4.10.21. U.S. Withholding Agent Examinations - Form 1042

(1) A foreign person that is claiming benefits under an income tax treaty must be a resident of the relevant treaty country. The 2016 U.S. Model Treaty, Article 4, defines "resident of a Contracting State" as any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature. A resident of a Contracting State includes that State and any political subdivision or local authority thereof. It also provides that a person who is liable to tax in respect only of income from sources in a Contracting State or of profits attributable to a permanent establishment in that State is not a resident of that State.

(2) A nonresident noncitizen individual who is claiming benefits under an income tax treaty must be liable to tax in that country as a tax resident. This is a determination made under foreign law whose treaty is being applied, often based on the individual’s days of physical presence in that country.

(3) An individual may be a resident under the laws of the United States and a treaty country (dual resident individual). This happens frequently in the case of U.S. green card holders who are living in a treaty country. A dual resident must apply the treaty tie-breaker rule (generally in Article 4 (Residence) of the treaty) to see if he or she may claim treaty benefits with respect to income sourced in the United States. If the individual applies a series of tests and determines that he or she is solely a resident of the treaty country, the individual may file a Form W-8BEN or a Form 8233 to claim treaty benefits. The individual must also comply with the reporting requirements in Treas. Reg. 301.7701(b)-7.

(1) The foreign person must also be the beneficial owner of the item of income for which it is claiming treaty benefits. Treas. Reg. 1.1441-1 (c)(6) defines the term beneficial owner for withholding tax purposes, but not for purposes of claiming a benefit under an income tax treaty. Treaties generally do not define the term "beneficial owner" but the technical explanations to treaties often state that the term is defined under the internal law of the country imposing tax (i.e., the source country). In other words, the beneficial owner of dividend, interest, royalty income, or other income under Articles 10, 11, 12 and 21, respectively of the Model Treaty, as the case may be, cannot be a nominee, agent, or custodian of the payment for U.S. tax purposes. See, e.g., Aiken Industries v. CIR, 56 T.C. 925, 933 (1971).

(2) In addition, the conduit regulations under IRC 7701(l) and Treas. Reg. 1.881-3 apply to determine the beneficial owner, as do judicial principles such as substance over form and step transaction doctrine, assignment of income, and constructive ownership. See, e.g. Del Commercial Properties, Inc. v. CIR, T.C. Memo 1999-411, aff. 251 F.3d 210 (D.C. Cir. 2001); Treas. Reg. 1.1441-7(f)(2) discusses knowledge and reason to know standard concerning conduits.

(3) Because the special rules in Treas. Reg.1.1441-1(c)(6)(ii) do not apply, a partnership or disregarded entity that is a resident of a treaty country is not disqualified per se from being the beneficial owner of an item of income for treaty purposes. It may beneficially own an item of income as long as it is a treaty resident that derives the item of income, and, taking into account all the facts and circumstances, it is not acting as an agent or nominee or conduit of another person.

(1) An item of U.S. sourced FDAP income paid to a foreign entity is not eligible for treaty benefits unless the income is "derived by" a resident of a treaty jurisdiction under Treas. Reg. 1.894-1(d). An item of income may be derived by the entity receiving the item of income, by the interest holders (e.g., partners, members, or other unit holders) of the entity that receives the income or, in certain circumstances, both (dual treaty claims are explained in paragraph (7) below).

(2) An item of income paid to an entity shall be "derived by the entity" only if the entity is not fiscally transparent under the laws of the entity's jurisdiction with respect to the item of income. See Treas. Reg. 1.894-1(d)(1) and (d)(3)(ii).

(3) An item of income paid to an entity is "derived by its interest holder (not the entity)" only if under the laws of the interest holder’s jurisdiction: (1) the interest holder itself is not fiscally transparent with respect to the item of income, and (2) the entity receiving the payment is fiscally transparent under the laws of the interest holder's jurisdiction with respect to the item of income. See Treas. Reg. 1.894-1(d)(1) and (3)(iii).

(4) To the extent that, under the laws of the country in which the fiscally transparent entity (FTE) is a resident, of the income flows through the FTE to its owners, the income is not derived by the entity and the entity is thus ineligible for a reduced withholding tax rate under the treaty. However, a treaty-reduced withholding rate may apply at the interest holder level depending on the status of the interest holders (and whether such persons meet all the requirements of the treaty). The focus is on the law of the applicable foreign jurisdiction or jurisdictions, and not whether the entity is fiscally transparent for U.S. tax purposes.

(5) Notwithstanding the preceding provisions, an item of income paid directly to a type of entity specifically identified in a treaty as a resident of a treaty jurisdiction shall be treated as derived by a resident of that treaty jurisdiction. See Treas. Reg. 1.894-1(d)(1).

(6) To more fully understand the concept of "derived by" it will be helpful to briefly describe fiscally transparent entities, hybrid entities and reverse hybrid entities below. The related topic of limitation of benefits is discussed after "derived by", fiscally transparent entities, hybrids and reverse hybrids.

