The proposed regulations make several changes in an attempt to ensure appropriate US source withholding is made with respect to deemed distributions to non-US holders. These rules presumably are needed to clarify how withholding is to be done when there is no contemporaneous payment of the amount that is generating the withholding requirement. While there are rules that currently deal with situations like this (e.g., cancellation of indebtedness), the application of withholding to deemed distributions under Section 305 (not to mention Section 871(m)) are far more prevalent.
Who are the withholding agents? Very generally, under current regulation 1.1441-7(a)(1), any person that has control, receipt, custody, disposal, or payment of an item of income of a foreign person subject to withholding. This makes pretty much everyone in the custodial chain a “withholding agent”. For example, let’s say an Issuer issues a note and has a Paying Agent. The note is purchased by an Investor, a foreign individual, through their Broker. The note is actually held at a Custodian in the Broker’s account on behalf of the Investor. Under 1.1441-7(a)(1), the Issuer, the Paying Agent, the Custodian, and the Broker are all withholding agents. This, of course, does not mean that all of these parties will actually deduct a withholding amount and remit payment to the IRS. In general, the rules are designed such that one of the above will be the “primary” withholding agent. That is, all but one of the above will generally have an exception from the obligation to withhold. For example, while not technically an exception, the requirement to withhold generally only applies to payments made to payees that are foreign persons. 1.1441-1T(b)(1). Subject to certain exceptions, this rule generally makes the last U.S. person in the chain of custody the one who bears the primary responsibility for withholding since a payment to a U.S. intermediary is not subject to the general requirement to withhold. Of course, any of the above withholding agents could ultimately still be responsible for the actual withholding depending on who in the custodial chain is or is not a U.S. person.
An important part of the “withholding agent” definition above is that it asks who has control and custody over items of income of a foreign person. However, the issue with Section 305(c) is that it applies to so-called “deemed distributions”. It is difficult, in the first instance, to see how someone has control, receipt, custody, disposal, or payment of something that is entirely a tax construct (e.g., it’s not “real” cash movement). At least, not without getting into some really abstract form of thinking.
To avoid this, Prop. Reg. 1.1441-7(a)(4) simply states that any person that issues or holds directly or indirectly (e.g., through an account maintained for another intermediary) on behalf a beneficial owner, or a flow-through entity that owns directly or indirectly, a security upon which a deemed distribution or deemed payment is made has custody or control of the deemed distribution or deemed payment. Therefore, no abstract thinking is required.
Deemed distributions are subject to withholding (subject to a new exception). Unsurprisingly, the proposed regulations obligate a withholding agent to withhold on a deemed distribution subject to the general exemptions under 1.1441-4 as well as a new exception. Prop. Reg. 1.1441-2(d)(4)(i).
The new exception provides that the withholding agent (other than the issuer) is not required to withhold if (1) the issuer has not satisfied its reporting requirements (which I discussed in Section 305 Proposed Regulations, Part 3: Issuer Reporting), AND (2) the withholding agent does not have actual knowledge of the deemed distribution before the due date for filing a Form 1042 for the calendar year in which the deemed distribution or deemed payment occurred.
This, of course, provides that withholding agents down the chain are not required to withhold if there isn’t sufficient information available for them to determine the amount of the deemed distribution (or even that a deemed distribution occurred); information that the issuer is required to either provide in a statement to withholding agents or through a public web site.
As I said in my previous post, I would expect issuers to publish most of this information through a web site so it will be up to withholding agents to ensure that they have systems capable of capturing all of this information. It’s interesting that the government does not act as a central repository for this data since it could collect the returns and make them publicly available but I guess that’s wishful thinking and likely not in their budget. Instead, I suspect that some third party service will develop (assuming it doesn’t already exist) that will aggregate this data for withholding agents as it strikes me as very inefficient for each and every withholding agent to invest in systems to collect this data.
Another interesting question arises if an issuer doesn’t satisfy its reporting obligations under 1.6045B-1. First, this apparently turns off every other withholding agent’s obligation to withhold down the chain assuming lack of actual knowledge of the deemed distribution. But since it doesn’t turn off the issuer’s withholding obligation, does this make the issuer subject to liability for the withholding? Not necessarily. What if the next person in the chain of custody after the issuer is a U.S. person? As I indicated above, withholding agents aren’t generally obligated to withhold on payments to U.S. persons (subject to exceptions). If that’s the case for deemed distributions, the issuer may never directly face a non-U.S. person. In fact, it’s likely that U.S. issuers will, more often than not, use U.S. paying agents.
Well, do the proposed regulations turn off the requirement that one does not have to generally withhold on payments to U.S. persons in respect of “deemed distributions” or “deemed payments”? That is, do the regulations get rid of the general rule that the last U.S. person in the chain is the one that is responsible for withholding? Nothing really addresses this but one would have to think that they do not. Otherwise, in situations where the issuer does report correctly, the new proposed regulations would create multiple obligations to withhold on the same deemed distribution (i.e., where several custodians downstream the “deemed distribution” to a U.S. person). This could not be the intent of the proposed regulations. Therefore, I think the issuer should be able to claim that they do not have to withhold if they directly face a U.S. person in the chain of custody.
But isn’t this weird? If my analysis is correct (and I’m not entirely sure it is), then there is the potential that no withholding agent has any liability in the case the issuer fails to satisfy its reporting obligations. The issuer’s sole liability may relate to failure to file a return as required under 6045B.
