US International Inbound Tax Issues: A Tax Advisor’s MusingsBy Julio M. Jimenez | June 13, 2019
As the US finalizes regulations under its tax reform provisions, many parties outside the US are scratching their heads wondering what, if anything, still affects them. On top of the tumultuous tax reform, there are still some creatures from even before tax reform that loom, lurking in the shadows waiting to strike and catch taxpayers off guard. Global compliance efforts are at an all-time high. Being an in-house tax advisor is not the same now as it was 10 years ago in 2009, much less 20 years ago in 1999. Brexit, trade wars, cryptocurrency, IRS scams, BEPS, GAAR, and BEAT, court rulings in the US, UK, France, Luxembourg and Germany, the crescendo of the tax shelter wars, transfer pricing scuffles, new treaties held up indefinitely in the US Senate, new US judges – the news is replete with stories out of a surrealist horror novel. Many out there wonder what still matters, what matters to them, and what is still lurking from the land before time.
Without getting into detail or legal precision, but rather presenting things in broad strokes, we need to focus on what things need to be kept in mind. As we know, very broadly speaking, the US is still a curious beast when it comes to taxation (among other things). Regardless of the effects of tax reform, the US remains a bit of a hybrid system – a worldwide taxation system for its citizens and permanent residents, mixed with a territorial limited taxation system on non-US taxpayers coming into the US. Regardless of how academia might evaluate the conundrum that is the US tax system, the US still lives in a hybrid tax realm of a worldwide system with territorial components, regardless of how much tax reform tried to erode it away.
For non-US taxpayers (non-resident aliens or ‘NRAs’), the US provides two categories: (1) NRAs passively investing into the US and (2) NRAs engaged in a US trade or business. This is what we call ‘inbound’ taxation; non-US taxpayers seeking economic exposure to the US. Under the first category, the passive investors are generally withheld at source on a gross basis by payors of particular investment type income that is also considered to be US sourced. For the second category, those engaged in a US trade or business, they file a US income tax return and are taxed on a net basis, allowing deductions etc.
For US citizens and residents with activities outside the US (again, broadly speaking), the US taxes them on their worldwide income. There are certain types of relief afforded to them, including tax credits and deferrals, although after US tax reform, it is less of a deferral relief and more of a “stick” for some types of income (GILTI) and a “carrot” consisting of a lower tax rate for some offshore income (FDII). This tax landscape is what we call ‘Outbound’: US taxpayers doing “stuff” outside the US.
Keeping this architecture in mind, here is a cursory survey of what the new US inbound landscape looks like and what items must be on your radar. While there certainly are outbound and domestic US tax issues that are equally important, this article will focus on the US international inbound landscape:
For those outside the US looking to invest into US markets or get exposure to US stocks, bonds, derivatives, deposits, alternative investments, mutual funds, investment funds, commodities, annuities, royalties, etc. (i.e. putting money into something other than real estate and then just sitting back), the US requires the payor of the US-sourced “fixed, determinable, annual and periodic income” (known as ‘FDAP’) to withhold at a gross basis of 30% tax, or less if a treaty provides relief. Some other issues may have you suffering withholding tax at a lower rate, such as real estate or partnership sales. A few noteworthy items include:
Section 871(m) – In the old days, the only way for an NRA to suffer US tax on a dividend was to own the actual physical stock (lending it or holding it directly). Under section 871(m) and the regulations thereunder, any type of instrument referencing a US equity may be in scope for US taxation, even if no cash is actually paid on the instrument. Since 2018, instruments have been in scope if they are designed to economically mirror the underlying stock dollar for dollar, but for January 2021, that threshold lowers to what is tantamount to a rough 80% correlation (or substantially equivalent to 80%). This may cause not only tax drag on your investments, but create reporting, recordkeeping, and regulatory compliance requirements as well as data system nightmares.
Section 305(c) – Variations of a theme here, but convertible bonds have always been deemed to pay a dividend when the conversion ratio is adjusted, even if no actual cash is distributed. What is new? Two years ago, the industry began withholding on those dividends due to new regulations. There are a few ways to calculate the tax, so make sure you are using the most favorable method.
Section 1446(f) – Tax reform introduced a new provision taxing partnership interest transfers involving non-US parties with a 10% percent withholding tax. The IRS issued proposed regulations a few weeks ago, including provisions affecting publicly traded partnerships. As a side note, investments in derivatives based on master limited partnerships have been examined by the IRS under the constructive ownership rules.