(7) A dual treaty claim occurs when a foreign entity and its interest owners are both claiming treaty benefits for an item of income, either each claiming separate portions of the same item of income, or both claiming the same portion of the income. The withholding agent may, at its option, accept such dual claims based on withholding certificates or other appropriate documentation furnished by the entity and its interest holders, or reject both claims. See Treas. Reg. 1.1441-6(b)(2)(iii) and (iv) for more information. If a foreign entity is not fiscally transparent in its own jurisdiction, it may claim a reduced rate of tax under a treaty as the beneficial owner of any portion of income to the extent the entity is receiving income by providing valid Form W-8BEN-E to the withholding agent; If a foreign entity is treated as fiscally transparent in any interest holder’s jurisdiction, it acts as a flow-through entity claiming a reduced rate of tax on behalf of any of its interest holders with respect to the same or a different portion of the income by providing the withholding agent a Form W-8IMY and other supporting documentation (e.g., interest holder’s Form W-8BEN or W-8BEN-E, and withholding statements).

(1) The Limitation on Benefits (LOB) article is an anti-treaty shopping provision included in many U.S. income tax treaties.  The purpose of the LOB provisions is to deny treaty benefits to taxpayers that have only a minimal nexus to the treaty country, e.g., when a resident of a non-treaty jurisdiction establishes an entity in a treaty jurisdiction solely to access the benefits of a treaty.  The LOB rules help prevent this by generally requiring the taxpayer to satisfy at least one of the objective tests contained in the LOB article to be eligible for treaty benefits (See IRM 4.60.2.7.1 Limitation on Benefits (LOB) Requirement).

(1) To use these procedures, a withholding agent must submit any delinquent withholding tax returns, including related information returns, along with full payment of the tax due and a statement including:

1. An explanation of the areas or lines of business for which there was non-compliance with tax, withholding and reporting obligations on payments to foreign persons

2. An explanation of how the non-compliance was discovered

3. A description of corrective procedures implemented to ensure future compliance

4. A copy of the procedures described in item (c) as communicated to employees or other responsible parties of the withholding agent

5. The withholding agent cannot have filed delinquent returns using these procedures in prior years.

(2) A withholding agent may file delinquent returns using these procedures if it is a withholding agent, as defined in Treas. Reg. 1.1441-7(a)(1) of the Income Tax Regulations, that is not a qualified intermediary, a withholding foreign partnership, or a withholding foreign trust,, as these entities are subject to other agreements.

(3) The withholding agent must report and remit any tax not already paid and will be expected to pay interest and any penalties for which relief is not otherwise granted pursuant to these procedures. In cases involving large underpayments, the IRS will consider the withholding agent's proposal for payment of the liability in more than one installment or will consider the withholding agent's posting of a cash bond under the procedures outlined in Rev. Proc. 2005-18, 2005-1 C.B. 798.

(4) The IRS reserves the right to verify that corrections to the withholding agents’ procedures have been made. This verification does not constitute an examination. If the IRS determines an examination is warranted the withholding agent will be notified and the examination will be completed as soon as possible.

(5) The IRS will issue an acknowledgment letter at the conclusion of its verification, if the IRS is satisfied that the withholding agent has corrected its systems and has paid or made satisfactory arrangements to pay the outstanding liabilities that arose from the delinquent return filings.

(1) A withholding agent is not eligible to use these procedures if the withholding agent is under examination with respect to any liabilities related to withholding tax filings on the date of the delinquent return(s) submission. For this purpose, an examination is treated as commencing on the date the withholding agent receives notification from the IRS of an impending examination or of an impending referral for examination. In addition, filing under these procedures is not available to any withholding agent that has the same issue pending in Appeals or is in litigation on issues involving Chapter 3 or 4 tax, withholding, or reporting obligations.

(1) Consistent with IRM 1.2.1.6.18, the filing of delinquent returns generally applies to six (6) years of non-filed/delinquent returns with managerial approval required for any additional years.

(1) The IRS will not provide a closing agreement for any submission. The delinquent returns received will be processed in accordance with IRM 4.4.9, Delinquent and SFR Processing.

(1) For penalty relief to be considered, the withholding agent must provide a request for penalty relief and include, at a minimum, the following items with their submission package:

1. A description of the current procedures the withholding agent uses to determine tax, withholding, and reporting obligations regarding payments to foreign persons, as previously mentioned.

2. A description of the failures in the withholding agent's tax, withholding, and reporting procedures for payments to foreign persons, why the failures occurred, and the years affected by such failures, as previously mentioned.

3. The number of persons affected by such failures and how the number was determined.

4. A calculation of the total amount of taxes the withholding agent failed to withhold, pay, or report, not including interest and penalties, for tax periods open for assessment or collection under the provisions of IRC 6501. This calculation should identify any adjustments under IRC 1463 for tax already paid and provide documentation of the same.

5. A list of the documents being provided with the submission.

6. A required penalties of perjury statement: The following declaration must accompany a submission, any information submitted after the original submission, or any subsequent change in the submission. "Under penalties of perjury, I declare that I have examined this submission, including the accompanying documents listed below, and to the best of my knowledge and belief the facts presented in support of this request are true, correct, and complete. "

7. The declaration must be signed by the withholding agent, not the withholding agent's representative, as stated under Treas. Reg. 301.6651–1 (c).

