The prior Chapters dealt with characterizing types of income as U.S. or foreign source. Once the income has been sourced, the next determination which must be made is whether there is a U.S. trade or business to which such income is effectively connected. Where there is a U.S. trade or business to which such income is effectively connected, then the NRA or foreign corporation will be subject to tax in the U.S. at a graduated rate of tax on net income. There is no gross basis withholding tax related to effectively connected income. Where such income is not effectively connected to a U.S. trade or business, then all such U.S. source income will generally be subject to a 30 percent (or lower treaty) gross basis withholding tax.
In addition to the net basis tax on effectively connected income and gross basis withholding tax on FADPI income, there is also a third system of withholding tax known as backup withholding. A withholding agent is required to backup withhold at a rate of 31 percent on specified payment where the payee fails to properly identify themselves. A completed Form W-8 or Form W-9 identifying the payee, providing their EIN number or TIN number in the case of foreign payees or other statement providing the similar type of information will be considered sufficient to avoid the backup withholding provisions. Where a taxpayer does not properly identify itself, it becomes more difficult for the U.S. Government to apply their tax regimes to the recipient. In order to remedy this the U.S. requires backup withholding in such circumstances, under the theory that they will withhold the tax and wait for the taxpayer to properly identify itself when it files an annual tax return or when it files a refund claim.
In addition to the various exemptions provided in sourcing U.S. income, there also exists exemptions from the application of the net basis tax and gross basis withholding tax.
One of the most notable exemptions from U.S. Withholding Tax is interest on qualified portfolio indebtedness. This exemption allows U.S. businesses to access foreign capital and foreign financing by exempting interest on qualified portfolio indebtedness from U.S. taxation and allowing the U.S. businesses an interest deduction for such interest payments.
This section briefly discusses income which is classified as effectively connected with a U.S. trade or business and subject to U.S. net basis taxation. However, since this volume’s principal focus is to discuss Non Resident U.S. Portfolio Investments, we have briefly discussed these rules. For a more detailed discussion of net basis taxation of income effectively connected with a U.S. trade or business see in this topical library, “Taxation of Foreign Corporations” and for a more detailed discussion of gross basis withholding tax see “Withholding Obligations for U.S. Payors on Payments Made to Foreign Persons”.
Deciding whether a foreign person is engaged in a U.S. trade or business will be determinative as to whether the foreign person will be taxed in the U.S. on a gross or net basis.
NRAs have their U.S. income tax liability determined pursuant to Code Secs. 871-877. The type of income subject to tax, allowable deductions and the rate of tax depends on whether the taxpayer is engaged in a trade or business in the U.S. An NRA who is not engaged in a U.S. trade or business is subject to 30 percent gross basis tax on FADPI income, which is collected through withholding. Code Secs. 871 and 1441(a). A nonresident alien individual engaged in a U.S. trade or business is subject to tax on a net income basis for effectively connected income which is subject to regular U.S. graduated tax rates. Code Sec. 871(b).
Foreign corporations are subject to U.S. tax pursuant to Code Secs. 882-884. A foreign corporation not engaged in a U.S. trade or business is subject to a 30 percent gross basis withholding tax on U.S. source FADPI income. Code Secs. 881(a) and 1442. A foreign corporation engaged in a U.S. trade or business is subject to tax on a net income basis for effectively connected income at regular graduated U.S. tax rates and is also subject to a branch profit tax on an amount essentially equivalent to a dividend. Code Secs. 882 and 884.
Besides actually being engaged in a trade or business, U.S. law imputes a trade or business activity to certain taxpayers. Where an NRA or foreign corporation has a gain from the sale of U.S. real estate, U.S. tax law imputes a trade or business to such activity. Code Sec. 897(a).
Example 1: Mr. NRA owns vacant land in America which he sells at a gain. Mr. NRA will be deemed to be engaged in a U.S. trade or business, from this isolated sale, and the gain will be subject to tax net of offsetting deductions at normal graduated tax rates for U.S. individuals.
There are also special rules which impute a U.S. trade to business to partners of partnerships, which include LLCs and LLPs which elect to be taxed as partnerships and beneficiaries of Estates and Trusts. Code Sec. 875. An NRA or foreign corporation shall be considered as being engaged in a U.S. trade or business where it is a partner in a partnership which is engaged in a U.S. trade or business. Code Sec. 875(1). Additionally, any NRA or foreign corporation which is a beneficiary of an estate or trust, which is engaged in a U.S. trade or business, shall also be treated as engaged in such trade or business. Code Sec. 875(2).
The interesting issue with such imputed U.S. trade or business is whether the foreign partner or foreign beneficiary’s other U.S. source income is treated as effectively connected with this imputed U.S. trade or business. Code Sec. 864(c)(3). The intention of imputing a U.S. trade or business to a foreign partner or beneficiary is to define how the particular partner or beneficiary should be taxed on its share of the income which is effectively connected with the partnership’s U.S. trade or business or on its share of the trust or estate’s effectively connected income. The imputation of a U.S. trade or business is necessary because partnerships are generally not taxable as an entity. Partnerships determine solely the character of the income, which is attributed and taxed to each separate partner. For trusts and estates, income which is distributed to foreign beneficiaries, is characterized at the trust or estate level and is taxed to the beneficiaries. Rev. Rul. 91-32, 1991-1 C.B. 107.
805: Income Effectively Connected with U.S. Trade or Business.
(A) U.S. Trade or Business
The definition of a trade or business is not specifically provided in the Internal Revenue Code. The term trade or business within the United States includes the performance of personal services within the United States at any time during the tax year. Code Sec. 864(b). The rules for determining whether other activities constitute a U.S. trade or business have developed over the years through rulings and court decisions. As a result, the determination of whether a taxpayer’s income is effectively connected with a U.S. trade or business is not an exact science but rather a matter of particular facts and circumstances.
Engaging in considerable, continuous and regular activity is the keystone for classifying a taxpayers activities as a U.S. trade or business. The passive collecting of income does not constitute a U.S. trade or business. Pinchot v. Comr., 113 F. 2d 718 (2d Cir. 1940). A single transaction generally does not amount to engaging in a U.S. trade or business. An isolated and relatively unplanned sale will not, in and of itself, constitute a U.S. trade or business. Linen Thread Co. v. Comr., 14 T.C. 725. Significant transactions consummated on a sporadic basis will not give rise to a U.S. trade or business. Continental Trading, Inc. v. Comr., 265 F. 2d. 40 (9th Cir.). Sporadic sales may reach a significant volume, without being classified as a U.S. trade or business. George Pasquel, 12 TCM (CCH) 1431 (1953).