Cryptocurrency – Investments in cryptocurrency were hotter than pancakes on a Christmas morning, then not so much, then again, then not so much again, then…you get the idea. Tax rules are sorely needed, and this past May, the IRS promised special tax rules addressing cryptocurrency promptly. While it is not foreign currency per se for US tax purposes, it isn’t the same as property either. Keep an eye out for cryptocurrency rules from the IRS in the very near future
Updated Withholding Tax Forms 1042/1042-S – From a compliance perspective, as we can expect, the IRS has updated its Form 1042 withholding tax return regime to make room for the new categories and new taxes, including excise taxes. Make sure you are familiar with the new lines on the forms.
Treaty changes – The US Senate is charged with ratifying treaties that have been signed by the President. The Senator who Chairs the committee to begin this process, Senator Rand Paul and Treasury are at an impossible impasse, since as of early June, it was reported that talks between them for ratifying tax treaties have gone colder than an Alaskan winter. Various organizations have written to the committee requesting ratification of various treaties requiring updating, already signed by a President. Given the change in the political climate, expect 2020 to potentially bring new, updated treaties. In the meantime, treaties with the US are still available, and there may be many issues to manage, particularly with the OECD issuing new reports earlier this year, at the end of last year, and more to come. Even if Brexit happens, or doesn’t happen, the US treaty network is still available.
IRS Enforcement – Last December and earlier this past May, the IRS made it a point to indicate that examination of foreign payments is a priority, training thousands of new agents. Expect audits of your withholding agents and custodians.
For those outside the US that are involved in a US trade or business, many new items will be on the horizon, whether a business owns US holding companies, operational subsidiaries, or partake in direct presence in the US. Regardless of the structure and approach used, some important issues that require attention include, but are not limited to:
BEAT – The Base Erosion and Anti-abuse Tax is perhaps the most controversial provision affecting US inbound taxation. Comment letters poured into the Treasury Department when the proposed regulations were issued last year, and thus final regulations are expected shortly. Under BEAT, payments leaving the US to a non-US parent or related non-US entity may have tax consequences in the US. Questions on thresholds, definitions, and many other items are still unanswered, but the proposed regulations shed some light. BEAT affects broker/dealers with an even higher tax rate than it affects other taxpayers. It is essential to know this provision well.
The “Broker Shield” – The IRS has stepped up enforcement activities reviewing structures designed to avoid engagement in a US trade or business, including treaty use of agents of independent status, use of independent agents, section 864(b)(2) exceptions for traders of securities and commodities; and activity thresholds in general. Any structuring used to avoid a US presence should be thoroughly reviewed and documented.
Import/Export/Tariffs – The trade war situation is a red herring for tax veterans. The real issue is the tax treatment of inventory, risk management, and distribution agreements. In the US, the tax rules for such items and distribution arrangements do not always conform with the accounting rules.
FDII - The new tax reform carrot of FDII, Foreign-Derived Intangible Income (a true misnomer as it looks to other types of income) may have the effect of increasing US competition in other jurisdictions. US companies may get a tax benefit for certain income earned outside the US under a complicated formulation. It may also help a US subsidiary or sister entity.
Information reporting and disclosures – Everything from FBARs to Forms 5471, 8865, 8889 and 8938s – a veritable alphabet soup of compliance forms – now give the IRS a more complete picture of cross-border business activities and global income. Combined with common reporting standards, copious repetitive data may overburden what was once a much easier task. Moreover, as of spring 2019, IRS examinations on these fronts have increased three-fold, with many penalty assessments requiring good faith effort disputes.
CFC rules - Tax reform changed the controlled foreign corporation (‘CFC’) rules significantly. One example is the change to the attribution rules to determine a CFC. It is now possible for a structure involving a non-US parent with two subsidiaries, one US and one non-US, to now have the foreign subsidiary considered a CFC of the US subsidiary! This not only requires planning but also is an enormous trap for the unwary – without knowing, there may be CFC compliance requirements.
US assets of interest allocation – For business that maintain excess US dollars in the Federal Reserve System, as most business do, a pending case in the US Tax Court involving a Brazilian bank demonstrates the IRS challenging the use of those dollars to amplify interest expense deductions in the US. This may change the way US interest deductions are calculated under section 882.
After all this, the good news is that Marks Paneth has the right tools and resources to help. Our International Tax professionals are readily available to assist with these needs.
About Julio M. Jimenez
Julio M. Jimenez, JD, LL.M., is a Principal in the Tax Services Group at Marks Paneth LLP, where he specializes in international tax services for multinational corporations and individuals. Prior to joining the firm, he served in technical leadership roles at two different national public accounting firms, his own international tax advisory practice and the Internal Revenue Service National Office of the Chief Counsel, where he was involved in both IRS examinations and Department of... READ MORE +