(1) In addition to the information described above the delinquent return filing must contain the following:

1. The related information return Forms 1042-S with signed Form 1042-T if filing on paper, or a schedule of them if filed electronically.

2. Information returns on Form 1042-S must indicate the withholding tax was paid by the withholding agent unless the withholding agent actually withheld the tax at the time the payment was made to the recipient.

3. Include a spreadsheet tying the information returns to the primary Form 1042 if there are more than 25 information returns.

4. A properly completed Form 2848, if applicable. To appear before the IRS regarding the submission, a representative must comply with the requirements of IRM 4.11.55.2.6.

(1) Send the signed, original delinquent tax returns, payment, and related information to:
Internal Revenue Service
Attn: WEIIC, W&C Team 1743
5100 River Road, MS 603
Schiller Park, IL 60176-1076

(2) Questions or messages relating to these procedures may be left at (630) 493-5009. Calls will normally be returned within 5 business days.

(1) The first step is a review of written procedure and training manuals such as:

• Summaries of withholding tax systems

• System flow charts covering payments made to account holders

• Internal control, audit reports or other information which relate to the withholding tax function

• Payment system design manuals

• Account opening procedure manuals

• Validation procedures for Form W-8

• Procedures for determining or classifying undocumented accounts;

• Deposit procedures

• Procedures to apply the reimbursement/set-off procedures (if applicable)

• Procedures to apply escrow procedures (if applicable)

• Application of presumption rules to undocumented accounts

• Other manuals related to functions that may have withholding tax implications

(1) Reconciliation: The gross income, net tax liability and withholding reported on Form 1042 should generally match the gross income and taxes withheld as determined by combining these amounts from all Forms 1042-S filed. To verify this, the examiner should obtain the taxpayer’s reconciliation workpapers and Forms 1042-S and should compare Form 1042 with aggregate amounts from Forms 1042-S. The examiner can also request for a computer audit specialist (CAS) to perform a reconciliation in certain cases of payments and Forms 1042-S contained in computer sensitive files.

(2) Deposit Requirements: The tax liability for each applicable period of the year (normally quarter-monthly which is the 7th, 15th, 22nd and last day of the month) is required to be shown in the Record of Federal Tax Liability section on Form 1042. The examiner should ensure that the withholding agent did not instead complete this section, in some situations, based on deposit dates, as this error may prevent identification of late deposits. The examiner should otherwise ensure that deposits were made timely by reviewing the taxpayer’s payments and deposits records. Due dates for deposits and associated penalties are discussed below:

• If the total withholding tax for a calendar year is less than $200, the tax can be paid when the tax return (Form 1042) is timely filed.

• If at the end of any calendar month the total amount of withholding tax is more than $200 but less than $2,000, the withholding agent must deposit the taxes within fifteen days after the end of the month.

• If at the end of any quarter-month period the withholding tax is $2,000 or more, the withholding agent must deposit taxes within three banking days after the end of the quarter-monthly period.

(3) Escrow Procedures: If the withholding agent applied escrow procedures under Treas. Reg. 1.1441-3(d) (e.g., determined by a review of Forms 1042-S or through a review of the withholding agent’s coding for withholding purposes), the examiner should also look at the Form 1042 filed for the previous year or any filed in the subsequent year to ensure that the reporting of withholding under these procedures was done correctly. The corollary rule for Chapter 4 can be found in Treas. Reg. 1.1471-2(a)(5)(ii).

1. Under the escrow procedures, if a withholding agent cannot determine the source of the income or the amount that is subject to withholding, it can withhold at the maximum rate of 30% but instead of depositing such amount withheld, it can elect to hold that 30% in escrow until the earlier of the date that the determination of the amount subject to withholding is made or one year from the date that the amount is placed in escrow at which time the withholding becomes due. To the extent that withholding is not required, the escrowed amount must be repaid to the payee.

2. If the escrow procedures are followed, a Form 1042 for a calendar year may include the income that was paid to all recipients during the calendar year but if escrow procedures were followed, the form will not include the tax withheld as part of the tax withheld or tax liability. Instead, such amounts will be reported as tax withheld and as part of the tax liability in the Form 1042 for the following year. See Instructions to Form 1042 for reporting requirements when applying escrow procedures.

(4) Adjustments for overwithholding: Examiners should also review whether the withholding agent applied the reimbursement or set-off procedures under Treas. Reg. 1.1461-2 , and if so, whether the application of such procedures was properly applied and reported on Forms 1042 and should compare to Forms 1042-S. See Instructions for Form 1042 and Instructions for Form 1042-S for additional guidance on how to account for adjustments for overwithholding on Forms 1042 and 1042-S.

