The White House issued a proposed 2010 budget which includes the Obama administration’s plan to reform sections of the U.S. Tax Code on international transactions. One proposal includes a change in how international and domestic banks with foreign clients withhold tax and report to the Internal Revenue Service. The rule change is aimed at improving collection efforts on taxes owed by foreign investors and reducing tax evasion by U.S. citizens and residents. The change in withholding taxes is likely to be implemented because it does not require approval by Congress. It can simply be implemented through new regulations issued by the Treasury Department.

This change is of interest to many domestic and international banks in South Florida which rely on crossborder transactions and deposits from their foreign clients and foreign affiliate offices. The same rules also are likely to affect private investment funds, such as private equity funds, venture capital funds and their managers, which solicit foreign investors. Likewise, the private bank departments in Miami serving the wealthy families of Latin America that wish to invest in the U.S. capital markets will be impacted.

Under current law, banks and other payors, also known as withholding agents, of certain types of income generated in the U.S. and 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 documentation to the withholding agent, which reduces or eliminates the withholding tax. For example, an income tax treaty may apply to reduce the withholding tax. Or a particular U.S. tax law may provide an incentive for foreign persons to invest in U.S. capital markets by exempting from tax certain income earned in the U.S. Submitting the proper documentation to the withholding agent can be a relatively straightforward process when the foreign beneficial owner of the income is the direct recipient of the payment made by the U.S. payor.

But the process becomes much more complicated when a foreign intermediary, such as a foreign bank office or investment fund, is submitting or investing the funds on behalf of the foreign investor. Currently, the foreign intermediary is required to obtain documentation from the foreign beneficial owner and supply that documentation to the U.S. bank or payor. Alternatively, the foreign intermediary may enter into a lengthy agreement with the IRS granting it qualified intermediary, or QI, status permitting the intermediary to properly withhold and remit appropriate tax amounts. The benefit to the QI for voluntary compliance is the IRS will not generally audit the QI’s withholding records and will not review specific information of its investors. Instead, the QI is permitted to contract its own independent auditor to confirm it is collecting proper documentation from its clients. The QI status also shifts the withholding responsibility from the U.S. bank or payor to the QI, and this shift allows the QI to control the amounts withheld and remitted to the IRS without disclosing the private and personal information of its clients to the U.S. payor or the IRS. Sometimes, QI status also is obtained because the foreign bank office must comply with local privacy laws.

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 foreign entities do not voluntarily submit themselves to IRS scrutiny, by entering into a QI agreement, there seems to be the perception that an opportunity for abuse exists for U.S. citizens or residents to avoid U.S. taxes when

 utilizing a foreign intermediary.

The Obama administration seeks to remedy the perceived abuse by imposing a withholding tax on all U.S. source payments made through a nonqualified intermediary without the possibility for a reduction or elimination of the withholding tax. A beneficial owner, who under current law would be able to reduce or eliminate withholding tax by providing appropriate documentation, would instead be subject to withholding tax and would then be required to file a U.S. tax return claiming a refund. This would be the case even when an amount paid to a foreign beneficial owner would be exempt because of a tax treaty or a tax exemption under another provision of the U.S. Tax Code. Conversely, a beneficial owner investing through a QI could continue to avoid withholding tax when appropriate by simply providing the proper documentation. Unfortunately, even those banks and foreign intermediaries that do business only with foreign clients and maintain all proper documentation of their foreign status will still be subject to the new proposal requiring withholding tax on all payments to foreign clients.

Another significant proposed change is that a QI would be forced to comply with enhanced reporting standards equal to those of U.S. financial intermediaries. While information is not currently available on exactly what information would be reported, a significantly higher level of transparency and disclosure seems imminent under the proposal.

If the changes are implemented as proposed, local and international banks operating in the U.S. will need to assess their obligations under the new rules from several perspectives, including the kinds of documentation required from foreign payees. Further, foreign banks and investment funds acting as intermediaries will need to consider the advantages of applying for QI status against the potential reporting burdens, especially considering the privacy issues under local laws and the QI disclosure standards.