Over the last 18 months, the offshore activities of United States taxpayers have been the subject of considerable attention, both in the media and from U.S. policymakers. This scrutiny included the highly visible criminal indictment against international banking titan UBS. The motive behind the criminal indictment was to compel UBS to disclose the identities of thousands of U.S. account holders.
On the heels of the UBS enforcement activity, the Internal Revenue Service (IRS) launched a voluntary disclosure program designed to encourage U.S. taxpayers to disclose offshore accounts that had not previously been disclosed. Participating in the voluntary disclosure program allowed U.S. taxpayers to avoid criminal prosecution and potentially reduce the draconian civil penalties that are imposed for failing to disclose an offshore account. During the process, the IRS informally suggested that foreign offshore accounts that are subject to taxpayer disclosure might include a much broader category of interests, such as equity interests in private equity or hedge funds. The rationale for increasing disclosure is to increase compliance with U.S. tax laws and reduce incidences of tax evasion and money-laundering activities. Increasing the disclosure of the offshore activities of U.S. taxpayers has, thus, been at the forefront of U.S. tax compliance initiatives.
On March 10, 2010, the Hiring Incentives to Restore Employment Act of 2010, popularly known as the HIRE Act, became law in the United States. The primary purpose of the HIRE Act is to provide incentives to businesses to encourage job creation. In an era of rapidly expanding federal deficits, to offset the costs of incentives to the federal budget, legislation will often include revenue-raising measures. One such revenue-raising measure in the HIRE Act is a rider that will impact cross-border activities by significantly increasing the disclosure of cross-border investments and modifying withholding rules for payments made to certain offshore entities. The rider to the HIRE Act is the Foreign Account Tax Compliance Act (FATCA).
FATCA was the subject of a March 2010 article in Casino Enterprise Management, “A Legislative Assault on Tax Havens,” which provided a nuts-and-bolts overview of the FATCA rules. IRS officials recently publicly stated that its offshore compliance initiatives would continue to be a priority. Now that FATCA has been enacted as part of the HIRE Act, the practical application of the new requirements for the gaming industry is worthy of further discussion. Both U.S. and foreign businesses will feel the impact of the new rules, which will go into effect for payments made after Dec. 31, 2012.
Absent meeting an exception, the HIRE Act imposes a withholding tax on any person making a U.S.-sourced payment to either a “foreign financial institution” or a “non-financial foreign entity” equal to 30 percent of the amount of the payment.
The types of U.S.-sourced payments caught by the withholding tax may include such items as interest, rents, royalties, dividends and wages. The determinative factor is whether the payment is derived from sources within the U.S. The U.S. federal tax law establishes income-sourcing rules. For example, the source of a dividend payment is determined based on the place of incorporation of the payer. Thus, a Delaware corporation would be considered to pay dividends in the U.S. and the dividend payments would be sourced to the U.S. Different income-sourcing rules apply to rent and royalties, which typically consider the payment to be sourced to the place where the property is used.
At first blush, it would appear that only a narrow scope of payments will be caught by the new withholding tax based on the identity of the payment recipient. That is, the payment must be paid to either a “foreign financial institution” or a non-financial entity. The definition of “foreign financial institution” casts a wide net to capture entities that are normally not considered to be a financial institution. The HIRE Act defines a financial institution in a manner that includes any entity that may (1) accept deposits in the ordinary course of a banking or similar business; (2) hold financial assets for the account of others as a substantial portion of its business; or (3) is engaged primarily in the business of investing or trading in securities, partnership interests, commodities or any interests of the foregoing. The legislative history to the HIRE Act acknowledges that a foreign financial institution could include investment vehicles, such as hedge funds and private equity funds. Even if the foreign business escapes qualification as a foreign financial institution, it is likely to fall within the catchall category of foreign non-financial entities.
To avoid the 30 percent withholding tax, a foreign financial institution must enter into an agreement with the IRS to annually disclose detailed information. For a foreign financial institution, the information required to be disclosed concerns the financial institution’s “United States accounts.” The information that is required to be disclosed includes identifying the account holder, the account balance or value, and the gross receipts and gross withdrawals or payments from the account. If an account holder refuses to disclose the required information to the foreign financial institution, the 30 percent withholding tax will apply. Non-financial entities must disclose the identity of any substantial U.S. owner.
