2008 Internal
Revenue Manual Update
Recent Guidance:
IRS Issues Audit Procedures for Payments Made
to
Foreign Persons
On July 29, 2008 the IRS issued a new Internal Revenue
Manual (“IRM”) provision setting forth the procedures an IRS agent should
follow during an examination of Form 1042,
Annual Withholding Tax Return for U.S. Source
Income of Foreign Persons. In recent
years the IRS has increased its focus on information reporting requirements
for payments made to foreign persons. The issuance of the new provisions in
the IRM demonstrates that the IRS is increasing its enforcement activity
towards this cause.
U.S. source income received by foreign persons is subject to
U.S. gross basis taxation. U.S. source income is categorized into: 1) income
that is effectively connected (ECI) with any U.S. trade or business of that
person and 2) income that is fixed or determinable, annual or periodical (FDAP).
Tax on ECI is collected by the IRS when the taxpayer files its business
income tax return (Form 1040NR or 1120F). However, tax on FDAP income is
required to be withheld by the payer, who acts as a withholding agent on
behalf of the IRS. The withholding rate is generally 30% but can be reduced
or eliminated based on a treaty or eliminated based on a specific exception
under the Internal Revenue Code.
Financial institutions such as commercial banks and
brokerage firms commonly act as U.S. withholding agents. In addition, these
institutions also act as intermediaries for their clients’investments in
securities and deposits. As a result, these institutions generally have
reporting and withholding responsibilities for the income received by
foreign persons.
In addition to financial institutions, the new IRM
recognizes the information reporting responsibilities of non-financial
institutions and provides revenue agents with a separate information
document request (IDR) for those organizations. The focus on non financial
institutions will start with payments made from the accounts payable system
including for services, rents and royalties. This reflects a new focus
beyond financial institutions in the area of cross-border withholding.
The new IRM provision titled, U.S. Withholding Agent
Examinations – Form 1042, (IRM 4.10.21.1) explains the basic principles
of reporting and withholding U.S. source income paid to foreign persons. The
IRM discusses the rules on information reporting in detail and provides
definitions of relevant terms. It also provides a summary of code sections
that are relevant to information reporting. Section 4.10.21.1.8 discusses
U.S. Financial Institution Withholding Agent Audit and section 4.10.21.1.9
discusses Non Financial Institution Withholding Agent Audit.
IRS Insights Copyright
©2008 by Deloitte Touche Tohmatsu. September 2008
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