On May 7, 2009, the White House issued its proposed budget for fiscal year 2010, which outlines the Obama administration’s plan to reform certain of the Internal Revenue Code’s provisions on the taxation of international transactions. Proposed changes to the rules on withholding taxes, which are aimed at reducing tax evasion by U.S. citizens and residents and improving collection efforts for taxes owed by foreigners investing in the U.S., are of specific interest to many domestic and offshore private investment funds, including private equity funds, hedge funds and venture capital funds. Significantly, the changes discussed below can be implemented through regulations issued by the Treasury, which means there is an increased likelihood that these proposals will be implemented, since congressional approval is not required.

Under current law, payors ("Withholding Agents") of certain types of U.S.-sourced income paid to foreign individuals or entities are required to withhold a percentage of the income and remit that amount to the IRS. In some instances, the foreign recipient can provide the withholding agent with documentation that reduces or eliminates withholding. For example, a tax treaty may apply. This can be a relatively straightforward process if the beneficial owner of the income is the direct recipient. But the process becomes much more complicated when a foreign intermediary, such as a foreign partnership or a foreign bank acting as a nominee, sits between the withholding agent and the beneficial owner.

Currently, a foreign intermediary may become a qualified intermediary ("QI") by entering into an agreement with the IRS to properly withhold and remit appropriate tax amounts. The benefit to the QI for voluntarily complying with this program is that the IRS will not generally audit the QI’s withholding records as long as they are audited by an outside independent auditor. The QI program also shifts the responsibility for withholding from the U.S. payor to the QI, which in some instances allows the QI to control the amounts withheld and remitted to the IRS without disclosing the identities of the beneficial owners to the U.S. payor or the IRS.

Foreign intermediaries that do not elect QI status are referred to as nonqualified intermediaries. There is nothing inherently wrong with a nonqualified intermediary, but because these entities do not voluntarily subject themselves to IRS scrutiny, there may be a perception of potential abuse by beneficial owners receiving income via such entities.

Currently, a foreign intermediary may become a qualified intermediary ("QI") by entering into an agreement with the IRS to properly withhold and remit appropriate tax amounts. The benefit to the QI for voluntarily complying with this program is that the IRS will not generally audit the QI’s withholding records as long as they are audited by an outside independent auditor. The QI program also shifts the responsibility for withholding from the U.S. payor to the QI, which in some instances allows the QI to control the amounts withheld and remitted to the IRS without disclosing the identities of the beneficial owners to the U.S. payor or the IRS.

Foreign intermediaries that do not elect QI status are referred to as nonqualified intermediaries. There is nothing inherently wrong with a nonqualified intermediary, but because these entities do not voluntarily subject themselves to IRS scrutiny, there may be a perception of potential abuse by beneficial owners receiving income via such entities.