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Institute of International Bankers Seminar on Taxation of International Banks New Developments in Information Reporting and Withholding Beatrice Montaudy,

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Presentation on theme: "Institute of International Bankers Seminar on Taxation of International Banks New Developments in Information Reporting and Withholding Beatrice Montaudy,"— Presentation transcript:

1 Institute of International Bankers Seminar on Taxation of International Banks New Developments in Information Reporting and Withholding Beatrice Montaudy, Barclays Capital (moderator) Roger J. Cardinal, Burt, Staples & Maner LLP Anthony Inzerillo, Ernst & Young John M. Staples, Burt, Staples & Maner LLP

2 New Developments in Information Reporting and Withholding Issues for the US Withholding Agent –Total Return Swaps –Cross-Border Withholding, Documentation, and Reporting Issues for Syndicated Loans –IRS Financial Institution Audits –Cross-Border Withholding, Documentation, and Reporting Issues for Accounts Payable QI Issues –GAO QI Program & U.S. Withholding Agent Report

3 Institute of International Banks TOTAL RETURN SWAPS GAO REPORT ON QIs John Staples Burt, Staples & Maner LLP 24 June 2008

4 TOTAL RETURN SWAPS: WORST CASE SCENARIO Worst case scenario from likely IRS perspective: –Assume that a foreign person (and potentially a US person) wants to avoid withholding tax on a dividend that is about to be paid on a US source stock. –Foreign person sells the stock to a US broker and enters into a TRS with that broker to receive the economic equivalent of that dividend gross of the withholding tax. –Foreign person has a pre-existing agreement (explicit or implicit) to reacquire the stock after the transaction. –NOTE: There are many variations on this theme, with some scenarios likely more problematic for the IRS than others.

5 IRS REACTION TO TRS Not surprisingly, IRS does not believe that the use of a TRS is appropriate to avoid US withholding tax. Policy and administrative concerns are exactly the same as that which led to the securities lending regulations in 1997. IRS even in 1997 stated that it saw no real economic difference between the use of a TRS and a securities lending transaction to avoid US tax. Securities lending was a relatively “easy” fix (although one can certainly debate how administrable withholding on foreign to foreign manufactured dividends actually is under those rules). IRS backed away from launching similar rules for TRS because of fears that rules would be either too broad (and kill the US based swap industry – i.e. the genesis of foreign sourcing for swap payments), or too narrow and largely useless. (Same concerns still present?) Administrative concerns -- and internal IRS debate -- with how to deconstruct swap transactions to require withholding also derailed the project.

6 IRS AUDIT ACTIVITY State of current law on swaps has not prevented IRS from launching audit type activity against withholding agents engaging in TRS. –News articles have stated that IRS is examining certain US brokers who engaged in such transactions, presumably to help their foreign clients avoid US withholding tax. IRS activity likely is to gather information on the wide array of TRS structures to achieve several distinct purposes: –Determine if current legal action against the US brokers is warranted; –Provide information to a Congress newly energized and focused on withholding tax issues and information exchange issues; –Determine if regulatory changes are viable (next panel to cover this).

7 POTENTIAL IRS CHALLENGE UNDER CURRENT LAW Assume IRS establishes that a US broker helped foreign customer avoid US withholding tax through a TRS and there are pre-arranged agreements for customer to reacquire stock. IRS most likely attack would be that the economic substance of the transaction requires the swap to be ignored –Some IRS comments have suggested that the substance is that of a securities lending transaction (and the IRS cites general anti-abuse language in the securities lending regulations and Notice 97-66 as support). –May be tough to argue this given clarity of source rules without a legislative change. –Consider also the import of cases such as Compaq and IES. Far from a foregone conclusion that the IRS would win this argument.

8 WHAT SHOULD A WITHHOLDING AGENT HAVE DONE? Withholding rules under Treas. Reg. 1441-4(a)(3) for swaps are clear and state that no withholding is required on amounts paid under the terms of a notional principal contract even if a Form W-8 is not provided. –Same reg. does not have an actual knowledge standard that turns on withholding but does require reporting if withholding agent “knows, or has reason to know, the payment is [ECI].”