(1) With the assistance of the CAS, year-end account statements (or the information included on them) should be obtained on a sample basis. The Forms 1042-S for these accounts should be compared to verify the correctness of such items as:

• Gross income (Box 2)

• Tax Withheld (Box 7)

• Income code (Box 1)

• Tax rate (Box 3b or 4b)

• Exemption code (Box 3a or 4a)

• Recipient status code (Boxes 13f and 13g)

• Recipient’s account number (Box 13k) (for an account for which a foreign TIN, or reasonable explanation for the absence of, is required (see Notice 2017-46))

(2) See Form 1042-S instructions for income, exemption and recipient codes, and other application form requirements. Tax treaty tables can be found at:https://www.irs.gov/individuals/international-taxpayers/tax-treaty-tables.

(1) Generally, a withholding agent will be considered to have reason to know a claim of foreign status or for a treaty-based withholding rate to be incorrect or unreliable if the statements contained in the withholding certificate or in other information which the withholding agent has, would cause a reasonable person to question the claims made. However, a more specific reason to know standard applies with respect to payments by financial institutions for determining a payee’s foreign status or entitlement to a claim for treaty benefits. See Treas. Reg. 1.1441-7(b)(3)(i) (limits on reason to know).

(1) Despite representations made on an otherwise valid withholding certificate or the presumption rules, a withholding agent must withhold and report based on its actual knowledge of facts concerning the recipient when that knowledge results in a higher rate of withholding than would have otherwise applied. For example, if a withholding agent makes a payment to a U.S. person and the withholding agent has actual knowledge that the U.S. person is acting as an agent for a foreign person, the withholding agent must treat the payment as if it was made to a foreign payee. (This example does not apply when the U.S. person is a financial institution.)

(1) For Chapter 3 purposes, if a withholding agent cannot reliably associate a payment with a valid withholding certificate (or documentary evidence, when permitted, that the withholding agent is permitted to rely upon under the reason to know or actual knowledge standards), the withholding agent must follow the presumption rules contained in Treas. Reg. 1.1441-1(b)(3) to determine the status of the payee for withholding and reporting purposes. The IRC 1441 presumption rules are summarized below.

(1) A person's permanent residence address is an address in the country where the person claims to be a resident for purposes of that country's income tax. In the case of a certificate furnished to claim a reduced rate of withholding under an income tax treaty, the residence must be determined in the manner prescribed under the applicable treaty. See Treas. Reg. 1.1441-6(b) and 1.1441-7(b)(6)(i).

(2) The examiner should check addresses indicated on records such as the customer master files, which may include changes in circumstance (i.e., new U.S. addresses or addresses outside treaty country) that have not been considered by the withholding agent for updating its certification forms.

(1) The U.S. withholding agent can rely on a Form W-8 with a defective address (i.e., one that renders the Form W-8 unreliable) to establish foreign status if it has obtained certain information or documentation as prescribed in Treas. Reg. 1.1441-7(b)(5)(i). Examples of such additional documentation for different types of taxpayers are in the following paragraphs. See the Instructions for the Requester of Forms W–8BEN, W–8BEN–E, W–8ECI, W–8EXP, and W–8IMY for further information on curing W-8 series forms.

(2) For individuals:

1. A valid identification issued by an authorized government body that is typically used for identification purposes that does not contain a U.S. address (e.g. passport, driver license), and

2. A reasonable written explanation from the account holder supporting foreign status.

(3) For entities:

1. Documentation establishing foreign status that substantiates that the entity is organized or created under the laws of a foreign country. For a payment made with respect to an offshore obligation, see Treas. Reg. 1.1441-7(b)(5)(i)(B)(2).

2. The figure below shows examples of documentation which can be accepted for an entity:

Note: More specific rules apply with respect to a treaty claim as the withholding agent much have documentation supporting residency in the treaty country. See Treas. Reg. 1.1441-7(b)(6).

(1) An examiner should pay special attention to a withholding certificate that was provided after the date of payment. Such a withholding certificate is acceptable if it contains an affidavit that states that the information on the withholding certificate was accurate at the time of payment, and, if the certificate is a Form W-8ECI, the information described in (2) below. The affidavit should be signed by the payee under penalties of perjury and dated. It can be added to the bottom of the form or on a separate page attached to the form.

(2) If the withholding certificate is received more than a year after the date of payment, the withholding certificate is acceptable if, in addition to the affidavit, the withholding agent obtains documentary evidence that supports claim of foreign status and or treaty claim. Examples of acceptable documentary evidence supporting a claim of foreign status includes: an individual’s government identification which does not contain a U.S. address or a certificate of incorporation from a foreign country. See Treas. Reg. 1.1471-3(c)(5)(i). Documentary evidence supporting an individual’s treaty claim includes any government issued identification that includes the individual’s name, address, and photograph that has been issued no more than three years prior to presentation to the withholding agent. If older than three years, additional evidence of the person’s residence in the treaty country is needed (i.e., a bank statement, utility bills, or medical bills). See Treas. Reg. 1.1441-6(c)(4)(i). For entities, the documentary evidence needed includes any official government document that includes the name of the entity and the address of its principal office in the treaty country. See Treas. Reg. 1.1441-6(c)(4)(ii).

