The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Kimberly S. Blanchard, Esq.
Weil Gotshal & Manges LLP, New York, NY
Remuneration received by a nonresident alien individual (an "NRA") in consideration of testifying as an expert witness in a U.S. courtroom is presumably subject to U.S. withholding tax, except as otherwise provided by an applicable tax treaty.1 I use the word "presumably" because the U.S. taxable portion is limited to compensation for services performed while physically present in the United States. Typically, an NRA will have done much of the preparation for his or her testimony while outside the United States, but given the nature of court procedures the real value component lies in his or her physical testimony in the courtroom. Whether payments made to an expert witness can be allocated between the time spent preparing outside of the United States and the time actually present in the U.S. courtroom is a question most withholding agents won't want to wrestle with.
Payments to Non-Treaty Witnesses
If the NRA is not a qualified resident of a country having a tax treaty with the United States, the amount he or she receives for witness services will generally be subject to U.S. withholding or backup withholding tax.2 This is true even though the amount would ordinarily be treated as income effectively connected with the conduct of a trade or business (ECI). While most types of ECI are not subject to withholding tax – instead, the foreign person is required to file a U.S. tax return and pay tax on the net amount at normal applicable rates – compensation for services is subject to the 30% withholding tax provided by §1441(a). While §1441(c)(4) empowers the IRS to make an exception from withholding for compensation for personal services, the applicable regulations provide no general exception.3
Where a payment to an expert witness is subject to a 30% withholding tax, in many cases the witness will simply refuse to testify. If the NRA resides in a country that imposes little or no tax, or adopts a territorial exemption for income earned abroad, the NRA would not be entitled to credit the U.S. tax against his or her residual home country tax, and the U.S. tax would be a deadweight cost.4 In such cases, where the testimony of the witness is critical to the client's case, it will be necessary to "gross up" the witness for the U.S. tax.
The person required to withhold the tax is the person who makes the payment. In many cases, this will be the lawyer or law firm that has retained the witness on behalf of a client. Because the lawyer as withholding agent will have direct liability to the IRS for any taxes, interest, and penalties resulting from a failure to withhold, the lawyer should protect herself by withholding in a full and timely manner. The lawyer should therefore take care to agree with the client up front as to who will ultimately bear the responsibility for payment of any gross-up for U.S. withholding tax.
In most cases, payments made to the NRA witness will also be subject to state and possibly local withholding tax as well. The withholding agent should take steps to assure that all parties are made aware of this cost and that taxes are properly withheld and paid over to the proper authorities.
Payments to Witnesses Entitled to Treaty Benefits
If the NRA witness is a qualified resident of a treaty country, an exemption from U.S. withholding tax will nearly always be available.5 The withholding tax regulations acknowledge this and provide rules for claiming the benefit of a treaty exemption.6 Unfortunately, the applicable rules are quite convoluted, and are not easy to apply to one-off lump-sum payments.
Most practitioners having a general familiarity with the withholding tax rules that apply to non-U.S. persons know that the normal way to claim a treaty benefit is for the foreign person to file a Form W-8BEN with the withholding agent. However, the regulations and instructions to IRS forms make clear that a Form W-8BEN cannot be used to claim treaty benefits in respect of the payment of compensation for personal services. Instead, the applicable form is Form 8233 (which form can also be used to claim any prorated personal exemptions of the NRA). Moreover, most of us assume that once you have a Form W-8BEN on file, there is no need to send it to the IRS for approval; instead, the withholding agent simply files a form with the IRS at year end listing all the payments it has made and noting where treaty benefits have been claimed, without identifying information. In contrast, the Form 8233 must be filed with the IRS, generally at least 10 days in advance of making a payment.
The Form 8233, like the Form W-8BEN, must provide a U.S. tax identification number for the recipient beneficial owner. Most expert witness candidates, unless they make a living testifying in the United States, will not have such a number, and will not be happy to learn they need to obtain one. They will be even more unhappy to learn that obtaining one is not an easy thing to do. Unlike the process most of us are familiar with for obtaining domestic EINs, which one can do in minutes over the phone, the process for obtaining an individual number for an NRA can take months and seems designed to frustrate and confuse.
The instructions to Form 8233 begin by informing the NRA that he or she may be required to apply for a social security number (SSN), using Form SS-5, as a first step in the process. Not surprisingly, however, filing Form SS-5 nearly always results in the Social Security Administration (the "SSA") denying the request for a number on the grounds that the applicant is, in fact, an NRA, and not entitled to a SSN. The applicant is then required to attach proof that he or she is ineligible to receive a SSN to the application in the next step (described below). That proof, of course, will be the letter from the SSA denying the SSN. This pointless Catch-22 should be eliminated from the instructions.7
Only after having taken the time to go through this futile first step will the IRS agree to process the real request, which is for an "individual taxpayer identification number" (ITIN). To apply for an ITIN, the NRA must complete Form W-7, providing proof (in the form of the letter from the SSA denying him or her a SSN) that he or she is ineligible for a SSN. The Form W-7 is then mailed to the IRS together with a completed Form 8233. According to the instructions on the latter form, securing an ITIN "usually takes about 4-6 weeks."
The good news is that the parties do not need to wait out the 4-6 week period in order to act upon the Form 8233. Regs. §1.1441-4(b)(2)(ii)(A) provides, and the instructions to Form 8233 state, that the NRA may attach a copy of a completed Form W-7 (or even SS-5) to the Form 8233, showing that the number has been applied for. Although the rules do not explicitly state that the withholding agent may rely on the Form 8233 before the ITIN is issued, and may go ahead and make a payment without withholding, there would appear no bar to doing so if the withholding agent is comfortable doing so.
