by an entity that is fiscally transparent under the laws of the US or any other relevant jurisdiction will be eligible for treaty benefits only if the item of income is derived by a resident of the applicable treaty jurisdiction.(19) An income item can be derived by the entity receiving the income, the interest holder in the entity, or both.(20)
If an entity is not fiscally transparent with respect to that item of income under the laws of the entity's jurisdiction, it will be considered to have derived that income.(21) In Example 3 of the regulations, an entity is treated as a corporation under the laws of its jurisdiction and thus, as it is not fiscally transparent, will be considered to derive the income.
Under a separate rule, if the tested treaty specifically lists the entity as a resident of the treaty jurisdiction, the income will also be considered derived by that entity, and no further investigation will be required to determine whether the entity is fiscally transparent or not.(22) The theory behind this rule is that the two treaty countries have already agreed to the classification of that entity, and thus the entity should be entitled to all treaty benefits associated with that classification.
It is apparent that under these rules both the entity and its interest holders could be considered to have derived an item of income (for example, assuming that they are residents of different countries). In such a case, they may both be able to qualify for benefits under their respective treaties.(23)
If an entity is considered fiscally transparent, then the interest holder in the entity can claim to have derived the income and be entitled to treaty benefits under its treaty if the holder can establish that (1) the entity is fiscally transparent with respect to that item of income under the laws of the holder's jurisdiction and (2) that the holder itself is not also fiscally transparent with respect to that item of income in its jurisdiction.(24) If the interest holder is itself considered fiscally transparent, it seems that the fiscally transparent test should then be applied at the level of the owner of the interest holder, but the regulations do not specifically address this scenario. In the earlier proposed and temporary regulations, the recipient had to be "subject to tax" in the treaty jurisdiction, but it was decided that the term "subject to tax" was ambiguous and easily misinterpreted, especially in cases where no actual tax was ever paid by the income recipient.
An entity will be considered fiscally transparent only if (1) the interest holders in the entity, wherever they are resident, are required to take into account currently(25) their share of the items of income paid to the entity, whether or not such items are actually distributed by the entity, and (2) the source and character of the income in the hands of the interest holder are determined as though such income item was derived by the interest holder directly from the source that paid the entity.(26)
Fiscal transparency is determined on an item-by-item basis, so an entity can be fiscally transparent with respect to one item (such as interest income) but not with respect to another (such as dividend income), depending on the laws of a given jurisdiction. In determining fiscal transparency, it is irrelevant that an entity is permitted to exclude an income item from gross income or is required to include it in gross income but is allowed a deduction for distributions to its interest holders.(27)
Many foreign investment vehicles will not be considered fiscally transparent under these regulations because the interest owners are not required to include income until it is distributed, and thus the interest owners will not be entitled to treaty benefits on income actually distributed to them. These vehicles will not be entitled to treaty benefits under the new regulations.(28)
Entities such as trusts are not necessarily automatically treated as being fiscally transparent; instead, they will have to be tested on an item-of-income basis to see whether the beneficial owners are required to take the item of income into account in the year earned by the entity, regardless of whether the income is distributed. As an illustration, example 5 in the final regulations describes a trust that is not considered fiscally transparent.
Commentators had argued that controlled foreign corporations and similar entities subject to anti-deferral regimes should be considered fiscally transparent entities for the purposes of these rules, since interest holders are required to include income on a current basis. In those cases, however, the Service's view is that the income included by interest holders is effectively a deemed distribution of after-tax profits of the entity, not simply a passthrough of each income item earned by the entity (as though the interest holder had earned it directly), and thus the regulations specifically exclude such entities from being considered fiscally transparent.(29)
Some commentators were concerned that these rules could limit the treaty benefits of pension funds and other tax-exempt organizations when those entities invest in companies that are treated as partnerships under US law and as corporations under the law of the applicable treaty jurisdiction (like US limited liability companies). The Service noted in the preamble to the final regulations that those organizations can avoid such problems by carefully choosing the types of vehicles in which they invest, and in other cases, specific treaty provisions can be negotiated to allow such entities to invest in non-fiscally transparent entities and still qualify for treaty benefits. The Canada - United States Income Tax Treaty, as amended(30), for example, provides in Article XXI, paragraph 2,
Subject to the provisions of paragraph 3, income referred to in Articles X (Dividends) and XI (Interest) derived by:
(a) A trust, company, organization or other arrangement that is a resident of a Contracting State, generally exempt from income taxation in a taxable year in that State and operated exclusively to administer or provide pension, retirement or employee benefits; or
(b) A trust, company, organization or other arrangement that is a resident of a Contracting State, generally exempt from income taxation in a taxable year in that State and operated exclusively to earn income for the benefit of an organization referred to in subparagraph (a);
shall be exempt from income taxation in that taxable year in the other Contracting State.