(3) If the withholding certificate that is provided after the date of payment is a Form W- 8ECI, Certificate of Foreign Person's Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, the affidavit must include certain information regarding the inclusion of that income in the recipient’s U.S. income tax return. Specifically, in addition to indicating that the information and representations contained on the certificate were accurate at the time of the payment, it must indicate that either (i) the beneficial owner has included the income on its U.S. income tax return for the taxable year in which the income must be reported, or (ii) the beneficial owner will include the income on its U.S. income tax return for the taxable year in which the income must be reported and the due date for filing the return (including any applicable extensions) is after the date on which the affidavit is signed. See Treas. Reg. 1.1441-1(b)(7)(ii)(B) .

(4) The examiner may consider, among other factors, the following factors in determining whether a withholding certificate received after the date of payment (or other documentation or documentary evidence if the payment is made with respect to an offshore obligation) should be accepted for purposes of allowing a reduced withholding rate with respect to payments to foreign persons:

1. Whether information and representations on a later secured withholding certificate (or on other documentation if it is an offshore obligation) provided are consistent with information in the account file or in other records maintained by the withholding agent. The examiner should request and review all account files as a result.

2. Whether the withholding certificate (or other documentation if it is an offshore obligation) establishes facts in existence at the time the relevant payments were made.

(1) Under ordinary circumstances, absent actual knowledge or reason to know otherwise, a withholding agent may rely on a claim of exemption (for effectively connected income) if, prior to the payment to a foreign person, the withholding agent can reliably associate the payment with a Form W-8ECI, Treas. Reg. 1.1441-4(a)(2)(i).

(2) If an examiner determines that Form W-8ECI is unreliable because the person has not reported the income identified on the form, the examiner should contact the Foreign Payments Practice (FPP) Program Office, Team 1190 manager regarding unreliable Form W-8ECIs.

(3) Notification to Withholding Agent - The examiner may be able to determine and then notify the withholding agent that the Form W-8ECI being used is unreliable and can no longer be honored and therefore they should begin withholding at 30%. If appropriate, Counsel will draft a letter to the withholding agent which will serve as the notification of the unreliable Form W- 8ECI. The letter will inform the withholding agent that it can no longer accept Form W- 8ECI from this particular recipient. Due to IRC 6103, the reason why the Form W-8ECI is unreliable may not be disclosed to the withholding agent.

1. If the foreign person submitted Forms W-8ECI to other withholding agents, the examiner cannot disclose the foreign person’s filing status to these other agents.

2. The examiner should consult with Counsel if they are contemplating providing any other information about the payee in question to the withholding agent.

(4) At the time that the notification letters are issued, the examiner will complete a Form 3870, Request for Adjustment, and submit the form to the manager who will forward it to the proper individual for processing. This will enable the issuance of the notification letter to appear on the withholding agent’s transcript. A separate Form 3870 must be prepared for each unreliable Form W-8ECI. The information needed in the Form 3870 request includes:

1. Withholding Agent 1042 module (EIN, TY, and MFT 12)

2. Transaction Code - 971, Action Code - 710

3. Recipient’s TIN, RECIP Name Control (4 characters), and 20 characters to note date letter was received.

(5) For future cycles, examiners should confirm that withholding agents who have been issued letters are now withholding tax with respect to payments to the particular recipient. If the withholding agent has ceased making payments to that particular recipient, no withholding tax is due.

(1) REIT distributions to foreign shareholders are subject to NRA withholding, except when the distribution is designated as a capital gain dividend, a return of basis, or a distribution of more than the shareholder’s basis in the REIT stock. Treas. Reg. 1.1441- 3(c)(4)(i)(C). For capital gain dividends, a 21% withholding tax applies under IRC 1445 (35% for 2017 and prior years). See IRC 1445(e)(6) and Treas. Reg. 1.1445-8. As enacted under the American Jobs Creation Act of 2004, however, capital gain distributions are not taxed under IRC 1445 for foreign shareholders owning REIT stock regularly traded on a U. S. exchange that have not held more than 10% of such class of REIT’s stock (5% for dispositions before December 18, 2015). Such distributions are instead subject to NRA withholding. Also, a "qualified foreign pension fund" is not subject to withholding under IRC 1445 on the capital gain dividend portion of a distribution by a REIT. The examiner should question how the withholding agent determines the correct withholding rate and should spot check several REIT (or RIC) distributions.

(2) Generally, similar rules apply to a Regulated Investment Company (RIC) that is a "Qualified Investment Entity" (see IRC 1445(e)(6)).

(1) Generally, NRA withholding applies to the redemption of OID debt obligations whenever a calculation of OID is included in the amount of the redemption. The portfolio interest exemption or treaty reductions may reduce or eliminate the NRA withholding tax. Redemptions of obligations that carry OID are subject to withholding tax whether the redemptions are early or as originally scheduled. The amount subject to withholding tax is the amount accrued to the holder from the date of purchase, as determined by the withholding agent, reduced by any amount of OID that was considered prior to that time (due to a payment made on the obligation).

