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The Long Arm of the IRS

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It used to be that the phrase “The Long Arm of the Law” applied to catching fugitives but recently in this decade the term “fugitive” can be replaced with “U.S. taxpayer”. Since the passing of Foreign Account Tax Compliance Act (FATCA) in March 2010 in order to catch U.S. tax cheats who hide assets and money offshore, many U.S. taxpayers abroad have voluntarily filed tax returns and reports to the appropriate U.S. authorities to divulge their foreign assets and pay any taxes owing to avoid hefty civil penalties and in some extreme cases, criminal penalties. Unfortunately, FATCA not only affects U.S. citizens and U.S. resident aliens with foreign investments, it also affects many foreign individual and businesses with U.S. source income resident in countries that have agreed to FATCA such as Canada, the U.K and China.

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Absent an exception under U.S. tax law or U.S. tax treaty, a foreign (non-U.S.) person or entity that has any U.S. source income is generally subject to U.S. income tax. There are two types of taxable U.S. source income: 1) fixed, determinable, annual, or periodical (FDAP) income, and 2) effectively connected income (ECI). To avoid getting too technical, for simplicity reasons let us define ECI as U.S. source business income and FDAP as all other U.S. source income excluding gains from property.

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Even before FATCA, the IRS had implemented methods of making foreign (non-U.S.) taxpayers pay U.S. income tax through a withholding tax system in which the U.S. tax laws automatically “volunteers” the U.S. payer of income to become the withholding agent of the IRS. A withholding agent that fails to withhold on payments to foreign recipients could be liable for the withholding tax. Even if the withholding agent is caught by the IRS and forced to pay the withholding tax that it failed to collect and remit, it does not relieve the foreign payee from being liable for the same withholding tax. In those cases, the IRS could potentially receive a windfall in collecting the withholding tax twice.

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For FDAP income the default withholding rate is 30% unless reduced by a U.S. Tax Treaty with the foreign taxpayer’s country of residence. Depending on the specific U.S. tax treaty and type of income, the withholding tax could be reduced to zero.

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For foreign corporations that have U.S. ECI or U.S. business income, there is no U.S. withholding tax if the Corporation provides proof to the U.S. payer that such income is ECI. This tells the U.S. payer that the Corporation is subject to U.S. corporate income tax on such income and thus withholding is not required. For foreign corporations, U.S. ECI is taxed at gradual tax rates which range from 15% to 35% federally.

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But what if you had U.S. ECI from a partnership with foreign non-U.S. partners? The U.S. withholding regulations also have that covered. Partnerships are considered flow-through entities and do not pay U.S. federal income tax at the partnership level and instead the partners pay tax on their share of the partnership’s profits. If any partnership has foreign partners, the partnership is deemed the withholding agent and must withhold at the top tax rate for that particular foreign partner. So if the foreign partner is a foreign corporation, the withholding would be at the 35% maximum rate (39.6% for individuals).

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Withholding tax is required even when you sell property situated in the U.S., such as a U.S. vacation property. Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), the buyer becomes the IRS’s withholding agent and must withhold 15% of the amount realized (usually gross proceeds). Certain exceptions to FIRPTA may apply so you should contact your U.S. tax advisor for more information.

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So before FATCA, the IRS had an army of withholding agents and now after FATCA, it now has another ally in foreign (non-U.S.) financial institutions such as your local bank. Under FATCA, each foreign financial institution must put into its internal controls a system to find U.S. taxpayers. Once a red flag is triggered, such as a U.S. mailing address, the bank will send the account owner a form to complete. Once that form is complete and a U.S. taxpayer is identified, under FATCA the bank could send the information to the IRS or to the resident country’s tax authority to be then sent to the IRS depending on the FATCA agreement signed with the taxpayer’s resident country. A red flag can be triggered if the account balance is over a certain amount or the recipient is receiving U.S. income from the financial institution so even non-U.S. residents and non-U.S. corporations are receiving these forms. Each bank may have its own different form but the information requested is generally the same.

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If you receive these forms from your financial institution and you are a U.S. citizen or green card holder and have not filed returns please contact an international tax specialist as soon as possible. Even if you are not a U.S. citizen or resident, do not ignore them since failure to respond could result in a 30% withholding tax on your U.S. source income or account closure. If you have been “on the run” from the IRS it has now become even harder to escape their “Long Arms”.

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About the Author:

Lionel Chen is Director of US Corporate Tax Services with Trowbridge, a firm specializing in international tax. Since 1997, Lionel has assisted his clients with cross border tax issues to successfully navigate the U.S. tax system. Having worked as both an independent consultant and a Big 4 tax manager, Lionel has worked with a wide range of clients from owner-managed businesses, billion dollar companies and accounting firms. In addition, he has consulted clients with U.S. businesses on tax efficient structures and reorganizations such as mergers, acquisitions, and divestitures. For more information, please contact him below.