Of course, the intent here may be to make the issuer liable for all withholding tax due in all cases where they have failed to satisfy their obligations under 1.6045B-1 but would think that this needs to be clarified.
Time for withholding. Except as provided in 1.1441-5 (dealing with withholding by partnerships and trusts), a withholding agent must satisfy its withholding obligation by withholding at the earliest of:
- the date on which a future cash payment is made with respect to the security;
- the date on which the security is sold, exchanged, or otherwise disposed of (including a transfer of the security to another account not maintained by the withholding agent or a termination of the account relationship); or
- the due date (not including extensions) for filing Form 1042 with respect to the calendar year in which the deemed distribution occurred.
Where the issuer has failed to report properly under 1.6045B-1, but the withholding agent has actual knowledge of the deemed distribution before the due date (not including extensions) for it to file Form 1042 for the calendar year, the obligation to withhold doesn’t arise until January 15 of the following calendar year.
The above is actually pretty interesting because “deemed distributions” make withholding fairly difficult in certain situations which the proposed regulations attempt to anticipate. First, the proposed regulations anticipate that it’s possible that there may be insufficient future cash payments on the security before the requirement to withhold occurs. To avoid penalties for under withholding, the proposed regulations modify 1.1461-2(b) to provide that the withholding agent can obtain contributions from the beneficial owner to satisfy these obligations.
The preamble for the proposed regulations amusingly notes that the client may have terminated its account relationship before the obligation to withhold arises and gently encourage the withholding agent to make arrangements before the client terminates its relationship with the withholding agent. In the absence of such arrangements, I believe the IRS response will be “too bad, so sad”.
Another, perhaps more complicated, issue arises where the “primary” withholding agent is not at a point in the chain of custody where thy would have any real knowledge of who the holders actually are or when dispositions occur. This generally doesn’t matter when withholding is keyed off an actual payment because, at some point, the payment will likely be made by a withholding agent to a recipient that they can actually identify as a party from whom they must withhold. However, this doesn’t necessarily always work well with respect to dispositions and proceeds.
For example, let’s say a U.S. issuer uses a U.S. paying agent. A U.S. investor purchases the security using a non-U.S. broker (for whatever reason) and the note is held by a U.S. custodian in a global account for the non-U.S. broker. Assume in this case that the non-U.S. broker is not a qualified intermediary and is otherwise not required to withhold. Now, let’s say the U.S. investor sells the security to a non-U.S. investor that uses the same non-U.S. broker. We’ll stop here but we could assume many sales or dispositions could take place.
In this case, let’s assume the “primary” withholding agent would be the U.S. custodian. However, while sales and dispositions are occurring, the non-U.S. broker may be holding the securities in a global account. While the non-U.S. broker would itself note that the beneficiary has changed, I’m guessing that a U.S. custodian may not have any knowledge of those transactions. I could be wrong about this but I could also be right (wouldn’t it be great if i was right? I like being right). Assuming I’m right, this is problematic and the regulations don’t address this very well. I would imagine this is why tax regimes such as FIRPTA (or capital gains withholding taxes in some non-U.S. jurisdictions) have special rules that deal with sales and dispositions. Ultimately, you have to build a very tricky mousetrap to make this work properly.
In this case, assuming the regulations aren’t amended to provide exceptions (perhaps withholding rules relating to OID are something to piggyback off of?), I imagine that U.S. custodians will need to require information of downstream sales or dispositions to move upstream back to the U.S. custodian. I would think that some sort of contractual arrangements will need to be made to ensure proper transfer of information and, assuming the absence of that information, the proper placement of the risk and liability of withholding.
Extended to substitute payments. I won’t go into this too much but the regulations extend the concept of deemed payments to stock lending, modifying 1.861-3(a)(6) to make it clear that substitute dividend payments include deemed distributions. The same general rules apply here including that the withholding agent is generally off the hook if they issuer has failed to satisfy its reporting obligations and the withholding agent doesn’t otherwise have actual knowledge of the distribution. Of course, this exception does not apply to the issuer, potentially making the issuer subject to all withholding liability for substitute payments on stock loans if they don’t report accurately (subject to my general comments above regarding technical issues). Amusing.
Foreign qualified intermediary. Withholding agents facing non-U.S. persons that do the withholding have to send the foreign withholding agents the issuer statements showing the issuer’s calculation of the deemed distribution (assuming the issuer didn’t take publish the information on a public website).
U.S. reporting. The regulations seem to have punted on this. They do provide for issuer reporting of the deemed distribution under 1.6045B-1 with respect to basis adjustments and state that they expect similar principles to apply for section 6042 dividend (e.g., 1099-DIV) but then ask for commentary on implementation. I’m not sure what they expect in the meantime but suspect that brokers should take whatever information that they have available to them, either through issuer reporting under 1.6045B-1 or otherwise, and report dividends on U.S. tax forms even in the absence of further guidance.
Effective date. All of this stuff is generally effective when the regulations go final but they may rely on proposed regulations with respect to deemed distributions or deemed payments after January 1, 2016 until the finalization of the regulations. They state that no inference is made as to application of current law by permitting reliance.
See also: Section 305 Proposed Regulations, Part 3: Issuer Reporting