(2) If the withholding agent has not been provided with reliable date of purchase information or cannot otherwise calculate the amount of OID that accrued to the holder, then the withholding agent must withhold on the entire amount of OID accrued since the obligation’s issuance until the date of redemption. In determining the taxable amount of OID, a withholding agent may rely on information provided in Pub 1212, List of Original Issue Discount Instruments. The amount of taxable OID (including OID that is portfolio interest) is reportable on Form 1042-S. Short-term OID (i.e., on an obligation with a maturity of 183 days or less from the date of original issue) is not subject to NRA withholding tax or reporting on Form 1042-S. Banks and brokerages often use an outside service to compute the annual OID on marketable securities as the information is required for 1099 reporting to U.S. residents.

(1) When a loan of securities is outstanding during the record date for a dividend or interest payment, the lender of the securities is, among other things, typically entitled to a payment from the borrower to account for the foregone dividend or interest (i.e., since the lender is not the holder of record on the record date). The payment made by the borrower of securities is called a “substitute dividend” or "substitute interest", which may be subject to NRA withholding tax if paid to foreign persons.

(2) A "look-through" rule applies to define the character and source of the substitute amount paid relating to the loan of any securities. Based on the “look-through” rule, a substitute interest amount is treated as portfolio interest for NRA withholding purposes if the underlying security generates portfolio interest regarding the payment. These rules further apply to security lending transactions between foreign counterparties, subject to provisions to mitigate over-withholding that could result from repeated lending of the same underlying security. See Notice 2018-5, 2018-6 I.R.B. 341.

(3) Any substitute dividend payments made pursuant to a securities lending transaction, sale-repurchase, or a substantially similar transaction that references an underlying security is a dividend equivalent. An underlying security is any interest in an entity that could give rise to a U.S. source dividend, considering rules for derivatives that reference partnership interests. As a dividend equivalent, the substitute dividend payment is treated as U.S. source dividend that is subject to withholding.

(4) A financial institution may borrow securities for short sales or when sellers fail to deliver securities in sales transactions. As a borrower, the financial institution is responsible for any withholding required on payments to the lender. A financial institution may also act as an intermediary or counterparty in securities lending transactions between unrelated counterparties. If a financial institution that is a custodian loans a security of its customer that is a foreign person, it is responsible for any withholding on subsequent payments made to the customer.

(1) Commercial banks sometimes offer their larger accounts preferred treatment. One of these benefits is earning interest on the balance at the close of the business day. Typically, the balances are combined and used to purchase interest bearing securities. The next business day the interest earned is credited to the customer’s account.

(1) Under U.S. tax principles, a REPO is typically characterized as a collateralized loan where the purchaser of the underlying security is deemed to be a lender of funds to the seller in the amount of the purchase price. The seller of the security is treated as the borrower. The loan is for the period until the REPO matures, when the securities are sold back to the original seller (i.e., the cash borrower). Typically, the repurchase price exceeds the original sales price, giving rise to a charge treated as financing interest.

(2) If the financing interest is U.S. sourced and paid to a foreign person, it may be subject to NRA withholding. See Treas. Reg. 1.1441-2(a)(3), (5) and (6) for exceptions from withholding that may apply. In addition, an examiner may find substitute payments (dividend or interest) made by the cash lender to the borrower as part of the REPO. These substitute payments are like those typically seen in securities lending transactions, whose sourcing is determined with respect to the underlying security for withholding and reporting purposes. See the Securities Lending section and IRC 1058 for more information.

(3) Financial institutions engage in REPOs for obtaining or making short-term financing or for acting as dealers in transactions between unrelated counterparties (including so-called "tri-party" REPO transactions made to support the obligations of the counterparties).

(1) Except as provided in (2) below, there is no NRA withholding obligation on payments made under NPCs described in Treas. Reg. 1.863-7(a) or 1.988-2(e) to foreign persons because the income is foreign source income. See Treas. Reg. 1.1441- 4(a)(3). However, if these payments are ECI or presumed to be ECI as to the foreign person, the withholding agent is required to report such payment on Form 1042-S indicating the exemption from withholding because it is ECI. See Treas. Reg. 1.1441-4(a)(3). A withholding agent must presume the payments as ECI if the income is paid to, or to the account of, a qualified business unit of a foreign person located in the U.S. If the payment is paid to, or to the account of, a qualified business unit of a foreign person located outside the U.S., the income must be treated as ECI if the withholding agent knows or has reason to know that the income relates to the conduct of a trade or business within the U.S. The ECI presumption may be rebutted by a withholding certificate representing that the payments are not effectively connected with the conduct of a U.S. trade or business. Instead of a withholding tax certificate, a payee may represent in a master agreement governing the transactions in NPCs between the parties that the counterparty is a U.S. person or a non-U.S. branch of a foreign person. Income on NPCs that is regarded as embedded interest or recharacterized as certain other payments under U.S. tax principles might be subject to NRA withholding and reporting.