While an isolated sale may not constitute a U.S. trade or business, a single taxable event which is tailored to produce an isolated contact with the U.S. may constitute a U.S. trade or business. For example, a rock concert or a prize fight, a horse race or a recording session will not be continuous but they are designed to be a single taxable event and have been held to constitute a U.S. trade or business. Therefore, a single rock concert in the U.S., racing a horse in the United States on one occasion, or cutting a record in the United States will be a U.S. trade or business.
An NRA or a foreign corporation is engaged in a U.S. trade or business, if they are so engaged at any time during the tax year. Therefore, an annual determination as to whether the taxpayer is engaged in a U.S. trade or business needs to be made. It is possible to be in a U.S. trade or business in one year and not in the next. Income which is effectively connected during a particular tax year but which is received in another tax year, when the taxpayer does not have a U.S. trade or business, will be treated as effectively connected in the year received if it would have been effectively connected in the year to which it is attributable. Code Sec. 864(c)(6).
Example 1: F Co. was engaged in a U.S. trade or business in Y1. F Co. sold an item requiring installment payments over 5 years. F Co. discontinued its U.S. trade or business in Y3. The income which F Co. collects in Y4 and Y5 from its sale in Y1 are treated as U.S. source effectively connected income in Y4 and Y5. F Co. will have to continue to file a Form 1120F showing its U.S. source effectively connected income from this installment sale in Y4 and Y5.
Furthermore, gain from the disposition of any property that is being used or held for use in a U.S. trade or business, within ten years of the cessation of such U.S. trade or business, will be treated as effectively connected upon its disposal. Code Sec. 864(c)(7).
Example 2: NRA had a printing business in the United States and owned a printing machine which cost $100,000 upon which it took $40,000 of U.S. depreciation deductions in Y1 and Y2. NRA closed his business at the end of Y2, moved the machine to Argentina and used the machine there for 3 more years. In Y5, NRA sold the machine for $70,000. The depreciation which would have been allowable in years Y3-Y5 is $60,000. Therefore, for U.S. purposes, the taxpayer has a gain of $70,000 ($70,000 minus a zero basis) of which $40,000 is recharacterized as U.S. source effectively connected income. Code Secs. 865(c)(3) and 864(c)(7).
An NRA or foreign corporation can also have a U.S. trade or business imputed to it without any specifically identifiable events, where U.S. tax law so provides. A good example of such imputation of a U.S. trade or business are the U.S. tax rules regarding gain from the sale of U.S. real estate by NRAs and foreign corporations. Any gain which a foreigner recognizes from the sale or disposition of U.S. Real Estate is treated as income which is effectively connected to a U.S. trade or business. Code Sec. 897(a).
There are two statutory exemptions from being categorized as a U.S. trade or business. One is for personal services where the NRA is in the U.S. for less than 90 days and their compensation does not exceed $3,000.00. Code Sec. 864(b)(1). The second exception is for trading in stocks or securities or commodities through a resident broker, commission agent, custodian or other independent agent. Code Sec. 864(b)(2). The volume of securities transactions are irrelevant in determining whether a U.S. trade or business exists. Reg. § 1.864-2(c)(1).
Examples of activities which have been held not to constitute a U.S. trade or business based upon the specific facts include:
(1) Management of one’s investments. Continental Trading, Inc. v. Comr., 265 F2d 40(9th Cir.)
(2) Investigating a Business Opportunity in the U.S. Abbeg. v. Comr., 50 T.C. 145(1968).
(3) Mere Ownership of U.S. Rental Real Estate, Herbert v. Comr., 30 T.C. 26 (1958); and
(4) Occasional sales of securities. Continental Trading Inc. v. Comr. 16 T.C.M. 724 (1957).
(B) Effectively Connected Income
(1) In General
All U.S. source income, other than certain FDAPI income, is automatically treated as effectively connected income whether or not it is related to a U.S. trade or business. Code Secs. 864(c)(2) and 864(c)(3). FADPI income is treated as effectively connected to a U.S. trade or business only where it is deemed to be related to the U.S. business activity. Code Sec. 864(c)(2).
(2) Effectively Connected FADPI Income – Special Rules
Two classes of FADPI income are subject to U.S. tax as effectively connected income:
(a) Gain or loss from the sale or exchange of capital assets, and
(b) Income of the type described in Code Sec. 871(a)(1), 871(h), 881(a), or 881(c). Code Sec. 864(c)(2).
The first category refers to capital gains arising from disposition of capital assets as defined in Code Sec. 1221 and generally includes nondepreciable tangible personal property. The second class is FADPI income.
Furthermore, there are two rules set out to determine whether capital assets and FADPI income are effectively connected with a U.S. trade or business:
(a) Whether the income or loss was derived from assets used in the conduct of the U.S. trade or business (asset use test) or
(b) Whether the activities of the U.S. trade or business were material factors in the realization of the income, gain, or loss (business activities test). Code Sec. 864(c)(2).
Examples of assets used in a U.S. trade or business would include cash, operating capital, interest on accounts receivable, and other assets held in direct relationship to the ordinary course of the U.S. trade or business. Reg. § 1.864-4(c)(2)(ii). However, assets held for future diversification, expansion, future replacement or contingent events do not give rise to effectively connected income, as these are not assets held in the ordinary course of operating the existing U.S. trade or business. Reg. § 1.864-4(c)(2)(i).
Capital Gains and FADPI income will also be effectively connected where the U.S. trade or business was a material factor in obtaining the income. Reg. § 1.864-4(c)(2)(ii). This business activity test is primarily significant where the operation is financial, banking, or a similar business or is a licensing business and the income derives from these activities. Reg. § 1.864-4(c)(3). Dividends or interest derived by a dealer of stock and securities is effectively connected income. Gains from sale of capital assets by an active investment company are also effectively connected. Interest on accounts receivable would generally meet the business activities test for all types of taxpayers, as the business is a material factor in the realization of income from these accounts receivable.
Example 3: F Co. engages in a U.S. trade or business through a U.S. branch. Interest on overdue receivables is paid directly to the parent corporation abroad. Such interest is effectively connected with F Co.’s U.S. trade or business, since the activities of the U.S. branch were a material factor in the realization of this interest income.
