On its webpage, IRS has announced that, as a result of its recent issuance of a new final Qualified Intermediary (QI) agreement in Rev Proc 2017-15, several of the Chapter 3 status codes on 2017 Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, shouldn’t be used by issuers of that form.
Background—Chapters 3 and 4 of the Code. Chapter 3 of the Code includes Code Sec. 1441-Code Sec. 1463. Under Code Sec. 1441 and Code Sec. 1442 , a withholding agent is required to deduct and withhold a tax equal to 30% on any payment of U.S. source fixed or determinable, annual or periodical (FDAP) income that is an amount subject to withholding made to a foreign person. A reduced rate of withholding may apply under the Code (for example, Code Sec. 1443) or an income tax treaty. (Reg. § 1.1461-1(c))
A QI is an eligible person that submits an application and enters into a QI Agreement with IRS. Generally, under the QI Agreement, the QI agrees to assume certain documentation and withholding responsibilities in exchange for simplified information reporting for its foreign account holders and the ability not to disclose proprietary account holder information to a withholding agent that may be a competitor. (Reg. § 1.1441-1T(e)(5)(ii))
A foreign partnership becomes a withholding foreign partnership (WP) by entering into a withholding agreement with IRS and assuming the withholding and reporting obligations under Chapters 3 and 4, and 61 and Code Sec. 3406 for payments of U.S. source income made to its partners and persons holding interests in the WP through one or more foreign intermediaries or flow-through entities. (Reg. § 1.1441-5(c)(2)(i))
A foreign trust becomes a withholding foreign trust (WT) by entering into a withholding agreement with IRS and assuming the withholding and reporting obligations under Chapters 3 and 4, and 61 and Code Sec. 3406 for payments of U.S. source income made to its beneficiaries, owners and persons holding interests in the WT through one or more foreign intermediaries or flow-through entities. (Reg. § 1.1441-5(e)(5)(v))
A withholding agent making a “substitute dividend payment” to a financial institution that satisfies the regulatory definition of a qualified securities lender (QSL) (and makes the appropriate certifications) will not be required to withhold on that payment. Regs coordinate the QSL’s obligations to withhold on substitute dividend payments that it makes, pay and deposit tax on substitute dividends it receives, and report on substitute dividends it makes (on behalf of itself or any other person) and define the obligation in terms of two distinct categories of substitute dividends that QSLs pay or receive. (Notice 2010-46, 2010-24 IRB 757, Sec. II.A)
Background—Rev. Proc. 2017-15. IRS recently issued, in Rev Proc 2017-15, 2017-3 IRB (see Weekly Alert ¶ 26 01/05/2017), a new QI agreement that spells out a new qualified derivatives dealer (QDD) regime. The QI agreement is effective on or after Jan. 1, 2017. The QDD regime replaces the QSL regime that previously existed. The QSL rules will continue to apply for substitute dividend payments made under sale-repurchase or securities lending transactions.
The QDD regime was developed to mitigate cascading withholding that would occur as a result of the withholding requirements imposed on “dividend equivalents.” Code Sec. 871(m) imposes withholding on certain payments that are determined by reference to or contingent upon the payment of a U.S. source dividend. As a result, when a foreign financial institution holds U.S. equities and issues derivatives to non-U.S. investors that are based on the stock, it may be subject to withholding on dividend payments made with respect to the underlying equities and have to withhold on the payments it makes to the holders of the derivatives. Under the proposed QI agreement, only a subset of QIs called “eligible entities” will be permitted to act as QDDs.
Background—2017 Form 1042-S. Generally, a withholding agent must report the payments on Form 1042-S, regardless of whether withholding is required. Persons who file Form 1042-S must complete Box 12b of the form, entitled “Ch. 3 status code,” with a withholding agent status code(s) that they choose from Form 1042-S’s list of Recipient Codes.
Four of the codes are:
…33—Joint account withholding rate pool
…36—Qualifying dividend equivalent offsetting payments to U.S. persons
…37—Nonqualifying dividend equivalent payments to U.S. persons—Undisclosed
…38—Other qualifying dividend equivalent offsetting payments (ECI)
And, a footnote to the codes provides “Codes 27 through 33 should only be used by a QI (including a QI acting as a QDD), QSL, WP, or WT.”
Certain Chapter 3 status codes should not be used. On its webpage, IRS has announced that, based on the new QI agreement, the above four Chapter 3 status codes on the 2017 Form 1042-S are no longer valid, and withholding agents should not use these codes for Form 1042-S reporting purposes.
And, IRS has revised the above footnote to eliminate mention of code 33. The footnote now reads: “Codes 27 through 32 should only be used by a QI (including a QI acting as a QDD), QSL, WP, or WT.”
References: For withholding under Chapter 3, see FTC 2d/FIN ¶ O-11900; United States Tax Reporter ¶ 14,414.
IRS Webpage, “Four codes on the 2017 Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, that are not to be used” (Feb. 1, 2017).