Consistent with the robust nature of the withholding tax, the obligation to disclose “United States accounts” is similarly broad by virtue of adopting an expansive definition of the term “United States account.” An account includes not only traditional financial institution accounts—namely, depository and custodial account—but also reaches any equity or debt interest in the financial institution. The HIRE Act carves out equity or debt interests that are publicly traded. Accounts held indirectly by a U.S. taxpayer are also considered to be a “United States account.”
The HIRE Act also imposes new disclosure obligations on individuals by requiring the disclosure of offshore accounts and assets worth $50,000 or more. Failure to disclose is subject to a penalty equal to $10,000 for each tax year. An underpayment of tax that is attributable to an undisclosed foreign financial asset is subject to a penalty equal to 40 percent of the understatement.
From a 30,000-foot view, the new withholding and disclosure rules would seem to apply to a limited set of financial transactions that involve traditional bank accounts. Digging deeper into the statutory language, however, reveals that the new withholding and disclosure rules can have a much more expansive reach. Specifically, common organizational structures used by U.S. businesses with offshore relationships could trigger a withholding and/or disclosure obligation. Furthermore, foreign entities that may have U.S. activities could also be pulled within the reach of the new withholding and disclosure rules.
Consider the following organizational structure, which is graphically illustrated in Figure 1. Suppose International Gambling Co. enters into an agreement with U.S. Gaming Corp. to license the use of certain intellectual property rights in the United States. U.S. Gaming Corp. agrees to pay a $100 annual royalty to International Gambling Co., which may be subject to no or a low withholding rate under a tax treaty. Further, assume that International Gambling Co. has two minority shareholders who are U.S. residents. International Gambling Co. conducts an active business in the gaming industry.
Under the new withholding and disclosure rules, U.S. Gambling Co. would be required to withhold $30—that is, 30 percent of its $100 royalty payment—unless International Gambling Co. entered into a disclosure agreement with the IRS. While International Gambling Co. may not qualify as a foreign financial institution (i.e., it does not accept deposits, hold financial assets or engage in the business of investing in securities), the withholding tax applies to non-financial foreign entities as well. To avoid the withholding tax, International Gambling Co. would have to disclose any U.S. substantial owner or certify it has no U.S. substantial owner.
As this example illustrates, the new withholding and disclosure rules can have a wide impact for both U.S. and foreign businesses. For a U.S. business, a withholding obligation may be triggered for payments it makes to foreign business entities. Similar to other withholding taxes, the payer (U.S. Gaming Corp. in the example) is primarily liable for the payment of the tax.
For foreign businesses, immediate economic returns can be impacted because the business will receive less if the 30 percent withholding tax applies. While the foreign business (or ultimate beneficiary of the payment) can seek a refund from the U.S., the U.S. now has 180 days to pay without interest accruing. Hence, the U.S. can receive funds interest free on a short-term basis. To avoid withholding, a foreign business subjects itself to new disclosure and reporting obligations, which can add administrative costs.
To determine whether the new withholding and disclosure rules apply, businesses can examine several steps. These steps include:
1) Determine whether the foreign entity is a foreign financial institution. If not, the business entity may still qualify as a foreign non-financial institution.
2) Determine the type of payment. That is, what is the payment made for? For example, does the payment represent rent, debt repayment or dividends?
3) Determine whether the foreign entity has entered into an agreement with the IRS. For a non-financial institution, does the foreign entity have U.S. substantial owners? If not, a certification may negate the withholding tax. Similarly, for a foreign business, it is important to determine whether it has any “U.S. accounts” or U.S. substantial owners that it may have to disclose to the IRS.
4) Finally, the U.S. entity making the payment must determine whether it has an independent disclosure obligation to the IRS.
A variety of common international transactions can become ensnarled in the new withholding and disclosure rules enacted as part of the HIRE Act. The above example illustrates a business transaction that could be subject to the withholding and disclosure rules. Other common business transactions, such as use of foreign debt financing entities or investments in private equity or hedge funds, may similarly be subject to the new withholding and disclosure rules. This means that payments, such as debt repayments, could be subject to withholding. The implications of these new rules are not solely for U.S. businesses to consider. Foreign businesses can be impacted as well, because payments may be subjected to a 30 percent withholding tax and because they may be obligated to disclose information to the IRS.
Peter J. Kulick is a tax and gaming attorney with Dickinson Wright PLLC, which has an international gaming law practice with offices in Michigan, Nashville, Washington, D.C., Toronto and Phoenix. He received his LL.M in tax law from New York University. Kulick may be reached at pkulick[at]dickinsonwright.com.