(3) Effectively Connected Income – All other income
All other U.S. source income, other than FADPI type income discussed above, is effectively connected with a U.S. trade or business. No additional analysis needs to be made as far as connecting the income to the U.S. trade or business.
Caution: Therefore, it is very crucial to determine whether a taxpayer’s activity is regular and continuous thus giving rise to a U.S. trade or business, since the minute the taxpayer is deemed to be engaged in a U.S. trade or business, all U.S. source income which is not FADPI income will immediately be treated as effectively connected income and subject to U.S. net income tax.
(4) Foreign source effectively connected income.
Three classes of foreign source income can be treated as effectively connected with a U.S. trade or business, but only where the taxpayer has an office or other fixed place of business in the U.S. to which the income is attributable. Code Sec. 864(c)(4)(B). The following types of foreign source income will be treated as effectively connected with a U.S. trade or business where the income is attributable to such U.S. trade or business:
(a) Rents, royalties, and gains from the sale of intangible personal property.
(b) Dividends, Interest and Gains from stocks and securities.
(c) Sale of personal property (including inventory).
The above mentioned three types of income can only be sourced in the U.S. where this foreign source income is attributable to a U.S. office.
Example 4: Where F Co. sells inventory and where title to inventory passes outside the U.S., and the U.S. office materially participates in the sale of such property, then such income will be foreign source income effectively connected with a F Co.’s U.S. trade or business. Code Sec. 864(c)(4)(B)(iii).
However, it is essential to point out that this foreign source income will only be effectively connected to a U.S. trade or business where the U.S. office materially participates in generating the income and where no foreign office materially participates in generating such income.
Comment: This foreign source effectively connected income is really a trap for the unwary, as it is relatively simple to have this foreign income attributed to a foreign office which materially participates in generating such income.
(D) Net Basis Graduated Tax on U.S. Source Effectively Connected Income
NRAs and foreign corporations who have U.S. or foreign source income, which is effectively connected with a U.S. trade or business, shall be taxed on a net basis using graduated income tax rates. Code Secs. 871(b) and 882. In determining the taxable income which is effectively connected to a U.S. trade or business, a foreign taxpayer must allocate and apportion deductions attributable to such income. Code Secs. 873 and 882(c).
Once effectively connected income is reduced by attributable deductions in arriving at taxable income, this taxable income is subject to graduated rates of tax. This income may also be subject to additional state and local taxes.
The imposition of tax on effectively connected income is administratively significantly more burdensome on the foreign taxpayer as a result of requiring the taxpayer to file U.S. tax returns and requiring the foreign taxpayer to allocate and apportion deductions attributable to its U.S. trade or business income. Furthermore, once a foreign taxpayer is engaged in a U.S. trade or business, it is also required to keep certain records relating to foreign activities in order to determine whether its apportionment of income and expenses to the U.S. is in fact correct. Code Secs. 482 and 6038(C). The benefit of having U.S. source income treated as effectively connected with a U.S. trade or business, is that it is taxed on a net basis, subject to graduated net income rates and is not subject to withholding tax when it is earned.
Planning Note: There may arise situations where a net income tax from a transaction results in less tax than a 30% gross basis withholding tax. In these situations, a taxpayer may plan to have more than an isolated transaction and attempt to have its income classified as effectively connected with a U.S. trade or business. Upon qualifying as a U.S. trade or business all non FADPI U.S. income will automatically be effectively connected and subject to a graduated rate of tax on net income.
815: Fixed and Determinable Periodic Income (FADPI).
(A) In General
All U.S. source income, which is not effectively connected to a U.S. trade or business, is subject to U.S. gross basis withholding tax. The rate of withholding is generally 30 percent (or lower treaty) rate, which is required to be withheld at the time of payment. Code Secs. 1441 and 1442. The obligation to withhold is imposed upon all persons, acting in whatever capacity, having the control, receipt, custody, disposal or payment of any kind of FADPI income derived from sources within the United States by an NRA or foreign corporation. The place of payment is irrelevant as it relates to the obligation to withhold. Foreign source income, is not subject to withholding.
U.S. tax rules make the withholding agent personally and primarily liable for the amounts required to be withheld. Code Sec. 1461. Where the withholding agent does not withhold such tax, it will be liable for such amount. In addition, there are multiple penalties imposed for failure to file, negligence and fraud, failure to make deposits and failure to collect and pay overtax. Code Secs. 6651, 6653, 6656 and 6672. However, where the withholding agent does not withhold and the taxpayer pays such amount with the filing of its tax return or otherwise, then the withholding agent is only responsible for interest from the date payment of income was made to the taxpayer (date of required withholding) until the date the taxpayer actually pays such tax.
(B) Withholding Tax On Payments of FADPI income to NRA’s
All persons acting, in whatever capacity (including lessees or mortgagors of real or personal property, fiduciaries, employers, and all officers and employees of the U.S.) having control, receipt, custody, disposal, or payment of any items of FADPI income are subject to these gross basis withholding requirements. Code Sec. 1441(a). The U.S. puts the withholding obligation on the U.S. payor in order to ensure the collection of this withholding tax.
The term FADPI income includes Fixed And Determinable Periodic Income. FADPI income is subject to gross basis withholding tax; regardless of whether it is received in a series of payments or in one lump sum. Reg. § 1.441-2(a)(1). An item of the income is fixed when the amount to be paid is definitely predetermined. Income is also determinable when there is a basis of calculation by which the amount to be paid can be ascertained. Reg. § 1441-2(a)(2).
Example 1: USCO entered into agreement to pay a royalty for the use of F Co.’s name in the United States. The royalty provides that USCO shall pay at the end of Y3 3% of its gross revenue from years Y1-Y3 from selling F Co.’s products. In Y3, when USCO makes the payment of such royalty, this royalty is FADPI income regardless of the fact that it is not paid every year.
(C) Foreigners are Subject to Gross Basis Withholding Tax on FADPI income
Gross basis withholding tax is imposed solely upon foreign persons who receive payments of FADPI type income. The following are foreign persons upon which withholding on payments of FADPI type income must be made:
(1) A Nonresident alien. Code Sec. 1441(a);
(2) A Foreign Corporation. Code Sec. 1442(a);
(3) A Foreign Partnership. Code Sec. 1441(a); and
(4) A Foreign Trust or Estate. Reg. § 1.1441-2(a).
825: Exemption from Withholding.