9 APPLY ACTUAL KNOWLEDGE? Questionable given the unambiguous “no withholding” rule in the 1441-4 regulations that other “actual knowledge” rules in the 1441 regulations would require a withholding agent to withhold. Question becomes: Assuming these other actual knowledge rules do apply, do they require a withholding agent to apply a judicial doctrine, such as the economic substance test, to unilaterally recast a transaction, such as a TRS, as a securities lending transaction and withhold accordingly? Implications of such a governmental position in the TRS context (assuming success in court) could have far reaching implications: –Does a withholding agent have an affirmative duty to investigate before applying withholding? –Under what conditions? Only if complicit in setting up structure? Some lesser standard such as circumstantial evidence of wrong doing by counterparty? –How would withholding agents ever be able to reduce the withholding rules to workable systems and procedures so that withholding and reporting is as automatic as possible?

10 GAO QI PROGRAM & U.S. WITHHOLDING AGENT REPORT U.S. Senate requested GAO review of QI Program and U.S. Withholding Agent compliance GAO was asked to: –Describe QI program features –Assess whether weaknesses exist in U.S. withholding system for U.S. source income –Identify weaknesses in QI external reviews and IRS use of program data

11 SOURCES USED BY GAO IRS regulations and industry directives IRS and Treasury officials Private practitioners Studies and reports on foreign investment and banking practices QI data as reported by withholding agents, edited by the IRS

12 GAO REPORT FINDINGS GAO states that while QIs handle only 22% of NRA type payments, they do so much more reliably than US withholding agents because of their “enhanced” account opening procedures and their external audits. –Uncertain if GAO considered US AML standards. –Are IRS audits easier than “agreed upon procedures” of QI external audit? GAO states that US withholding agents rely on “self-certified” documentation (presumably Forms W-8) as opposed to QIs and this leads to less reliable withholding results. –Also uncertain if GAO realized that QIs do not have to use KYC country attachment documentation but can also use Forms W-8BEN. –QIs also accept self certified documentation from NQIs. GAO seems to believe that US withholding agents (but not QIs) have a problem with payments to NQIs. –Uncertain if GAO realizes that NQIs can also be in the QI account base. –There is nothing that attempts to measure or contrast how the NQI population of a QI would be different from that of a US withholding agent.

13 GAO REPORT FINDINGS (Cont’d) GAO states that IRS data shows that payments to undocumented accountholders were far less than the expected 30%. The report unfortunately does not explain how this could be the case. One wonders though if the GAO assumed all payments to NQIs as suspect even with pass through documentation and this is a blend of treaty rates, portfolio interest exemption and 30% withholding. GAO recommends QI external audits be done as “true” audits designed to detect fraud, as opposed to an “agreed upon procedures” approach currently used. –Cost and practicality issues. –Define “fraud” in each jurisdiction – vastly different standards.

14 GAO REPORT FINDINGS (Cont’d) Strong concerns with US-owned “Tax Haven Corporations”. –Basic Structure: US person establishes corporation in tax haven and that corporation opens an account with either a QI or US withholding agent. –Tax Haven Corporation gives withholding agent a Form W-8BEN. –AML information identifies US owner as AML “Beneficial Owner”. –No withholding on proceeds or portfolio interest. –30% withholding on dividends. GAO thinks these structures are more of a problem for US withholding agents because QIs have “enhanced” account opening procedures.

15 GAO REPORT FINDINGS (Cont’d) GAO also recommends changing QI external audit criteria to find “fraudulent” Tax Haven Corporations. –Assumption that AML information on US owner = indicia of fraud? –External auditor (or withholding agent) must do tax investigation of US owner’s compliance with US tax law? Is this more appropriately handled with a change in US law? –Levin Bill –Treat as US direct account –Reporting?

