Negotiations over the payee tax representations to be made in an ISDA Master Agreement are often confusing, acrimonious and slow. U.S. negotiators, at the urging of expensive tax counsel, often insist that their foreign counterparties make comprehensive tax representations for U.S. tax purposes and deliver certain IRS tax forms to them. Typically, foreign counterparties resist making these representations because they don't understand the purposes behind them. However, these payee tax representations, and the related delivery of tax forms, serve important purposes.
The recent promulgation of new U.S. withholding and reporting tax regulations and revised tax forms have rekindled efforts by U.S. parties to obtain payee tax representations and tax forms from their foreign counterparties. U.S. parties obligated to make cross-border payments (the "U.S. payers") under an ISDA Master Agreement remain concerned about possible tax withholding and reporting issues. First, if a U.S. payer fails to withhold tax (when required) on certain cross-border payments, it can be held personally liable to the U.S. Internal Revenue Service (the "IRS") for those taxes. Second, if it does withhold when required, the U.S. payer may be obligated to gross-up the payment to the foreign recipient (the "foreign payee"). Finally, there is increased emphasis by the IRS for U.S. payers to report to the IRS payments made to foreign payees that constitute effectively connected income with a U.S. trade or business for such foreign payees.
Gross -Up
Under the ISDA Master Agreement, the U.S. payer is required to "gross-up" any cross-border payments to a foreign payee to the extent that U.S. tax was withheld. The policy behind the provision in the ISDA Master Agreement is that the foreign payee should receive the amount calculated under the terms of the confirmation (the "Confirmation Payment") without any reduction for tax withholding.
For example, assume the U.S. payer is required to pay a foreign payee $1,000,000 under the terms of the confirmation. Assume further that the U.S. statutory withholding rate is 30% and that withholding is required. Under the terms of the ISDA Master Agreement, The U.S. payer must still pay the foreign payee $1,000,000 in addition to the $300,000 of withheld tax paid to the IRS. The eventual total payments will be even larger if the U.S. payer is required to withhold tax on the additional gross-up payments made to the foreign payee.
The gross-up payment under the ISDA Master Agreement is only required if the withholding tax is an "Indemnifiable Tax." An Indemnifiable Tax is any tax imposed by the payer's taxing jurisdiction solely because the payee entered into the transaction. That is, if the foreign payee had subjected itself to the jurisdiction of the payer's tax authority for some reason other than doing the transaction at issue, the tax would not be an Indemnifiable Tax.
U.S. Tax Withholding Concerns
The U.S. imposes a 30% withholding tax on certain cross-border payments made by a U.S. payer to a foreign payee. This withholding tax applies to (subject to several important exceptions) cross-border interest and dividend payments, among others, and on other types of income referred to as "fixed or determinable annual or periodical gains."
Fortunately, U.S. Treasury regulations have clarified that a U.S. payer is not required to withhold tax on cross-border payments made pursuant to a notional principal contract. The regulations define a notional principal as a "financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts." The definition would appear to pick up standard OTC derivative transactions such as a swap. Although the regulations have eliminated much legal uncertainty and risk, U.S. payers still worry that payments made on transactions that do not expressly fit under the definition of a notional principal contract could potentially still be subject to withholding.
Apart from OTC derivative payments, U.S. payers worry about withholding on cross-border interest payments. Under the ISDA Master Agreement, interest must be paid on overdue or late payments (These particular interest payments, however, are generally not subject to the gross-up requirement). More troublesome, however, is the possibility that an OTC derivative could be characterized as a disguised loan, resulting in the cross-border payments being characterized as interest as opposed to payments under a notional principal contract.
In general, interest payments made under the ISDA Master Agreement will not be subject to withholding. First, the interest payments, as discussed below, may constitute income effectively connected to the U.S. business of the foreign payee and thus would not be subject to withholding. Second, there may be either reduced or no withholding on interest payments because of a tax treaty between the United States and the relevant foreign payee's country of residence. Third, most interest payments made under the ISDA Master Agreement will qualify for the portfolio interest exception, exempting the interest from withholding. The portfolio interest exception applies because the ISDA Master Agreement is considered to be in registered form for purposes of the exception.