(A) In General
After the withholding agent has determined that the payment which they are about to make is FADPI income, that the recipient is a foreign person, they must then analyze the payment to see whether it is an exempt payment pursuant to the exemptions provided within the Internal Revenue Code or whether it is a treaty reduced or exempt payment. The exemptions include but are not limited to the following:
(1) Certain types of interest;
(2) Non U.S. source income;
(3) Certain dividends from domestic corporations;
(4) Income that is otherwise effectively connected with a U.S. trade or business;
(5) Compensation for personal services which was already subject to tax as wage withholding;
(6) Annuities from certain qualified plans;
(7) Payments to foreign governments and foreign central banks of issue;
(8) Scholarship and Grants;
(9) Payments by the U.S. Government to nonresident trainees; and
(10) Certain Gambling Winnings.
(B) Exempt Interest
(1) Bank Interest. Bank Interest and Similar Types of Deposits (including original issue discount) that are U.S. source are exempt from withholding;
(2) Foreign Banking Branch. Interest on Deposits with a foreign branch of a domestic corporation or domestic partnership engaged in commercial banking. Code Sec. 861(a)(1)(B).
(3) 80 percent Foreign Income. Interest from a resident alien or domestic corporation where the payor receives 80 percent or more of its income from the active conduct of a foreign trade or business. Code Sec. 861(a)(1)(A).
(4) Interest on Short Term OID Instruments. Interest on all obligations, which are payable in 183 days or less from the date of original issuance, are exempt from U.S. gross basis withholding tax. Code Secs. 871(g)(1)(B) and 881(a)(3).
(5) Interest from State and Local Bonds. Bonds issued by state and local government organizations, in the United States, are exempt from U.S. gross basis withholding tax regardless of the term of such obligation. Code Secs. 871(g)(1)(B)(ii) and 881(a).
(6) Foreign Central Bank. Interest Payments to a Foreign Central Bank of issue or Bank for International Settlements, which are exempt by Code Sec. 895, are exempt from gross basis withholding tax. Code Secs. 871(i)(2)(C) and 881(d).
(7) Portfolio Indebtedness. Interest on Qualified Portfolio Indebtedness is Exempt from Gross Basis Withholding Tax. Code Secs. 871(h)(1) and 881(c) (see detailed discussion at ¶ 835 below).
(C) Income Effectively Connected With a U.S. Trade or Business
Income effectively connected with a U.S. Trade or Business is not subject to gross basis withholding tax. Code Secs. 1441(c)(1) and 1442(b). Income which is effectively connected with a U.S. trade or business does not escape U.S. taxation, it is taxed on the net basis and therefore is exempt from U.S. gross basis withholding tax. The withholding agent must be notified on Form W-8ECI (Form 4224 prior to January 1, 2000) or similar Form, prior to payment of the FADPI income.
(D) Exempt Dividends
(1) Dividends Paid by U.S. Corporations With 80% or more Foreign Income.
Dividends paid by a domestic corporation which derived at least 80% of its gross income, during the test period, from the conduct of an active foreign trade or business; shall have that same portion of its dividends exempt from U.S. gross basis withholding tax. Code Sec. 871(i)(2)(B) and 881(d).
(2) Foreign Dividends with Greater than 25 Percent ECI.
Dividends of a Foreign Corporation should be treated as U.S. source dividends where 25% or more of the corporation’s worldwide gross income consists of U.S. source effectively connected income, unless the foreign corporation had the same earnings subject to U.S. branch profit tax for the year. Code Secs. 861(a)(2)(B) and 884(c)(3)(A). Where the foreign corporation has U.S. source effectively connected income of 25% or more of its worldwide gross income, during the testing period then the same portion of dividends paid by the foreign corporation shall be treated as U.S. sourced dividends. Code Sec. 861(a)(2)(B).
Example 1: FCO had 30% of its worldwide earning from U.S. source effectively connected income, during the testing period. When FCO makes a $100,000 dividend, $30,000 of the dividend will be treated as U.S. sourced dividends.
The testing period is the three year period ending with the close of the tax year preceding the declaration of such dividend. Code Sec. 861(a)(2)(B).
(E) Compensation for Personal Services
Compensation for Personal Services is exempt from gross basis withholding tax, where such income has already been subject to normal U.S. wage withholding pursuant to Code Sec. 3402. Code Sec. 1441(c)(4).
(F) Annuities from certain qualified plans
Annuities from certain qualified plans are exempt from withholding where the amount received qualifies as an annuity.
(G) Payments to Foreign Governments
Payments to Foreign Governments (including a foreign central bank of issue, that are excludable from gross income pursuant to Code Sec. 892 exclusion for income of foreign governments and international organizations). Reg. § 1.1441-8(a).
(H) Scholarships and Grants
Scholarships and Grants are subject to a reduced 14% gross basis withholding tax. Code Sec. 1441(b).
(I) Per Diem of Certain Alien Trainees
Gross basis withholding is not required on per diem amounts for subsistence paid by the U.S. government to NRA trainees. Code Sec. 1441(c)(6).
(J) Foreign Tax Exempt Organizations
Amounts paid to foreign tax exempt organizations are exempt from withholding to the extent that the income which they receive is not income from a trade or business unrelated to their charitable purpose. Reg. § 1.1441-1(b)(4)(xvii).
(K) Gambling Winnings
No gross basis tax is required to be withheld from the foreigners on their recipient of gambling winnings from blackjack, roulette, baccarat, craps and big six wheel. Code Sec. 1441(c)(11).
(L) Treaty Exemptions
Amounts that would otherwise be subject to U.S. gross basis tax may be reduced or eliminated pursuant to an income tax treaty, which the United States has with certain foreign countries. Code Sec. 894.
835: Portfolio Interest Exemption
(A) In General
NRAs and foreign corporations are exempt from U.S. tax on certain “portfolio interest” income that is not effectively connected with the foreign recipient’s U.S. trade or business. Portfolio Interest includes noncontingent interest and OID, which is paid on certain obligations that meet specific requirements.
Two types of obligations may qualify for the portfolio interest exemption: (1) obligations which are in registered form and (2) certain bearer obligations. Portfolio interest is defined as interest otherwise subject to gross basis withholding tax on any obligation that is either:
(1) In registered form and the withholding agent receives an appropriate statement that the beneficial owner of the obligation is not a U.S. person or
(2) Not in registered form and it meets the foreign targeted obligation requirements of Code Sec. l63 (f)(2)(B). Code Secs. 871(h)(2) and 881(c).
(B) Obligations in Registered Form.
