The IRS has issued proposed new regulations that will further delay the imposition of withholding tax on foreign passthru payments, remove the potential imposition of withholding tax on gross payments and clarify the meaning of the definition of “investment entity financial institution”.
The US enacted the Foreign Account Tax Compliance Act (FATCA) and related regulations designed to use foreign financial institutions (FFIs) to combat tax evasion by US taxpayers with offshore investments. These rules, the principle consequences of which came into effect from 01 July 2014, require foreign financial institutions to report certain information about financial accounts held by specified US persons or suffer a 30% withholding tax on US related payments received. FATCA withholdings can be made by US withholding agents. The FATCA regulations also require a participating FFI to withhold 30% of any “passthru payment” to certain recalcitrant account holders or FFIs that do not meet the FATCA requirements (non-participating FFIs), although this obligation has been modified by the intergovernmental agreements (IGAs) between the US and many other jurisdictions.
“Passthru payments” means any “withholdable payment” and any “foreign passthru payment” and the implementation of such FATCA withholding obligations were intended to be phased in. There are two types of withholdable payments, one of which relates to payments of interest, dividends, rents, royalties and other fixed or determinable income from US sources (so-called “FDAP” withholding), and was brought into effect from 01 July 2014. The other type of withholdable payment relates to the gross proceeds from the sale or other disposition of property that can produce dividends or interests with a US source (so-called “gross proceed withholding”), which after previous delays was expected to be required from 01 January 2019.
On the basis of the desire to reduce the compliance burden of FATCA withholdings, the proposed regulations would scrap the introduction of gross proceed withholding altogether. The US considers that the existing FDAP withholding is a sufficient incentive for FFIs invested in US securities to comply with FATCA, and that such additional type of FATCA withholding was not required to be introduced in light of wide compliance with FATCA.
The imposition of a withholding tax on so-called “foreign passthru payments” has remained largely theoretical due, in part, to the fact that the US rules have, so far, not defined the term. In practice, the IRS have repeatedly issued guidance deferring the date when withholding on these payments would begin and in 2017 provided that such withholding would not begin until the later of 01 January 2019 or the date of publication of regulations defining the term “foreign passthru payment.” The IRS has now issued proposed regulations
that will, if enacted, delay the imposition of withholding tax even further to, at earliest, two years after the date of publication of regulations defining the term “foreign passthru payment”.
Importantly, the proposed delay of foreign passthru payment withholding means that more obligations issued by FFIs, such as bonds, notes and loans, may potentially benefit from grandfathering for existing obligations. Obligations issued by foreign financial institutions that are outstanding at any time up to six months after the publication date of regulations defining foreign passthru payments will be grandfathered and therefore exempt from any withholding.
It should be noted that most FFIs in Model 1 IGA jurisdictions are not currently required to make FATCA withholdings (on FDAP payments) on the basis of the terms of those IGAs. It remains to be seen whether and to what extent foreign passthru payment withholding (if any when finally introduced) will be applicable to FFIs in such jurisdictions.
Finally, another change included in the proposed regulations is an amendment to the definition of “investment entity” for the purposes of defining a “financial institution” to bring into line with the OECD Common Reporting Standard (CRS) interpretation. The IRS has clarified that if a financial institution sells an entity an investment in a collective investment vehicle that is widely held and benefits from investor protection legislation, that will not itself cause the investor to qualify as an “investment entity financial institution” on the basis of being “managed by” another financial institution. However, an investor investing via discretionary mandate arrangements may continue to be considered an investment entity financial institution on the basis that the discretionary authority of the financial institution over the entity can cause the entity to be “managed by” another entity that is a financial institution.
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