The Tax Cuts and Jobs Act’s looming expirations and changes require Congress to reconsider tax reform again. One item that probably won’t be high on Congress’ list—but ought to be—is reducing the high rate of US withholding tax on payments of fixed or determinable annual or periodic income, or FDAP.
Sometimes, withholding is a prepayment or means of ensuring payment of tax. Think of the wage withholding that an employer undertakes.
In the international context, there’s the withholding that a partnership undertakes on effectively connected income allocable to foreign partners, or that a buyer undertakes on the sale of a partnership interest under Section 1446(f) of the tax code or of a US real property interest under Section 897. The tax rate applied in this kind of withholding affects cash flow but not ultimate tax liability.
FDAP is different. The 30% tax rate imposed by Section 871(a) on payments to non-US individuals and by Section 881 on payments to non-US corporations aims to be a final payment of tax liability.
Rarely will a non-US recipient file a US federal income tax return. Rather, the payor withholds because the recipient usually resides outside the US, and the IRS has no means of requiring the recipient to file tax returns and remit tax.
FDAP’s withholding system makes sense conceptually. Allowing US persons to make tax-free payments to non-US persons can create undesirable incentives and disincentives. But setting the FDAP withholding tax rate too high simply creates another set of undesirable distortions, such as discouraging non-US persons from investing in, or licensing intellectual property to, US companies.
So, why are FDAP withholding tax rates the same as they were in 1954, despite all the changes in US tax rates and rules over the last 70 years? The various justifications given for such high rates don’t withstand scrutiny.
One reason given for the high tax rates is to protect the federal income tax base. That rationale is partial at best. It might justify a withholding tax on deductible payments, but not one on non-deductible payments such as dividends.
Another stated rationale is symmetry. A US person would be taxed on the payment, and if it could be made free of tax to a non-US person, the US tax rules would favor payments to non-US persons.
That rationale justifies a withholding tax, but it can’t explain the current rate for US withholding tax. Rarely, if ever, would a US person face a net income tax liability equal to that of a 30% gross basis tax.
An additional justification sometimes given is that high US withholding taxes strengthen the hand of US negotiators in obtaining withholding tax rate reductions for US taxpayers in tax treaties.
Even if this is true, it isn’t a satisfying explanation. The US won’t negotiate treaties with countries where there isn’t significant unrelieved double taxation. So, countries that don’t impose withholding tax can never get a reduction in US withholding tax under this rationale.
The candid answer for the 30% rate is inertia. Lowering tax on nonresidents is never going to be a popular political slogan or bumper sticker. And many non-US persons manage to avoid the 30% rate by using workarounds and exceptions.
For example, a non-US investor who wants to avoid the US withholding tax on dividends may acquire shares in domestic corporations that don’t expect to pay dividends before the investor sells the shares. If the domestic corporation isn’t a US real property holding corporation—and the investor isn’t engaged in the conduct of a US trade or business and avoids spending too much time in the US—the gain on the sale of the shares isn’t subject to US income or withholding tax.
Similarly, for non-portfolio investments, the domestic corporation often can be liquidated so non-taxable gain, and not dividend income, is realized. If cash needs to be withdrawn from the domestic corporation, the non-US person can fund the domestic corporation with debt to allow tax-free withdrawals of principal.
As for interest payments, many non-US persons can avoid the 30% withholding tax on interest by using the portfolio interest exemption of Sections 871(h) or 881(c). For non-US persons residing in treaty jurisdictions, the applicable US income tax treaty usually reduces or eliminates the US withholding tax on FDAP.
Finally, if a non-US person concludes that operating through a US company or branch is a better tax result than suffering under FDAP, the non-US person can do just that.
As a result, a non-US person that wants to avoid or reduce FDAP taxation has opportunities to do so. These workarounds can affect the form or amount of investment, however, and lead to artificial (and sometimes aggressive) structures simply to avoid the FDAP withholding tax.
The US has criticized other countries for enacting digital service taxes and other taxes it views as targeted against US companies and applied in a discriminatory manner. Yet withholding tax rates that exceed the effective rate imposed on domestic taxpayers do the same thing.
There is a clear role for withholding taxes on cross-border flows. Still, any withholding tax should be set at a rate that is consistent with its objectives. Reducing US withholding tax, for example to no more than the US corporate tax rate, may not win public acclaim. But it is tax reform.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
John Harrington is co-leader of Dentons’ US tax practice and advises on transactions, compliance, and international and domestic tax issues.
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