(1) In General
Portfolio interest includes interest paid on an obligation that is in registered form and for which the United States person who would otherwise be the withholding agent on such interest has received a statement that the beneficial owner of the obligation is not a United States person. The statement can be made either by the beneficial owner or the securities clearing organization, bank, or other financial institution that holds customer’s securities in the ordinary course of their trade or business. The purpose of the registration requirement is to insure that the issuer knows the identity of the holder of the instrument. This enables the issuer to furnish the appropriate reports to the IRS regarding interest payments made to foreign persons. An obligation does not have to be registered with the U.S. Securities and Exchange Commission in order to be qualified as a registered obligation for the portfolio interest exemption.
(2) Registered Form
The term “registered form” has the same meaning giving such term by Code Sec. 163(f). Code Secs. 871(h)(7) and 881(c)(7).
An obligation will be in registered form if:
a. The obligation is registered as to principal and interest with the issuer or its agent, and transfer of the obligation can be effected only by surrender of the old instrument and either re-issuance of the old instrument or issuance of a new instrument to the holder;
b. The right to principal of and stated interest on, the obligation can be transferred only by a book entry system maintained by the issuer (or its agent); or
c. The obligation is registered both as to principal and interest with the issuer or its agent and can be transferred only through both surrender and issuance (or re-issuance) of the obligation and the issuance is recorded on the book entry system of the issuer (or its agent). Temp. Regs. § 5f. 163-1 and 5f. 103-1(c)(1).
Although the temporary regulations do not further explain what constitutes registration, in practice this means that the issuer must maintain a written record of the ownership of the obligation and the holder is identified in the certificate, promissory note, or other document issued to him in evidence of the obligation.
The temporary regulations explain that a book entry is a record of ownership that identifies the owner of an interest in an obligation. In effect a book entry system requires maintenance of records in the same manner of the stock registered. The temporary Regs. impose additional requirements on post January 20, 1987 instruments, designed to disqualify instruments that are convertible into bearer interest instruments at any time before maturity. Temp. Reg. § 5f. 103-1(e). In short, a registered obligation is disqualified where it is convertible into bearer form.
(3) Certificate of Foreign Status
For the portfolio withholding exemption to apply to interest received by a foreign holder of an obligation in registered form, a further requirement is that the withholding agent (U.S. payor) must receive a statement meeting prescribed requirements that the beneficial owner of the obligation is not a U.S. person. The statement must be prepared, renewed, and retained under the procedures applicable under Reg. § 1.6049-5(b)(7). That regulation requires that the statement on form W-8 (or a substitute) to be received in the calendar year the interest payment is made or collected or in either of the proceeding two calendar years (W-8 is good for 3 years). The payor must retain this statement for 4 years following the end of the last calendar year the statement is relied on (7 years in total). The payee must notify the payor of any change in residence or citizenship within 30 days following the change of status.
The form W-8 or substitute form generally most contain the following information:
1. Certification that the owner of the portfolio note is not a United States person,
2. The name and address of the beneficial owner of the portfolio note, and
3. A signature by the beneficial owner under penalties of perjury.
Even though the portfolio interest is exempt from tax, the withholding agent generally is required to file form 1042 (Annual Withholding Tax Return For U.S. Source Income Of Foreign Persons) and 1042S (Foreign Persons U.S. Source Income Subject to Withholding) for all payments on portfolio interest on a registered obligation. Form 1042 is a summary of all payments made to foreign persons that are subject to (or exempt by treaty from) withholding and identifies the payees and the amounts withheld. The form must be accompanied by copies of each 1042S issued by the withholding agent and each form W-8 received by the withholding agent. Form 1042S is a form that must be given separately by the withholding agent to each payee. The holder of a portfolio interest obligation is not required to file from 1001 with the withholding agent. Form 1001 is a form used to establish entitlement to tax treaty exemptions or rate reductions.
(C) Bearer Obligations
(1) In General
There are three requirements which the bearer instrument must meet to qualify for portfolio interest exemption. The obligation must be foreign targeted, the interest must be payable outside the United States and the obligation must bear a legend on the face of it that U.S. people who hold such instrument will be subject to U.S. income tax laws. Code Secs. 871(h)(2)(A) and 881(c)(2)(A).
(2) Foreign Targeting Pre-9/7/90
The rules which define what qualifies as foreign targeting are encompassed in Reg. § 1.163-5(c). This regulation has two different standards: one standard for what qualifies as foreign targeting for obligations issued before September 7, 1990 and a different set of requirements for what qualifies as foreign targeting after September 7, 1990.
(a) Foreign Distribution.
The foreign targeting requirement is met if the obligation is offered for sale outside the U.S. and is not registered under the Securities Act of 1933 because it is intended for distribution to persons who are not U.S. persons. The issuer must obtain an opinion of counsel that such security is exempt from SEC Registration as it is foreign targeted. Reg. § 1.163-5(c)(2)(i)(A).
(b) SEC Registered or Exempt.
The foreign targeting requirement will also be met if the securities obligation is registered under the Securities Act of 1933 or is exempt from registration under Section 3 or Section 4 of such act or if it doesn’t qualify as a security under the Securities Act of 1933; where such obligation also meets the following requirements:
(i) The obligation is offered for sale outside the U.S. and only delivered outside the U.S.
(ii) The issuer and the underwriters covenant that they will offer the obligation only to foreign persons or qualified financial institutions;
(iii) The issuer or underwriter send the confirmation to each purchaser stating the purchaser represents itself either as a foreign person or qualified financial institution;
(iv) Before the obligation is released, the issuer or underwriter must receive the signed certificate from the person entitled to physical delivery that the obligation has been acquired by the foreign person, and
(v) The issuer and its underwriters do not have actual knowledge that the certificate is false. Reg. § 1.163-5(c)(2)(i)(B).
(c) Issued outside U.S.
In addition to the above mentioned alternative rules for meeting the foreign targeting requirement, Pre-September 7, 1990, there is a further obligation that the issuer does not engage in Interstate Commerce in issuing the obligations directly or through an agent. If the issuer is a U.S. person, the issuer may satisfy this requirement where:
(i) It is engaged in the active conduct of a banking business through a branch outside the U.S.;
(ii) The obligation is issued by the branch;
(iii) The obligation is sold directly to the public; and
(iv) The issuer maintains documentary evidence that the purchaser is not a U.S. person. Reg. § 1.163-5(c)(2)(i)(C).
(3) Foreign targeted Post-9/7/90.