Withholding agents should consider whether they need to obtain new or additional withholding certificates to confirm claims of treaty benefits from the appropriate parties for income items paid after the effective date. In particular, Canadian tax practitioners will want to get fully acquainted with these new rules, which will be applied by US withholding agents on payments of US source income beginning July 1, 2000. It appears that the US has unilaterally adopted this approach to solving a conflicts-of-law problem. It will be interesting to see whether Canada and other countries adopt similar rules or take alternative positions that could defeat the Service's stated objectives of avoiding double taxation and double exemption.
Regulations on Payments to Partnerships, Trusts, and Estates
In May 2000(31), the Service also amended the final US withholding tax regulations applicable to US source income payments to foreign persons. As originally drafted, the regulations provided extensive rules regarding withholding on US source payments made to partnerships, but had reserved on the treatment of such payments made to trusts and estates. The amended rules now include rules governing withholding on those payments made to trusts and estates. As noted above, these new regulations are to be effective on January 1, 2001.
US Partnerships, Trusts, and Estates
Generally, a payment made to a US partnership, trust, or estate will be treated as a payment to a US person and thus is not subject to chapter 3 withholding.(32) In general, however, US partnerships, trusts, and estates are required under the regulations to withhold on payments they make to any non-US partners, beneficiaries, and owners (in the case of grantor trusts).(33) For reporting purposes, it is the trust or estate that is the withholding agent that must fill out Forms 1042(34) and 1042-S,(35) not the fiduciary of the trust or estate.
Under the regulations, a recipient that is presumed to be a partnership is presumed to be a US partnership unless certain indicia of foreign status are present. A trust is presumed to be a US trust unless there are indicia of its foreign status.(36) If the withholding agent knows that the entity is a foreign trust but is unsure whether it is a complex, simple, or grantor trust (rules for each of which are described below), it is presumed to be a foreign complex trust.(37) If it is known that the foreign trust is a simple or grantor trust, the payees are presumed to be foreign unless proper documentation proving their US status is received.(38)
A simple trust is one that provides that all of its income is required to be distributed currently and does not require that any amounts are to be paid, permanently set aside, or used for specific purposes, such as charitable purposes.(39) A grantor trust is one in which the grantor is considered the owner of any portion of the trust under the Code.(40) A complex trust is any trust other than a simple trust or a grantor trust.
A US simple trust is generally required to withhold on the distributable net income ("DNI") includible in the gross income of its foreign beneficiaries to the extent that the DNI consists of amounts that are subject to withholding.(41) A US complex trust must withhold on the DNI that is included in the gross income of a foreign beneficiary only to the extent that the DNI consists of amounts subject to withholding that are, or are required to be, distributed currently.(42) A US estate is required to withhold on the DNI includible in the gross income of a foreign beneficiary to the extent that the DNI consists of amounts subject to withholding and that are actually distributed.(43) Finally, a US grantor trust must withhold on any income includible in the gross income of a foreign person who is treated as an owner of the trust to the extent that the includible amount consists of amounts subject to withholding, and must withhold at the time that the trust receives, or is credited with, the income.(44) If an amount is subject to withholding before its distribution to a partner, beneficiary, or owner, further withholding is not required when that amount is subsequently distributed.(45)
Where the entity is either known to be or can be presumed to be a foreign partnership, the question for the withholding agent is whether to treat the payment as if it were made to the entity or to an aggregate of the partners. Fortunately, the regulations address this issue. In general, a payment to a foreign partnership is treated as a payment made directly to its partners. Three exceptions to this rule -- a payment to a "withholding foreign partnership," a payment to a foreign partnership that has furnished a certificate upon which the withholding agent can rely to treat the payment as effectively connected with the conduct of a US trade or business, and a payment made when the agent can presume that the income is effectively connected -- are treated as payments made to the foreign partnership and not to the partners.(46) A non-withholding foreign partnership must provide a withholding certificate and attach to it the withholding certificates of its partners to claim an exemption or treaty rate reduction. The partnership's certificate must contain sufficient information to allow the withholding agent to reliably associate each partner's distributive share of the payment with an exemption or rate reduction. If a withholding certificate is furnished wholly for income that is effectively connected with the conduct of a US trade or business, withholding certificates from the partners need not be attached to the partnership's withholding certificate.(47) As suggested above, a withholding foreign partnership will assume the responsibility for withholding on payments made to its partners, and will thus file Forms 1042 and 1042-S for amounts subject to withholding that are paid to, or included in the distributive share of, its foreign partners.
