Author: Barragato, Charles A
Date published: January 1, 2010
the nature and amount of fees paid by US. entities to foreign persons has gained greater attention in recent years. Foreign persons include aliens who do not reside in the United States [Interna] Revenue Code Sec. 881(b)(2)], and foreign corporations are defined as those organized under the laws of a foreign country or U.S. possession [Sec. 7701(a)(5)]. In this article, we'll assume the recipient of the fees is a foreign corporation.
A foreign corporation is not subject to taxation by the United States on income that is neither from U.S. sources nor connected with a business entity conducting operations in the United States. This exemption is justified for foreign corporations owned by foreign persons. However, questions arise when U.S. citizens or U.S. domestic corporations own foreign corporations either partially or wholly. An example of this ownership structure is a foreign subsidiary of a domestic corporation.
Complex rules that define and govern foreign personal holding companies, controlled foreign corporations, passive foreign investment companies and foreign sales corporations have been adopted to prevent the avoidance or significant deferral of U.S. taxation of income beneficially owned by a U.S. person. In addition, rules were implemented with respect to transfers to and from foreign corporations to recognize the special status of foreign corporations in which US. persons have an ownership stake (sees. 951-971),
A number of interrelated IRC sees, must be considered when payments are made for fees by U.S. entities to foreign persons. The first set of sections Io note deals with income sourcing and whether fees paid are effectively connected with a U.S. trade or business.
The applicability of this rule is based on the facts and circumstances. If all of the services take place outside of the United States* and there is no connection to the United States through imputation or otherwise, then the income should not be considered sourced to the United States.
Identifying potentially imputed activities in this area is important. In most cases, the activities of agents, including entities such as partnerships, trusts and estates, will be imputed to the foreign corporation. Also, activities by persons subject to a high degree of control by the corporation. including employees, will be imputed to the foreign corporation.
There's a general requirement that a withholding agent must withhold 30 percent of any V.S.-sourCed payaient made to a payee that Is a foreign person, unless it can reliably associate the payment with documentation upon which it can rely to treat the payment as not being subject to withholding, or subject to withholding at a reduced rate (sees. 1441-1442).
The withholding agent also must obtain valid, reliable documentation that asserts the status of the payee prior to making the payment. Documentation refers to withholding certificates, Form W-8BEN and documents other than a withholding certificate that establish foreign status.
Form W-8BEN establishes the identification of the beneficial owner, including the type of entity and the country of incorporation or organization. In addition, this fprm allows for a claim of tax treaty benefits that provide for special rates and conditions.
Civil and criminal penalties are associated with failing to withhold and deposit taxes. In addition to liability for the tax and interest, a withholding agent may be liable for civil penalties, including the accuracy-related penalty of 20 percent of the amount of the underpayment in ease of negligence; 75 percent penalty in die case of civil fraud; or 100 percent penalty that imposes a penalty equal to die total amount of the tax evaded or not collected, or not accounted for and remitted to the TRS (sees. 6651 and 6672).
Criminal penalties can include a fine of up to $10,000 and /or five years' imprisonment, including die costs of prosecution for willful failure to collect or pay the tax (Sec. 7202).
Tax treaties can play a role if there is a concern that outbound payments may be construed to be U.S. sourced. Most treaties preclude the United States from taxing business profits of a resident of a country with which a treaty exists. However, if a person has a permanent establishment in the United States, then me United States can tax the profits attributable to the permanent establishment.
To add a layer of "insurance," a reduced or no-withhojding option can be applied when the foreign person's country of residence is treaty friendly.
Finally, information returns are generally not required for payments dial a payer can, prior to payment, associate or presume to have been made to a foreign payee. However, payments may be reportable when treatybased withholdingexemptions are claimed in connection with U.S.-sourced payments.
BY CHARLES A. BARRAGATO. CPA & MJCHAEL J. ABATEMARCO. CPA
Charles A. Barragato, Ph.D., CPA, CFE and Michael J.Abatemarco, J.D., LLM., CPA are accounting professors at Long island University. You can reach them at Charles.Barragato9liu.edu and Michael.Abatemarco@liu.edu.