16 Institute of International Banks Cross-Border Withholding, Documentation, and Reporting Issues for Syndicated Loans Roger Cardinal Burt, Staples & Maner LLP 24 June 2008

17 Syndicated Loans -- Agenda Background What are the responsibilities of the lead bank or agent bank? What kind of income is passed along? What are the possible withholding and reporting implications? What documentation is needed, and from whom? What are the challenges and risks?

18 Syndicated Loans -- Background Traditional purpose – parse out loan too big to take on alone Evolved to broader purpose -- provides credit facilities on wide scale, including LC, Synthetic LC, Loan Origination, Assembly of syndicate of potential lenders, process loan assignments, handle loan restructuring when needed. Focus of this session will be on issues involved as processor of payments from borrower to lenders

19 Background – (Cont) Players in the game: –Traditionally, only U.S. banks, or U.S. branches of foreign banks –Now: Non-bank corporations and holding companies Foreign central banks U.S. and foreign hedge funds Other U.S. and non-U.S. entities which may be flow-through vehicles under U.S. tax law.

20 Responsibilities of the lead bank Collect from the borrower and pay over to the lenders: –Principal and interest payment –Share of fees Withholding agent responsibilities: –Determine source and character of income –Collect valid U.S. tax forms from lenders –Apply correct rate of withholding or exemption –Deposit withheld taxes (if any) and file information returns in a timely manner

21 Types of income Interest Fees –Facility fee –Utilization fee –Breakage fee –Prepayment premiums –Up front fee –Bridge fee –LC fee –Synthetic LC fee

22 Reporting and Withholding Implications Withholding implications –U.S. Sourced income is subject to withholding unless an exemption applies Interest: –ECI? –Portfolio Interest? –Treaty exemptions? –Statutory Exemption (892) for certain lenders? U.S. Sourced Fees –ECI? –Treaty? –Statutory Exemption (892) for certain lenders? Reporting implications –U.S. Sourced income is ALL reportable, even if exempt from withholding!

23 Documentation needs For ECI exemption: –U.S. BRANCH of non-U.S. bank – no documentation needed. (Income presumed to be ECI in the absence of documentation.) –For all other foreign lenders – Form W-8ECI (must have U.S. TIN) For Portfolio Interest Exemption: –Form W-8BEN (no TIN needed) NOTE: a bank is not eligible for Portfolio Interest Exemption for interest on a loan in the normal course of banking business. If the bank is holding the loan as an investment, and wishes to claim the portfolio interest exemption – request a supporting statement that the obligation does not represent a loan in the course of their banking business, and that they are affirmatively claiming the portfolio interest exemption. Specifically identify the loan for which they are making this claim. NOTE 2: If unsure whether the lender is a bank, consider requesting a statement from them regarding this. (“We are not a bank, and are claiming exemption from withholding under the Portfolio Interest provisions.”)

24 Documentation needs (cont.) For treaty exemption/reduction: –Form W-8BEN Part I completed (including line 6, U.S. TIN) Part II, lines 9a (with country of treaty claim filled in), 9b, 9c all must be checked. Part IV, signed, dated, and an appropriate capacity filled in. ALL OTHER normal “validation” criteria must be met. (Permanent address country same as mailing address country, etc.) For Statutory exemption other than Portfolio Interest: –Form W-8EXP from foreign governments, International Organizations, central banks of issue, Section 501(c) entities

25 Challenges and Risks Determination of tax documentation needs Tax form validation –Being sure that you have a TIN when needed Determination of the source of interest –U.S. Borrower = U.S. sourced interest –Non-U.S. Borrower USUALLY means foreign-sourced interest Determination of character and source of fees –Some fees are a service – sourced by location of the provider of the service (the lender?) –Some fees will be treated as interest (i.e. payment for the use of money) –Some fees will be sourced like interest, but treated as a fee Making sure that treaty exemptions are valid –Not all treaties will bring withholding rate to zero

26 Anthony F. Inzerillo Financial Services Ernst & Young LLP (US), New York Phone (212) 773-6714 Fax (866) 219-4169 Institute of International Banks IRS Financial Institution Audits and Cross Border Accounts Payable Issues