The regulations incorporate presumptions upon which a withholding agent can rely when making payments to a foreign partnership for which the necessary documentation is lacking or unreliable. If the withholding agent can presume that the payment is made to a foreign partnership, uncertainties may remain regarding the status of the partners and the allocation of a payment among them. A payment that cannot be reliably associated with a withholding certificate from a partner must be presumed made to a foreign payee, for example, and the withholding agent is required to fully withhold tax from the payment and to file a Form 1042-S.(48)
If an entity is a hybrid, these basic rules have to be taken into account in applying the final section 894(c) regulations described above.
Foreign Trusts and Estates
Foreign complex trusts and foreign estates are generally considered the beneficial owners of income, and thus may provide a beneficial owner withholding certificate or other beneficial owner documentation.(49)
Foreign simple trusts and foreign grantor trusts are not considered payees or beneficial owners.(52) Instead, the beneficiaries or owners of the trust are generally considered the payees. The rules in that case are similar to the rules for non-withholding foreign partnerships in that the trust must provide a flowthrough withholding certificate and attach to it the withholding certificates, or other permitted documentary evidence, of its beneficiaries or owners, showing the allocation of income among these beneficiaries or owners. If the income is effectively connected to a US trade or business, however, the payment is treated as though it is made to the foreign simple trust, not to the beneficiaries.(53) In order to preserve confidentiality, consideration should be given to taking the necessary steps to ensure that these entities are classified as complex trusts.(54)
It is critical for the US to develop mechanical rules to enforce its withholding taxes. Given the recent US tendency to promulgate rules to enforce US anti-treaty-shopping principles and our experience with the prior temporary regulations, the new final section 894(c) rules include no surprises. While it is unfortunate that the new rules do not expressly include rules for tiered hybrids, the rules otherwise seem reasonably complete and workable. The Service's clarifications and simplifications are welcome.
The new rules dealing with trusts and estates in the general withholding regulations are also welcome, considering that the US is attempting to implement a comprehensive new withholding mechanism effective January 1, 2001. The effective date of the final withholding regulations has been pushed back several times, allegedly to allow taxpayers adequate time to review the new forms and understand the new procedures. Even so, it is not currently clear whether the new withholding tax regime will actually go into effect on January 1, 2001. It is dangerous to assume, however, that the effective date will be postponed again.
This column has explained some of the rules that apply to entities typically regarded as passthrough entities in one or more jurisdictions. The regulations that are presently scheduled to go into effect on January 1, 2001 now include rules that apply to most of the common withholding situations. Tax advisers and tax compliance officers have had to digest hundreds of pages of regulations, revenue procedures, and new forms. Mobilizing for the effort required to comply with the new regime has and will continue to consume thousands of hours of your fellow tax professionals' time. We hope our loved ones understand.
1. Internal Revenue Code of 1986, as amended (herein referred to as "the Code"). Unless otherwise stated, statutory references in this article are to the Code.
2. Treas. Reg. section 1.1441-1(b)(2)(vii)(A).
3. Form W-81MY, "Certificate of Foreign Intermediary, Foreign Partnership, or Certain U.S. Branches for United States Tax Withholding."
4. Form 1042-S, "Foreign Person's U.S. Source Income Subject to Withholding."
5. Form 1099.
6. Treas. Reg. section 1.1441-1(b)(2)(vii)(B).
7. Treas Reg. section 1.1441-1(e)(5)
8. Rev. proc. 2000-12, 2000-4 IRB 387.
9. Treas. Reg. section 1.1441-1(e)(5)(iii)(B).
10. Tax Notes Today (Arlington, VA: Tax Analysts) (online database), 2000 TNT 93-H, May 12, 2000.
11. TD 8722, 1997-2 CB 81.
12. Taxpayer Relief Act of 1997, Pub. L. no. 105-34, enacated August 5, 1997. The legislative history of this section shows Congress' intention to have Section 894(c) authorize the issuance of these earlier regulations. The Service had also issued a notice announcing its intention to prevent taxpayers from using hybrids to avoid the subpart F rules. Notice 98-11, 1998-6 I.R.B. 18. A moratorium on this Notice and the temporary and proposed regulations issued thereunder were pronounced in Notice 98-35, 1998-27 I.R.B. 35.