Unfortunately, the portfolio interest exception does not apply in two circumstances. First, it does not apply if the foreign payee is a 10 percent or greater shareholder of the U.S. payer. Second, it does not apply if a foreign payee is a bank that has made a disguised loan to the U.S. payer in the ordinary course of its trade or business (some U.S. payers may insist that a foreign payee represent that it is not a 10 percent shareholder or a bank making such a disguised loan).
Tax Representations
Cross-border parties generally require each other to make a payer tax representation that no taxes need be withheld on OTC derivative payments. In making a payer tax representation, however, the U.S. payer is entitled to rely on the foreign payee's tax representations. If the foreign payee's representations prove to be false, the U.S. payer is not obligated to gross-up the derivative payments for any required tax withholding.
U.S. payers also ask for IRS tax forms from foreign payees that parallel the payee tax representations that are requested. The tax forms provide important protection from personal liability to the IRS in the event that the U.S. payer should have withheld but did not. The receipt of the form provides a defense for the U.S. payer establishing that it had performed appropriate due diligence in assessing its obligation to withhold.
If the tax payee representation proves to be false at any time in the future, the ISDA Master Agreement relieves the U.S. payer of the obligation to gross-up. There is no similar protection, however, with respect to the delivery of a tax form. The foreign payee is only required to deliver the tax form at the execution of the ISDA Master Agreement. If a foreign payee's situation changed over time, the tax form may no longer be true or accurate. While the tax form would still protect the U.S. payer from past personal liability with the IRS with respect to a failure to withhold, it would not alleviate the U.S. payer's obligation to both withhold and gross-up any payments going forward as required by the ISDA Master Agreement.
Treaty Representation
U.S. payers often require a foreign payee to represent that it is entitled to the benefits of the relevant tax treaty between the United States and a foreign jurisdiction. For U.S. purposes, the relevant treaty is the U.S. tax treaty with the foreign payee's country of residence (versus, for example, the foreign payee's branch that is receiving the payment). The standard treaty representation, however, does not require the foreign payee to represent that there will be no withholding; but instead only that the foreign payee is eligible for benefits (if any) under the treaty.
If a U.S. payer is intending to rely on a treaty representation, it will request that the foreign payee deliver a Form W-8BEN (formerly Form 1001). As part of the form, however, the foreign payee must provide (and update) a statement to the U.S. payer "that identifies those notional principal contracts from which the income is not effectively connected with the conduct of a trade or business in the United States." Although the form is executed under penalties of perjury, the form is provided only to the U.S. payer and not to the IRS. The form is also required to be updated every three years.
Effectively Connected Income Representation
If the foreign payee is doing business in the United States, the U.S. payer will ask the foreign payee to represent that each payment it receives will be income effectively connected with its U.S. trade or business ("ECI"). Under the Internal Revenue Code, no withholding is generally required for payments (of any kind) that are ECI for the foreign payee. For example, if a foreign payee operates a branch office in the United States and negotiates transactions and receives payments there, those payments would typically constitute ECI.
If a U.S. payer is intending to rely on the ECI representation, it will request that the foreign payee deliver a Form W-8ECI (formerly Form 4224). Similar to the form W-8BEN, form W-8ECI is also executed under penalties of perjury and is provided only to the U.S. payer and not to the IRS. The form is also required to be updated every three years.
Although a U.S. payer is not required to withhold on a foreign payee's ECI, the U.S. payer is required to report the foreign payee's ECI to the IRS using form 1042-S. It is often difficult for a U.S. payer to determine which payments constitute ECI for the foreign payee. It is in the best interest of the foreign payee that the correct amount of ECI is reported to the IRS. To make the proper determination, the U.S. payer often requests as part of the representation that a foreign payee designate which payments are ECI.
This week's Learning Curve was written by Christian Johnson, associate professor at the Loyola Law School in Chicago.