(2) There is NRA withholding obligation on payments under an NPC when the payment references a dividend from an underlying security and the NPC is a specified notional principal contract (SNPC). Those payments are dividend equivalents under IRC 871(m). Treas. Reg. 1.871-15(c)(ii). An underlying security is any interest in an entity that could give rise to a U.S. source dividend, considering rules for derivatives that reference partnership interests. See Treas. Reg. 1.871-15(a)(15) and (m). As a dividend equivalent, the payment pursuant to the SNPC that references the payment of a dividend is treated as a U.S. source dividend that is subject to withholding. A withholding agent is required to withhold on the amount of the payment that is a dividend equivalent. Treas. Reg. 1.1441-7(a)(2). A specified NPC may include other payments that are not dividend equivalents. For those payments, there is no NRA withholding obligation on payments made under NPCs described in Treas. Reg. 1.863-7(a) or 1.988-2(e) to foreign persons. See Treas. Reg. 1.1441-4(a)(3).

(3) A financial institution engages in SNPC transactions when acting in a dealer capacity or for taking proprietary long and short positions in underlying securities (or as hedges of other transactions).

(1) There is NRA withholding obligation on payments under an ELI when the payment references a dividend from an underlying security and the ELI is a specified ELI. See Treas. Reg. 1.871-15(c) and (e).  An ELI is a financial transaction, other than a securities lending transaction, sale-repurchase transaction, or an NPC, that references the value of one or more underlying securities. Treas. Reg. 1.871-15(a)(4).  Examples of an ELI include, but are not limited to, a forward contract, a futures contract, an option, or a structured note. The payments made by that reference to a dividend from an underlying security are treated as dividend equivalents. A dividend equivalent is a U.S. source payment that is subject to withholding. Treas. Reg. 1.871-15(b).  A withholding agent is required to withhold on the amount of the payment that is a dividend equivalent. Treas. Reg. 1.1441-7(a)(2). A specified ELI may include other payments that are not dividend equivalents.  The withholding obligations for those other payments will depend on the type of instrument and the characterization of those other payments.  

(1) A syndicated loan or loan participation results when financial institutions collectively participate in funding a single loan with a lead bank. In some cases, each participating bank will be considered a direct lender, where in other cases the arrangement may be considered a separate loan between the lead bank and the participating banks (though the separate loan does serve to fund the original loan). Generally, the lead bank will act as an administrator, which will be the withholding agent. Generally, the Agent Bank maintains records of loan ownership. It processes loan assignments and corporate actions. It collects and pays principal and interest payments and applicable shares of loan fees to lenders that participate in the loan. Thus, the Agent Bank must determine the source and character of the income, collect valid U.S. tax forms from the lenders and apply the correct rate of U.S. withholding tax and/or exemption where applicable. The following issues should be considered related to syndicated loans/loan participations:

1. Bank loan exception: IRC 871(h) and IRC 881(c) generally provide that a non-U.S. person is exempt from the 30 percent NRA withholding tax on portfolio interest. There are several limitations on this exemption. One is the “bank loan exception”. The portfolio interest exemption does not apply to any U.S. source interest received by a bank on the extension of credit made pursuant to a loan agreement entered in the ordinary course of its trade or business. See IRC 881(c)(3)(A). Accordingly, foreign banks, who are participants in a syndicated loan, should not generally benefit from the portfolio interest exemption. As a result, the examiner should consider whether the arrangement should be properly treated as a direct loan made by each participating foreign bank in cases in which the lead bank is a foreign bank.

2. Change in participants to the loan: Often the participants will change. For example, when the original participants sell all or a portion of their interests in the loan to another bank, withholding related documentation is required from the new participants.

3. Required NRA withholding agent’s responsibilities: An audit concern is to determine if required Forms 1042 and 1042-S were not filed and/or Forms W-8 were not secured from the participating banks.

(1) Reportable amounts that withholding agents pay to foreign intermediaries or foreign flow-through entities require specific treatment because intermediaries and flow-through entities are not beneficial owners of income. Examples of flow-through entities are foreign partnerships, foreign simple and foreign grantor trusts, and, for payments for which a reduced rate of withholding is claimed under an income tax treaty, any entity to the extent it is considered to be fiscally transparent with respect to the payment by an interest holder’s jurisdiction.

(2) Foreign intermediaries and flow-through entities must provide the financial institution withholding agent a Form W-8IMY. This form indicates that the entity is not the beneficial owner of the reportable amount. The form also indicates if they have entered into an agreement with the IRS to act as a withholding agent (i.e., qualified intermediary, withholding foreign partnership or withholding foreign trust) for certain payments.

(3) Foreign financial institutions and certain intermediaries that are non-financial entities can enter into an agreement with the IRS to act as a qualified intermediary (QI). All foreign intermediaries, who do not have an agreement with the IRS to act as QIs are, by default, non-qualified intermediaries (NQIs). See Rev. Proc. 2017-15.

(4) Foreign partnerships, foreign simple or foreign grantor trusts, can elect to enter into an agreement with the IRS to become a withholding foreign partnership (WP) or a withholding foreign trust (WT). A foreign flow-through entity that has not become a WP or a WT is, by default, a nonwithholding foreign partnership (NWP) or a nonwithholding foreign trust (NWT). See Rev. Proc. 2017- 21.

(1) Foreign targeted debt in bearer form issued before March 19, 2012 may also qualify for the portfolio interest exemption if it meets certain requirements. See IRC 871(h)(2) and IRC 881(c)(2).