The applicable regulations require the withholding agent to review and accept the Form 8233, and to mail it to the IRS within five days of accepting it. The IRS then has 10 days to raise any immediate objections to the claim for exemption.8 Once this 10-day window has passed without objection, the claimed treaty exemption is effective retroactively to the first date covered by the Form.9 So the question for the withholding agent must be: "When do I feel comfortable paying the witness without withholding, given that the IRS will take weeks to assign an ITIN and 10 days to review the Form 8233?"
The problem presented by the expert witness is that the payment is a one-off payment, usually to a person that does not have an ITIN. The problem is primarily one of timing – the witness may be needed in court (and need to be paid) long before this process can work itself out. The IRS has issued regulations to deal with a similar problem, but those regulations will rarely be useful to expert witnesses. Worse, the regulations are outdated, poorly organized, and predicated upon erroneous assumptions about how the rest of the withholding tax regulations operate.
The regulations referred to contain special rules that an "acceptance agent" may use to get an ITIN for a payee on an expedited basis where there is an "unexpected payment."10 The examples in the regulations help to flesh out what an "unexpected payment" is, but the term is not well-defined. The procedure can be used only by an acceptance agent, and most potential withholding agents will not qualify or wish to qualify as such.11
Most discouragingly, these regulations were issued under Regs. §1.1441-6, which does not apply to payments of compensation for services. That regulation addresses claims of treaty benefits for fixed and determinable income claimed on a Form W-8BEN. Whoever drafted these unexpected payment regulations clearly was unaware of this problem: Example 4 of these regulations addresses a case involving payments covered by the independent services article of a treaty.12 The Example recites that the NRA in question provides a "beneficial owner withholding certificate" (i.e., a Form W-8BEN) to the acceptance agent, enabling the acceptance agent to rely on the treaty exemption and make payments without withholding. It seems impossible to rely upon this Example, given that the procedures it erroneously assumes to be applicable clearly would not excuse the withholding agent.
Even if the NRA and the withholding agent manage to negotiate all of these filings and a payment is properly made and reported as exempt from withholding, the NRA is still required to file a tax return and to disclose his or her reliance on a treaty.13 Query how many NRAs actually comply with this requirement. Although there are penalties for failing to report treaty-based positions under §6114, it is hard to imagine any real penalties applying to an NRA who has no substantive tax liability, particularly where entitlement to the treaty has already been documented.
In the interest of sound tax and legal administration, the rules summarized in this commentary should be changed and simplified – at least as applied to expert witnesses and others whose presence in a U.S. court is required for the proper functioning of our legal system. An expedited process for obtaining an ITIN should be put into place, and the requirement of filing a return should be waived where the NRA's only income consists of witness fees that are exempt by reason of a treaty.
This commentary also will appear in the January 2011 issue of the Tax Management International Journal. For more information, in BNA's Tax Management Portfolios, see Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, and Tello, 915 T.M., Payments Directed Outside the United States — Withholding and Reporting Provisions Under Chapters 3 and 4, and in Tax Practice Series, see ¶7120, Foreign Persons—Gross Basis Taxation.
2 There are very limited exceptions, and some ways of entering into advance agreements with the IRS to reduce the withholding tax, but these would typically not apply or be available in the simple case addressed herein. For a detailed overview, see Bissell, 916 T.M., International Aspects of U.S. Income Tax Withholding on Wages and Service Fees, VI. In most cases not involving treaty residents, the withholding agent will ask the NRA witness to provide a Form W-8BEN to document his or her status as a non-U.S. person, thereby avoiding application of the backup withholding rules. However, providing a Form W-8BEN raises the same difficulty of obtaining an identifying number as noted below in connection with Form 8233.
3 Regs. §1.1441-4(b)(1) provides a list of exceptions from withholding where the amount received is ECI, as it ordinarily would be under §§864(b) and 871(b). There is an exception for wages subject to employment tax withholding, but this would not apply to expert witness fees. The only other generally applicable exception is for payments exempt by reason of a treaty, as described below.
4 The NRA may, and is in fact required to, file a tax return on Form 1040NR (as well as estimated tax returns on Form 1040-ES(NR)) and claim a refund to the extent the substantive tax liability, computed on a net basis with regard to exemptions and deductions, is less than the amount withheld. In practice, it is probable that many NRA witnesses do not comply with these rules.
5 Older treaties typically cover this case under the article applicable to Independent Personal Services; in newer treaties that article has been deleted and the case is covered by the Business Profits article.
6 Regs. §1.1441-4(b). These regulations should not be confused with the regulations that apply to claims of treaty relief for items other than compensation for services, found at §1.1441-6. But see the text accompanying notes 10-12, below.
7 One can guess that the reason for this exercise was a concern that an individual might be posing as an NRA when in fact he was a U.S. citizen having, or entitled to have, a SSN. Suffice it to say that no such person would voluntarily apply to the IRS for an identifying number!
9 Regs. §1.1441-4(b)(2)(i). The regulations seem to contradict themselves on the effective date question, but the instructions to the Form are clear. One can assume that the effective date entered onto the Form cannot be backdated before the Form is first filled out, although neither the regulations nor the instructions are clear on this point.
13 Regs. §§1.6012-1(b), 301.6114-1. Although the taxes imposed by states of the United States are not covered by tax treaties with foreign countries, many states effectively grant treaty exemptions by starting with income reported on a federal return. In all cases, the state and local treatment of the NRA should be evaluated.
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