Absent the application of a treaty or other exception, U.S. payors of U.S. source dividends, interest, rents, royalties, compensation, and other fixed or determinable annual or periodical gains, profits, and income (FDAPI) are required to withhold 30% of such payments and pay them over to the U.S., and file appropriate withholding tax returns. A recent supplement to the Internal Revenue Manual signals increased future audit activity in this area, both as to U.S. financial institutions in connection with their brokerage and custodial activities, and non-financial institutions that may not be focused on withholding tax compliance. Non-financial institutions that can expect enhanced scrutiny include professional services firms (law, accounting, and architecture), high-tech medical equipment and computer hardware and software companies, intellectual property providers such as entertainment and publishing, pharmaceutical companies, and companies in the real estate industry.
One method to reduce penalty exposure is for taxpayers to adopt the same examination techniques of their own operations that IRS agents are being advised to use on audit. Thus, taxpayers (or their accountants) should consider:
a. Developing procedures for identifying payment recipients that are subject to withholding and procedures for determining exemptions from withholding and for reporting, which procedures are implemented and ready to be handed over the IRS if an audit arises. It would be all the better if such procedures are in writing and implemented in operating procedure manuals or similar training materials for employees;
b. Review Schedule M of Form 5471, which reports payments made by the taxpayer to controlled foreign corporations, and includes payments of commissions, rents, royalties, license fees, interest, and dividends, and Forms 5472, to determine that payments to all related parties on such forms are being subjected to withholding and reporting when required;
c. Reviewing accounts payable lists for accounts that indicate foreign ownership by reason of name, address, or taxpayer identification number, and assure withholding tax compliance for payments to such payees;
d. Doing the same review as to recipients of corporate dividends and interest payments to the extent not managed through the accounts payable department;
e. Confirming that all withholding is being properly included on Forms 1042 and 1042-S filings;
f. Confirming that copies of Forms W-8 and 8233 are being properly retained to substantiate no withholding based on such forms.
Since it is the payees that suffer the economic cost of withholding, there is no reason for payors not to comply, other than the marginal costs of compliance. Following the foregoing procedures should go a long way towards reducing or eliminating penalties for inadvertent noncompliance, and should further reduce the risk of being held responsible for taxes that are not withheld.