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Advisory group criticizes IRS plan to limit refunds involving foreign person/FATCA withholding

IRS’s Information Reporting Program Advisory Committee (IRPAC) has sent a letter to IRS Commissioner John Koskinen in which it finds fault with, and suggests improvements to, Notice 2015-10. That Notice provided that IRS will be issuing regs, effective for amounts withheld with respect to the 2015 calendar year and thereafter, that limit certain refunds available with respect to amounts withheld from foreign persons and under the Foreign Account Tax Compliance Act (FATCA).

Background. Chapter 3 (Code Sec. 1441 through Code Sec. 1464) contains reporting and withholding rules relating to payments of certain U.S. source income (e.g., dividends on stock of U.S. companies) to non-U.S. persons. For example, Code Sec. 1461 provides that the withholding agent would be indemnified against any claim against him for any amounts withheld.

Chapter 4 (FATCA, Code Sec. 1471 to Code Sec. 1474) requires withholding agents to withhold from certain payments to a foreign financial institution (FFI) unless the FFI has entered into an agreement (FFI agreement) with IRS to, among other things, report certain information with respect to U.S.accounts. Chapter 4 also imposes withholding requirements on withholding agents with respect to certain payments made to certain non-financial foreign entities.

A Qualified Intermediary is a type of withholding agent under chapters 3 and 4.

An amount withheld by a withholding agent is required to be deposited in accordance with Code Sec. 6302.(Reg. § 1.1461-1(a) and Reg. § 1.1474-1(b)) If the total amount of deposits received by IRS is less than the withholding tax liability of the withholding agent, and the withholding agent has not paid the tax due with the filing of its Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, the withholding agent remains liable for the taxes due and associated interest and penalties. (Code Sec. 6601, Code Sec. 6651(a)(2), and Code Sec. 6656 )

Code Sec. 33 allows as a credit against income tax the amount of tax withheld at the source under chapter 3.Code Sec. 1462 and Reg. § 1.1462-1(a) provide that the Payee (the person who received the income that was withheld upon) may claim a credit of the amount of tax actually withheld under chapter 3 against the total income tax computed on the Payee’s return. Reg. § 1.1474-3(a) provides that the amount of tax actually withheld under chapter 4 is a credit against the total income tax computed in the Payee’s return.

Notice 2015-10. In April, 2015, in Notice 2015-10, 2015-20 IRB 965 (see Weekly Alert ¶  39  04/30/2015), IRS announced that it was aware that withholding agents may not always be compliant with the requirement to deposit amounts withheld under chapter 3 or 4.If a refund or credit is issued for an amount that has not been deposited, IRS may not be able to recover that amount because the Payee and, in some cases the relevant withholding agent, may be outside the U.S.

And so, in the Notice, IRS announced that it will be issuing regs under which it will reject (either in whole or in part) certain withholding tax refund claims filed by Payees if the total amount of the withholding agent’s required deposit for a calendar year is less than the amount actually deposited by that withholding agent (“shortfall”).”Pro rata” refunds will be allowed, however, based on the ratio of the amount actually deposited by the withholding agent to the total amount required to be deposited. For example, if a withholding agent has a withholding tax liability of $100,000 with respect to payments made to all Payees, but has only deposited $95,000 to its deposit account for the year, IRS would deny a proportional 5% of refund claims made by any and all Payees from whom that withholding agent withheld tax.

IRS considered whether to permit a Payee to prove that the deposit of tax made by a withholding agent was specifically made with respect to an amount withheld from the Payee (i.e., under a tracing or specific identification methodology).However, it did not adopt that idea; it said that implementing a tracing or specific identification methodology would present a significant administrative burden for withholding agents who process substantial volumes of payments and for IRS.

IRS also announced that it was considering exceptions to the rules described above.For example, IRS was considering whether to provide an exception if the amount of the under-deposit of tax is de minimis or if the relevant withholding agent has a demonstrated history of compliance with its deposit requirements.

And, Notice 2015-10 said that the regs will apply to claims for refund or credit for amounts withheld with respect to the 2015 calendar year and thereafter.

IRPAC criticizes Notice 2015-10. IRPAC has sent a letter to IRS in which it criticizes the general approach in Notice 2015-10 and makes suggestions for improvement.

IRPAC began by acknowledging that fraudulent refund claims are a significant problem and lauding IRS’s effort to combat that problem.

It then found many reasons to criticize IRS’s pro rata approach.First, it said, the approach arguably exceeds IRS’s legal authority under Code Sec. 1462, which requires IRS to credit the amount of tax withheld against a Payee’s tax paid without regard to whether the withholding agent in fact deposited the withheld taxes.There is no authority within the Code that allows IRS to hold the Payee liable for a withholding agent’s failure to deposit taxes actually withheld. And, Code Sec. 1461 insulates the withholding agent from liability to the Payee for amounts withheld in accordance with the provisions of chapter 3.

Because the withholding agent has no legal duty to the Payee, the Notice creates unprecedented legal and administrative issues for Payees who seek to obtain legitimate withholding tax refunds. For example, can such a Payee seek recourse from the withholding agent, or will IRS eventually pay the refund in full once it has resolved the shortfall with the withholding agent? How is the statute of limitations impacted by these disputes?Who can the Payee sue for the denied portion of its refund claim, and by what date must that suit be brought?

IRPAC also said that there are many nonfraudulent reasons for a deposit shortfall and that most withholding agents have a proven track record in making accurate and timely deposits.For example, IRS might unilaterally debit a withholding agent’s chapter 3 tax deposit account in order to settle a tax liability associated with another account of that agent (e.g., backup withholding or payroll tax account).Or the agent could have made a coding mistake when it made its deposit.

Finally, IRPAC said that the pro rata approach conflated the legitimate problem of fraudulent refund claims with collection of shortfalls in withholding deposits.Fraudulent withholding claims (and associated phantom deposits) are unlikely to be related to a legitimate withholding agent’s deposit shortfall. To the extent that a fraudulent scheme somehow does target a legitimate withholding agent’s deposits (e.g., by claiming that a portion of such agent’s deposit should be refunded to the fraudulent claimant), IRS’s approach of denying only a pro rata portion of that claimant’s refund claim does not eliminate the overall problem (indeed, the claimant will still obtain an undeserved refund under these rules, diminished only by the pro rata portion of the overall shortfall).

IRPAC did agree with IRS that a tracing system would not be an appropriate measure to combat fraudulent refund claims.

IRPAC’s suggestions. IRPAC suggested that, if IRS did use a pro rata or tracing approach, it should create exemptions for the following:

  • payees of U.S. withholding agents, Qualified Intermediaries, and other withholding agents that have a significant U.S. tax nexus;
  • withholding agents that have an established history of compliance with their tax withholding, deposit and reporting obligations, and withholding agents that generally deposit a significant dollar amount of withholding; and
  • refund claims that are de minimis in relation to the total amount of tax that has been deposited should be granted.

But, IRPAC’s chief suggestion was for a different approach altogether.It criticized the use of broad exceptions without first determining if those exceptions themselves can be used by wrongdoers as a roadmap for the next fraudulent refund scheme.It recommended that IRS instead consider more targeted approaches to combating perceived withholding tax refund fraud.

References:For withholding under chapter 3, see FTC 2d/FIN ¶  O-11900; United States Tax Reporter ¶  14,414. For withholding under FATCA, see Federal Tax Coordinator 2d ¶  O-13070  et seq.; United States Tax Reporter ¶  14,714  et seq.

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