27 Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

28 US withholding tax update Senior IRS officials have approved a Compliance Initiative Program (CIP) for audits of US withholding agents –All LMSB audit teams have been instructed to include an audit of a Taxpayer’s Form 1042 filings with any income tax audit –The IRS has developed audit guidelines based upon the information learned during its Voluntary Compliance Program Guidelines should be published “soon” ”Two key types of US withholding agents Financial services institutions –Payments to account holders Multi-national companies –Payments to vendors –Significant focus on related-party payments Matching Forms 1042-S to Forms 5471 and 5472

29 Most common failures Incorrect reporting and withholding for “atypical” transactions –Derivative transactions –REITS –OID –Securities lending –Notional principal contracts –Syndicated loans –Payments to foreign intermediaries Documentation failures –Reliance on invalid Forms W-8 –Forms W-8IMY typically require additional information

30 Insights into audits of financial institutions Scope of audit –Functional review of procedures –Validation of Forms W-8 –Transactions requiring special treatment –Mechanical requirements –Consideration of penalties Preparing for the audit –Focus on the fundamentals What has the institution filed? Are procedures documented? –Who knows what is “really” done? Review Procedure Manuals

31 Issues to consider Statutes of limitations –Generally three years –Exceptions “Substantial understatement” –Six years No return filed –No statute Identifying mistakes –More likely than not; not everything is perfect –Options when mistakes are identified Voluntary disclosure Disclose to the agent –At the start of the audit or when found Let the agent try to find them

32 Scope of audit Functional review of procedures –Account opening procedures –Due diligence standards applied –Application of presumption rules All individuals are presumed US Entity status generally relies on mailing address

33 Scope of audit (Cont’d) Validation of Forms W-8 –Line by line review of forms Forms must be complete and accurate Are they consistent with account file information? Is there indicia of US status? –If yes, is there additional documentation? Capacity Are treaty benefits properly claimed? –US TIN where required? Has the form expired?

34 Scope of audit (Cont’d) Transactions requiring special treatment –REITS –OID –Securities lending –Notional principal contracts –Syndicated loans –Payments to foreign intermediaries

35 Scope of audit (Cont’d) Deposit requirements –Timely deposits –Accuracy –Reconciliation to Form 1042 Filing requirements –Forms 1042-S Timely filed Properly filed Furnished to payees –Form 1042 Timely filed Report amounts withheld properly Reconcile to Forms 1042-S

36 Scope of audit (Cont’d) Consideration of penalties –Potential penalties Failure to deposit – 10% Negligence or substantial understatement of tax – 20% Failure to file – 5.0% per month/up to 25% Failure to pay – 5.0% per month/up to 25% Failure to file/furnish information returns –$50 per failure to file/up to $250,000 –$50 per failure to furnish/up to $100,000 –Intentional disregard – 20% of understated income/no cap

37 Responding to Information Document Requests (IDRs) Try to respond timely –IDRs usually set time frames for response –Request more time when necessary Review responses objectively –Do they make sense? –Do not assume knowledge of facts that are not clearly presented –Do not assume knowledge of law –Does the response answer the question? –Think through implications of the response –Keep it simple

38 Curing The regulations allow a withholding agent to “cure” errors –Essentially retroactive Forms W-8 Curing takes time! How much remediation is needed? –Wholesale repapering? –Repapering of a specific business unit/line Fundamental procedures and process may need to be changed

39 Accounts payable Accounts payable was a big issue in the VCP for multi-national corporations –But, many financial institutions are multi-national too Most of the same issues that apply to customer payments apply to accounts payable as well –Documentation –Treaty benefits But they are more challenging to make – TINs are necessary Sourcing –Presumption rule says if you don’t know its foreign source, it is presumed US source

40 Four step process for accounts payable 1.Identify foreign vendors 2.Determine whether foreign vendors earned “fixed or determinable income” 3.Determine whether foreign vendors earned US source fixed or determinable income and how much US source income they earned 4.Obtain documentation from foreign vendors who earned US source fixed or determinable income


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