(2) A bearer obligation is one that is not in registered form. The bearer obligation is foreign targeted when it meets the following three requirements:

1. There are arrangements to ensure that the obligations are not sold to U.S. persons.

2. Payment of interest is made outside the U.S. and its possessions.

3. The face of the obligation states that any U.S. person who owns the obligation will be subject to U.S. taxation. See IRC 163(f)(2).

(3) None can be issued after March 18, 2012 per the HIRE Act.

(1) The following are interest income payments that do not qualify for the portfolio interest exemption even when the interest is paid with respect to a registered or foreign targeted bearer obligation:

1. Interest which is paid to a foreign person who owns directly or indirectly 10 percent or more of the entity paying the interest

2. Interest which is paid to a foreign bank on the extension of credit made pursuant to a loan agreement entered in the ordinary course of the bank’s trade or business

3. Interest which is paid to a foreign controlled corporation from a person related to that foreign controlled corporation

4. Contingent interest paid to a foreign person such that payments resemble dividends

(1) This first step requires the analysis of the vendor file to identify payees that may be foreign persons. The vendor file is a listing of all payees, including names and other pertinent information relating to the payee. All payees who meet one or more of the following criteria should be a possible foreign payee:

1. Payee’s EIN starting with 98-xxxxxxx

   Note: Only foreign corporations have EINs beginning with 98, and some may begin in 33.)

2. Payee’s ITIN starting with certain numbering ranges. See IRM 3.13.5.22, Individual Taxpayer Identification Number (ITIN) Format.

3. Country: not U.S. or blank

4. Zip Code: not U.S. format

5. State: not a U.S. state or blank

6. City: foreign city

7. Vendor number, if coded for foreign payees

8. Any other factors which indicate possible foreign status

(2) The above are recommended indicators to determine that the payee may be foreign. The examiner should review the vendor file to set any other criteria that may be used for the taxpayer.

(3) Some of the payees selected may be U.S. persons. Therefore, it is recommended that this list of possible foreign payees should be presented to the taxpayer for their review. If the taxpayer can establish that the payee is not foreign, the name should be removed from further review.

(1) In step two determine which of the payments to foreign payees are payments of FDAP income. Not all payments to the foreign payees selected in step one would be FDAP income. The examiner should consider the facts and circumstances of each taxpayer in determining all possible payments which may result in FDAP income to the foreign person. Some of the most common expenses paid by the taxpayer that may result in FDAP income payments to the foreign payees (both corporations and individuals) are:

1. Interest

2. Royalties, patents, copyrights (payments for intellectual assets)

3. Royalties – natural resources (payments for timber, oil, coal)

4. Rents

5. Dividends

6. Amounts paid to nonresident alien independent contractors for services rendered in the United States

7. Annuities and pensions paid to nonresident aliens previously employed by the U.S. entity or group

8. Salaries, wages remuneration paid directly by a U.S. person to its nonresident alien employees, directors

(2) It is recommended that the examiner should first test the accuracy of how expenses are categorized by the taxpayer before step two is performed. Often expenses are not accurately categorized by the taxpayer. For example, a contract for computer hardware might include a service component, such as training and maintenance services provided by the foreign payee.

(3) Once the examiner has determined the validity of the categorization, the step two analysis can be performed. The examiner should at least review material payments that may be FDAP even though the taxpayer did not correctly categorize them as such. The examiner should compile all payments of the selected expenses paid to the foreign payees.

(1) At this point the examiner has determined payments to foreign payees that are FDAP income. The source of the income (U.S. sourced vs. foreign sourced) should now be determined. See the summary of general sourcing rules from IRC 861, IRC 863, and IRC 865 in Figure 4.10.21-2 below.

(2) The regulations under Treas. Reg. 1.1441-2(a) require that the income payments be presumed U.S. source when the source is not known to the payer. Therefore, any FDAP income determined in step 2 that the source is unknown to the payer is presumed to be U.S. sourced and subject to a 30% withholding tax. The taxpayer has the burden of proof to overcome the presumption.

(1) Generally, the Form 5471 is required to be filed by a U.S. person having certain ownership interests in certain foreign corporations. A separate Form 5471 is required to be filed with respect to each foreign corporation meeting these ownership rules. This IRM will focus on the Schedule M attached to the Form 5471. Schedule M is completed by a U.S. person who has controlling interest in a foreign corporation that is a controlled foreign corporation (CFC). See IRC 957. Schedule M reports transactions between the taxpayer and its CFC and reports the following payments made by the taxpayer to the CFC, some of which may be U.S. sourced FDAP income to the CFC:

1. Compensation received

2. Commissions received

3. Rents received

4. Royalties received

5. License fees received

6. Interest received

7. Dividends received

(1) A separate Form 5472 is filed by a corporation with respect to each foreign shareholder owning 25% or more of a U.S. taxpayer. Part IV of the Form reports the following payments by the taxpayer to the foreign corporation, which may be U.S. sourced FDAP income to the foreign corporation:

1. Compensation / Consideration received

2. Commissions received

3. Rents received

4. Royalties received

5. Interest received