For obligations issued after September 7, 1990, to qualify as foreign targeted, the instrument must be offered and sold to a non U.S. person, the obligation must be delivered outside the U.S. and the issuer must receive a certificate stating that the recipient is not a U.S. taxpayer. Reg. § 1.163-5(c)(2)(i)(D).
(4) Interest payable outside the U.S.
The requirement that interest be payable outside the U.S. is satisfied if payment can only be made upon the presentation of a coupon or making the demand for payment outside the U.S. to the issuer of the obligation or its agent. There is an exemption for interest paid to a qualified institution as a step in clearing funds where the interest is promptly credited to an account maintained outside the U.S. Reg. § 1.163-5(c)(2)(v).
(5) Legend Requirement.
The legend which may be on the face of the obligation must state “any United States person who holds this obligation will be subject to limitations under the United State Income tax Laws, including the limitations provided in Sections 165(j) and 1287(a) of the Internal Revenue Code”. Reg. § 1.163-5(c)(1)(ii)(B).
(D) Exclusion from Portfolio Interest.
The portfolio interest exemption does not apply in the following cases:
(1) Interest received by a 10% shareholder.
In the case of a corporate issuer, this means the holder of 10% or more of the combined voting power of the issuer. Modified attribution rules apply, under Section 318(a), in determining ownership of stock. Therefore, it is a direct or indirect 10% ownership interest in the borrower, or in the case of an obligation issued by a partnership, any person who owns 10% or more of the capital or profits interest in such partnership, or
(2) Interest paid to a U.S. controlled foreign corporation by a related person, or
(3) Interest received by a banking corporation on the extension of credit made under a loan agreement entered into under ordinary course of its trade or business, or
(4) Interest which is contingent. Code Secs. 871(h) and 881(c).
Contingent interest received by a foreign person after December 31, 1993, will not qualify for tax-free treatment as portfolio interest. In the case of an instrument on which a foreign person earns both contingent and noncontingent interest, the portfolio interest exemption is denied only to that portion of the interest that qualifies as contingent interest. H.R. Conf. Rep. No. 213, 103rd Cong., 1st Sess. at 653(1993).
Contingent interest is defined as any interest the amount of which is determined by reference to:
1. the sales, receipts, or other cash flow of the debtor or any related person;
2. any income or profits of the debtor or any related person;
3. any change in the value of the property of the debtor or any related person; and
4. any dividend, partnership distribution, or similar payment made by the debtor or a related person (e.g., interest contingent on the payment of a dividend to the shareholders by the borrower). Code Sec. 871(h)(4)(A)(i).
For these purposes, a "related person" is any person who is related to the debtor within the meaning of Code Secs. 267(b) or 707(b)(l), or who is a party to any arrangement designed to circumvent the application of the contingent interest provisions. Code Sec. 871(h)(4). Interest is not contingent interest solely because the timing of the interest (or any related principal) payment is subject to a contingency. Code Sec. 871(h)(4)(C)(i). For example, if the debt instrument allows the borrower to defer the payment of interest in any period prior to maturity where the borrower has insufficient cash, such interest is not contingent interest, provided that the debt obligation accrues interest at a competitive market rate. H.R. Rep. No. 111, l03rd Cong., lst. Sess. at 725(1993).
The contingent interest provisions are not intended to override any existing U.S. treaties. See Notice 94-39; 1994-1 C.B. 350. Thus, any interest received by a foreign person that is exempt (or subject to a reduced rate of tax) under a current U.S. tax treaty will not be subject to U.S. tax as contingent interest.
845: Withholding Agents.
(A) In General
A withholding agent is responsible for deducting and withholding gross basis withholding tax from payments of FADPI. A withholding agent includes all persons, in whatever capacity acting (including lessees or mortgagers or personal property, fiduciaries, employers, and all officers and employees in the United States) having the control, receipt, custody, disposal, or payment of any FADPI type income. Code Secs. 1441 and 1442. Practically, this definition is so broad as to include every type of entity and every type of person who had any nexus with the payment of the U.S. source FADPI income. Therefore, any time a taxpayer has control or receives or has custody or disposes of or makes a payment of any U.S. source FADPI income, to be conservative, they should either withhold U.S. gross basis withholding tax or receive an exemption statement as to why the recipient is exempt from such tax. If several persons qualify as withholding agents with respect to a single payment, only one tax is required to be withheld and generally, only one return is required for such taxes withheld. Reg. § 1.1441-7(a). Furthermore, a withholding obligation does not arise until there is actual payment of the FADPI income. There is no withholding obligation on accrual of income which is legally payable to a foreign party.
(B) Agents and intermediaries
Any agents or intermediaries who receive payment on behalf of foreign persons are also withholding agents with respect to FADPI income where the income they received has not already been subject to U.S. gross basis withholding tax.
Example 1: U.S. Bank receives dividends on behalf of its foreign clients. U.S. Bank supplies USCO its EIN number, thereby exempting USCO from gross basis withholding tax on dividend payments to U.S. Bank. U.S. Bank, as an intermediary, then becomes a withholding agent on its subsequent payment of this dividend to its foreign clients.
Example 2: Foreign broker is organized in a country which has a tax treaty with the U.S. which provides for a 5% gross basis withholding tax on interest payments. Foreign broker receives interest from U.S. payor net of the 5% U.S. gross basis withholding tax. When foreign broker pays out this interest to its foreign clients, it becomes a withholding agent to the extent of the remaining 25% gross basis withholding tax. There are new withholding regulations that have been proposed in 1996 which are now scheduled to be effective for payments made starting January 1, 2001, which will impact the withholding tax obligation on withholding agents and intermediaries. See ¶ 845(E) below.
(1) U.S. Partnerships
U.S. Partnerships must withhold tax on:
(a) Actual Distributions of FADPI income to the foreign partner,
(b) A foreign partner’s distributive share of the U.S. partnership’s FADPI income whether distributed or not. Reg. § 1.1441-3(f). and
(c) A foreign partners share of the U.S. partnership’s effectively connected income. Code Sec. 1446(a).
Example 3: U.S. Partnership (P Ship) paid interest on shareholder loans, received dividends from U.S. companies which were not effectively connected with its trade or business and operated a restaurant in the United States. P Ship is required to withhold on interest payments to the shareholders when the interest is actually paid on the shareholder loans. P Ship is also required to withhold on the U.S. sourced dividends it receives which are not effectively connected with its trade or business to the extent USCO did not withhold on such payments to P Ship. Finally, P Ship must calculate its U.S. source net income and to the extent such net income is attributable to foreign partners, it must deduct and withhold tax at the applicable percentage provided in Code Sec. 1446(b)(2).