13. T.D. 8889, 2000-30 IRB 124.
14. Treas. Reg. sections 1.894-1(d)(3)(iv) and (v).
15. Treas. Reg. section 1.894-1(d)(3)(iii)(A).
16. Treas. Reg. section 1.894-1(d)(3)(i).
17. Treas. Reg. section 1.894-1(d)(2)(ii).
18. Treas. Reg. section 1.894-1(d)(2)(i). This proscription does not apply to non-US reverse hybrids.
19. Treas. Reg. section 1.894-1(d)(1).
20. Treas. Reg. section 1.894-1(d)(1).
21. Treas. Reg. section 1.894-1(d)(1).
22. Treas. Reg. section 1.894-1(d)(1). As suggested below, this merely answers one of several questions required to be addressed in determining actual eligibility for a treaty rate reduction or exemption (for example, a limitations-on-benefits provision of the applicable treaty could deny other treaty benefits).
23. Treas. Reg. section 1.1441-6(b)(2) outlines procedures for dual rate claims under separate income tax treaties.
24. Treas. Reg. section 1.894-1(d)(1).
25. An interest holder will be treated as taking its share of the entity's income into account currently even if such amount is taken into account in a different taxable year if the difference in years is solely due to the fact that the entity and the interest holder have different taxable years. Treas. Reg. sections 1.894-1(d)(3)(ii)(B) and (iii)(B).
26. Treas. Reg. sections 1.894-1(d)(3)(ii)(A) and (iii)(A). In order to comply with US tax principles regarding partnerships, the regulations clarify that it is not necessary that the interest holder separately take an item of income into account for the entity to be considered fiscally transparent with respect to that income item if this will not result in a different tax treatment under the tax laws of the applicable jurisdiction from that which would have occurred if such income item was separately taken into account.
27. Treas. Reg. section 1.894-1(d)(3)(ii)(A).
28. The term "resident" has the definition given to it in the applicable income tax treaty. Treas. Reg. 1.894-1(d)(3)(v).
29. Treas. Reg. section 1.894-1(d)(3)(iii)(A).
30. The Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by by Protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, and July 29, 1997.
31. TD 8881, 2000-23 IRB 1158.
32. Treas. Reg. section 1.1441-5(b)(1). But see backup withholding mechanisms under section 3406.
33. Treas. Reg. section 1.1441-5(b)(2).
34. Form 1042, "Annual Withholding Tax Return for US Source Income of Foreign Persons."
35. Supra footnote 4.
36. Treas. Reg. sections 1.1441-1(b)(3)(i) and 1.1441-5(e)(6)(ii).
37. Treas. Reg. section 1.1441-5(e)(6)(ii).
38. Treas. Reg. section 1.1441-5(e)(6)(iii).
39. Code section 651(a).
40. Code section 671.
41. Treas. Reg. section 1.1441-5(b)(2)(ii).
42. Treas. Reg. section 1.1441-5(b)(2)(iii).
43. Treas. Reg. section 1.1441-5(b)(2)(iii).
44. Treas. Reg. section 1.1441-5(b)(2)(iv).
45. Treas. Reg. section 1.1441-5(b)(2)(v).
46. Treas. Reg. section 1.1441-5(c)(1)(ii).
47. Treas. Reg. section 1.1441-5(c)(3)(iii).
48. Treas. Reg. section 1.1441-5(d).
49. Treas. Reg. section 1.1441-5(e)(2).
52. Treas. Reg. section 1.1441-5(e)(3)(i).
53. Treas. Reg. section 1.1441-1(e)(3)(ii).
54. Stephen E. Shay and Susan C. Morse, "Qualified Intermediary Status, Act III: Rev. Proc. 2000-12's Final Qualified Intermediary Agreement and Amendments to Final Withholding Rules," 403 Tax Management International Journal 2000, at 421.