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Editor's Note: The following is an excerpt from Chapter 11 of the LexisNexis® Guide to FATCA Compliance* by William Byrnes and Robert Munro. The title is now shipping to customers world-wide.
Importance of the Income Source
In cross-border transactions, the U.S. tax system, as well as the tax systems of most other nations or jurisdictions, contains rules to determine and identify items of income (or expense) derived from U.S. sources or foreign sources-referred to from the U.S, perspective as U.S. source income or foreign source income. This is generally referred to as the source of income rules. The U.S. Internal Revenue Code (IRC) contains source of income rules.1 Tax treaties also provide and often clarify source of income rules. The source of income rules provide the basis for taxation, but the operating rules are contained elsewhere in the IRC.
The income category generally determines the source of income rules. These rules attempt to assign income to a U.S. or non-U.S. source on a statutory basis by looking at the perception of what is the predominate situs (location) of the economic activity that generates the income, and the source of legal protections that facilitate such income generation.
Certain categories of U.S. source income are subject to withholding "at source"-i.e. in the U.S. Because the U.S. has no taxing authority or jurisdiction over foreign persons, the IRC finds one or more withholding agents who are required to withhold at source in the U.S. Generally when transfers of these certain categories of income are made to persons outside the U.S., the withholding agent in the U.S. withholds a certain percentage of the funds and remits the funds to the Internal Revenue Service (IRS). The withholding rules are generally described under the Qualified Intermediary (QI) program.
FATCA Is In Addition to QI
The U.S. added the Foreign Account Tax Compliance Act (FATCA) as an additional layer over QI.2 FATCA consists of worldwide reporting and withholding rules designed to greatly reduce U.S. tax noncompliance for accounts and certain assets held offshore by U.S. taxpayers. FATCA's withholding rules are discussed in this chapter.
GENERAL RULE FOR WITHHOLDABLE PAYMENTS3
When Do Withholdable Payments Begin?
After December 31, 2013 but prior to December 31, 2016, a withholdable payment is any payment of a U. S. source considered "fixed, determinable, annual, periodical income" (FDAP). After December 31, 2016, a withholdable payment will also include any gross proceeds from the sale or other disposition of any property which may produce interest or dividends that are U.S. source FDAP income.4
General Rule for Withholding on Withholdable Payments to a FFI
For payments made to a Foreign Financial Institution (FFI), a withholding agent must generally withhold 30% from a withholdable payment made regardless of whether the FFI is a beneficial owner of the payment or an intermediary.5 Exceptions include withholdable payments made to a FFI who has a valid intermediary withholding certificate and statement,6 payments are made under a grandfathered obligation,7 or if the payment is made to a U.S. branch of a Participating FFI (PFFI) where the branch qualifies as a U.S. person.8
General Rule for Withholding on Withholdable Payments to a NFFE
Generally, withholdable payments made by a PFFI to its Non-Financial Foreign Entity (NFFE) account holders are not subject to the 30% withholding.9 Otherwise, withholdable payments made to NFFEs are subject to withholding unless an NFFE is the beneficial owner of the payment, or the beneficial owner can be treated as an NFFE that has no U.S. beneficial owners or has identified all of its U.S. beneficial owners, and the withholding agent reports the required information about the U.S. beneficial owners of the NFFE.10
Transitional Relief for Withholding Payments Made to NFFE
For withholdable payments made prior to January 1, 2015 for a pre-existing obligation to a payee that is neither a prima facie FFI nor provides the payor with documentation indicating the payee is a passive NFFE with one or more substantial U.S. owners, then the withholdable payment is not subject to FATCA withholding.11 (See §11.03[b] for a definition of a prima facie FFI.)
Exception for Excepted NFFE
Withholdable payments made to an excepted NFFE are not subject to FATCA withholding. Excepted NFFEs include a publicly traded corporation, certain affiliated entities of a publicly traded corporation, territory entities, active NFFEs, or exempted non-financial entities.12
The affiliated entities of a publically traded corporation are the NFFEs in the same expanded affiliated group.13 (See Chapter 7.)
A territory entity is an entity organized under the laws of a U.S. territory and wholly owned by bone fide residents of that territory.14
An active NFFE has less than 50% of its income as passive income and less than 50% of its assets produce passive income or are held for passive income.15
Excepted non-financial entities are start-up companies, non-profit organizations, entities that are liquidating in bankruptcy or emerging from bankruptcy, members of a non-financial group such as holding companies, treasury centers, and captive finance companies.16 (See Chapter 8 for a discussion of NFFEs.)
* Copyright 2013, Matthew Bender & Company, Inc., a member of the LexisNexis Group.
1 Primarily IRC §§ 861, 862, 863, 865.
2 See Chapter 10.
3 See Chapter 12.
4 Treas Reg § 1.1471-1(a)(136), citing Treas Reg § 1.1473-1(a).
5 Treas Reg § 1.1471-2(a)(1).
6 Treas Reg § 1.1471-2(a)(4).
7 Any obligation outstanding on January 1, 2014, is a grandfathered obligation. Treas Reg § 1.1471-2(b)(2)(i)(A)(1).
8 See Treas Reg § 1.1441-1(b)(2)(iv)(A).
9 Treas Reg § 1.1472-1(a).
10 Treas Reg § 1.1472-1(b).
11 Treas Reg § 1.1472-1(b)(2).
12 Treas Reg § 1.1472-1(c)(1).
13 Treas Reg § 1.1472-1(c)(1)(ii).
14 Treas Reg § 1.1472-1(c)(1)(iii).
15 Treas Reg § 1.1472-1(c)(1)(iv).
16 Treas Reg § 1.1472-1(c)(1)(v).
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