(2) Foreign Partnerships
A Foreign Partnership is only required to withhold on a foreign partner’s allocable share of the foreign partner’s U.S. source effectively connected income. Code Sec. 1446(a). Where a foreign partnership does not have U.S. source effectively connected income, it has no withholding requirement for distributions to foreign partners or for foreign partners distributive share of U.S. source noneffectively connected FADPI type income. Reg. § 1.441-3(f).
(D) Determination of amount to be withheld
(1) In General
Generally, all FADPI type income is subject to a 30% gross basis withholding tax. Code Secs. 1441 and 1442. The amount is imposed on the gross amount paid or distributed to a foreign person without reduction for any type of deduction. Gross basis withholding tax is collected by deducting the 30% withholding amount from total amount of the FADPI payment and remitting it to the IRS. This withholding tax must always be deducted and paid in with the following exceptions:
1. The withholding agent receives an EIN number or social security number showing that the recipient is not a foreign person.
2. The withholding agent receives a Form 4224 showing that the foreign recipient is receiving this income and that this income is effectively connected with its U.S. trade or business (Form W8-ECI after January 1st, 2001).
3. Recipient receives a Form 1001 which sets forth the foreign recipient’s right to a reduced rate of or elimination of withholding tax pursuant to a U.S. foreign country tax treaty (Form W8-BEN after January 1st, 2001).
4. The withholding tax is in connection with a domestic or foreign partnership’s effectively connected income. Here the withholding rate for the allocable portion to a foreign partner is the highest rate for individuals specified by Code Sec. 1 or the highest tax rate for corporations specified in Code Sec. 11. Code Sec. 1446(b).
5. The withholding obligation is imposed on amount realized by a foreign person’s disposition of U.S. real property interest and the withholding tax rate is 10% on the amount realized. Code Sec. 1445(a).
(2) Corporate Distributions
There must be a gross basis withholding tax on the full amount of any corporate distribution. The fact that the corporation’s earnings and profits are less than the amount distributed, will not be determined until the end of the year. Therefore, withholding is required on all distributions during the year. The fact that the distribution is in excess of that U.S. corporation’s earnings and profits and therefore does not qualify as a dividend, does not impact the withholding requirement on the total distribution. The remedy for the foreign recipient is to file a claim for refund for the excess amount of taxes withheld on the portion of the distribution that did qualify as the dividend.
(3) Failure to Withhold
Every withholding agent is liable for the full amount of the tax required to be withheld. Code Sec. 1461. Where the withholding agent does not withhold such tax but the recipient of income pays the tax in thereafter, the withholding agent is absolved from its liability for the taxes which should have been withheld. Code Sec. 1463. However, the withholding agent still remains liable for interest between the time which it made the payment and was required to withhold tax and the time when the recipient actually paid such tax.
In addition to the liability for the tax and interest from the time the tax is imposed until it is actually paid, a withholding agent may also be subject to the following penalties:
(a) A penalty of 20 percent of the amount of underpayment of withheld tax in the case of negligence. Code Sec. 6662.
(b) A penalty of 75 percent of the amount of underpayment of withheld tax in the case of fraud. Code Sec. 6663.
(c) An addition to tax of 5-25 percent for negligent failure to file a return. Code Sec. 6651(a).
(d) An addition to tax of 15-75 percent for fraudulent failure to file a return. Code Sec. 6651(f). and
(e) A percentage of the amount required to be deposited but not timely deposited. Code Sec. 6656.
In addition to the civil penalties, the withholding agent may be liable for criminal penalties of up to $10,000 and/or 5 years in prison for willful failure to collect and pay over tax. Code Sec. 7202.
(5) Over Withholding of Tax
(a) In General
Where the withholding agent withholds tax in excess of the required amount to be withheld, the foreign taxpayer is entitled to a refund of such over withholding. If the withholding agent pays in an amount of tax in excess of the amount that was actually withheld from foreign taxpayers, the withholding agent is able to claim a refund. Code Sec. 1464.
Example 1: A withholding agent who is required to withhold $300 of tax from rents paid to an NRA mistakenly withholds $320 from the NRA’s payment and mistakenly pays $350 to the IRS. The NRA is entitled to a refund for the $20 of overwithholding from his rental payment. The withholding agent is also entitled to a $30 refund for the amount in excess which it withheld from the NRA and paid over to the IRS.
(b) Remedies for Over Withholding.
(i) Foreign Taxpayer receives refund from broker.
The broker may pay the over withheld amount to the foreign taxpayer directly. In the example above, the broker could pay $20 of overwithholding directly to the NRA. The broker would then have $50 of refund as a result of the $20 refund which it paid the NRA and the $30 which it paid the IRS in excess of what was withheld from the NRA. The broker can then amend the original tax filing showing the correct amount of tax which should have been paid or it can adjust the subsequent tax filing for other clients and pay $50 less with the subsequent filing. Reg. § 1.1461-2(a).
(ii) Application directly to IRS.
Alternatively, the withholding agent and the taxpayer could amend their respective returns to correct the mistakes in the above mentioned example. The withholding agent could amend its Form 1042 to show the correct amount of tax withheld as $320. This would result in the taxpayer having to file a Form 1040 or 1120 to claim a refund for the $20 over withholding. The disadvantage of this method is that the taxpayer will not be able to obtain a refund until after January 1, of the calendar year following the withholding agent's mistake.
(E) Revised Duty of Withholding Agents and Intermediaries under the 1996 Proposed Regulations.
(1) In General.
The Department of Treasury and the IRS issued a comprehensive set of new regulations affecting withholding requirements pursuant to Code Secs. 1441-1464. The original effective date of such proposed regulations was for all payments after December 31, 1999. However, due to various comments received by financial institutions describing the difficulty of implementing such regulations and adjusting their computer systems to become Year 2000 compliant; the Treasury and the IRS have amended the effective date to apply to all payments made after December 31, 2000. Notice 99-25, 1999-20 I.R.B. Therefore, the above-mentioned rules for withholding and the above mentioned forms to be received by foreigners claiming exemption from withholding remain in effect until January 1, 2001.
(2) Withholding Obligations After December 31, 2000.
A key component to these proposed regulations deals with qualified intermediaries. A qualified intermediary is a foreign entity or a foreign branch of the U.S. entity, that obtains the benefit of establishing the foreign status of its account holders and their entitlement to reduced rates of withholding, by using a single withholding certificate rather than having to provide documentation for each customer to a U.S. withholding agent. These new Proposed Regs. set out the new requirements for withholding agents.
The new Proposed Regs. combine several existing forms used in connection with withholding, including Forms 1001 and 4224, into four Form W-8s. The four new Form W-8s have been released and are available for use and must be used for all payments made after December 31, 2000. While the new Form W-8s are effective immediately, a withholding agent may wish to review the existing withholding certificates currently in its position to determine when new Form W-8s will be required.
Any of the older Forms, e.g. Form 1001 for treaty reduced income, Form 4224 for effectively connected income, etc. will expire on December 31, 2000 and will need to be replaced with the new Form W-8s. Most of the new Form W-8s are effective for a period beginning on the date that the Form is signed and ending on the last day of the third calendar year following the year in which the Form is executed.
Example 2: NRA signs Form W-8 on February 3, 2000, it will be effective for the period February 3, 2000, ending on December 31, 2003.
The new Form W-8s consist of the following:
1. Form W-8BEN – Certificate of foreign status of beneficial owner for United States tax withholding to be used to identify owner as a foreigner and used to claim tax treaty benefits (replaces Form 1001).
2. Form W-8ECI – Certificate of foreign person’s claim for exemption from withholding on income effectively connected with the conduct of a trade or business in the United States (replaces Form 4224).
3. Form W-8EXP – Certificate of foreign government or other foreign organization for United States tax withholding (replaces Form 8709).
4. Form W-8IMY – Certificate of foreign intermediary, foreign partnership, or certain U.S. branches for United States tax withholding to report individuals or entities which are either qualified or non-qualified intermediaries.
(3) Withholding Agent Responsibility After December 31, 2001.
First, a withholding agent needs to establish whether the payee is U.S. or foreign. Where the payee is U.S., the withholding agent must either receive a completed Form W-9 providing all the information regarding the U.S. payee, including their identification number or must subject the U.S. payee, to backup withholding. See ¶ 855 below. If the withholding agent has no actual knowledge or reason to know that the U.S. payee is acting as an agent of a foreign person, the agent may rely on a Form W-9 given by the U.S. payee. Prop. Reg. § 1.1441-1(d)(1).
Absent actual knowledge or reason to know otherwise, a withholding agent may treat a payee as foreign if the agent receives a Form W-8 from the payee, complies with any electronic confirmation procedure that may be issued by the IRS, and has not been notified by the IRS that the information on Form W-8 is incorrect or unreliable. Prop. Reg. § 1.1441-1(e)(1). Where a withholding agent cannot validate the Form W-8, it must conform to the following:
1. When payment of a reportable amount is made to a nonexempt payee and the withholding agent has not timely received a reliable Form W-8 or W-9, unless a specific grace period applies, the payee is presumed to be a U.S. individual subject to both information reporting and backup withholding provision. Prop. Reg. § 1.1441-1(f)(2)(i) and (ii).
2. A payment to an exempt payee may be presumed to be made to a foreign person if the payor knows the payee’s employer identification number and that number begins with “98”, communications with the payee are mailed to a foreign address or the payment is made outside the U.S. Prop. Reg. § 1.1441-1(f)(2)(iv). In all the other cases, the withholding agent must presume the recipient is a nonexempt U.S. payee.
Where the withholding agent does not conform to the foregoing, it will be liable for any underpayment of tax pursuant to Code Sec. 1461. Prop. Reg. § 1.1441-1(f)(5).
(4) Payments to Qualified Intermediaries
The Proposed Regs. permit one singular Form W-8IMY on behalf of beneficial owners, if that intermediary has entered into a withholding agreement with the IRS and the IRS appoints it as a qualified intermediary. Persons that may be qualified intermediaries include entities that are financial institutions or securities clearing houses, partnerships, and any other person acceptable to the IRS. Prop. Reg. § 1.1441-1(e)(5). A qualified intermediary would have the choice of whether to assume primary withholding liabilities for payments made to it for the benefit of others. Where the qualified intermediary accepts such responsibility, it could file one Form W-8IMY for itself and would not need to attach various Form W-8BENs for its beneficial owners. Prop. Reg. § 1.1441-1(e)(5)(iv)(C).
(5) Payments to Nonqualified intermediaries
A payment made to a nonqualified intermediary would require the withholding agent to obtain a Form W-8IMY from the nonqualified intermediary as well as a Form W-8BEN for each of the beneficial owners for whose benefit the payment is being made. Prop. Reg. § 1.1441-1(e)(3)(iv). This results in the nonqualified intermediary (as opposed to currently the withholding agent) becoming responsible for obtaining the requisite certifications from the beneficial owners of U.S. sourced FADPI income.
855: Backup Withholding
In addition to the net basis tax regime and gross basis tax regime mentioned above, there also exists a third tax regime entitled backup withholding. This third tax system applies where a payee has failed to furnish his taxpayer identification number to the payor or where the IRS informs the payor that such number is incorrect. The payor is required, under the backup withholding provisions, to withhold and remit to the IRS 31 percent of all payments to such taxpayer. Code Sec. 3406(a)(1). Backup withholding applies to:
(1) Reportable interest and dividend payments and
(2) Certain other reportable payments. Code Sec. 3406(b)(1).
Reportable interest and dividend payments are those with respect to which information returns are required, such as payments of interest pursuant to Code Sec. 6049(a), payments of dividends pursuant to Code Sec. 6042(a) and payments of patronage dividends pursuant to Code Sec. 6044. Other reportable payments are those with respect to which information returns are required such as payments made in the course of a trade or business pursuant to Code Sec. 6041, payments relating to remuneration for services pursuant to Code Sec. 6041A(a), payments relating to returns of brokers pursuant to Code Sec. 6045, payments relating to certain fishing boat operators pursuant to Code Sec. 6050A or certain royalty payments pursuant to Code Sec. 6050N.
Where the withholding agent is making a reportable payment and it has not received a Form W-8 or Form W-9 identifying the payee, then it must subject the payment to 31 percent backup withholding tax.
There is multiple overlapping between the regular and backup withholding tax rules. For example, generally backup withholding will apply where the payee fails to identify themselves, even where the regular system of tax exempts such payee from U.S. tax. The purpose of backup withholding is to allow the U.S. government to take a certain portion of each payment from a payee who has not identified themselves and thereby force the payee to either identify themselves and obtain the refund or a credit of such tax or to allow the IRS to keep such tax as a result of non identification of the recipient.