INSIGHT: Distributions From the U.S.: Withholding Tax Considerations

So, you are a U.S. corporation and you need to pay a cash distribution to a non-U.S. parent corporation-shareholder. How hard can that be? In truth, it is harder to do correctly than it sounds. The character of the distribution needs to be ascertained (e.g., will it be treated for U.S. federal income tax purposes as a dividend, or as something else?); two separate regimes for the withholding of tax apply to it; and a myriad of tax-related calculations and paperwork await. Sound daunting? Let’s use a common scenario to break it down.

All general references to “tax,” such as references to “tax purposes” or “tax consequences,” should be read as references to “U.S. federal income tax purposes” or “U.S. federal income tax consequences.”

RSL is an international company based in London, U.K. RSL’s shares trade on the London Stock Exchange. It is the parent company of a large multinational affiliated group and operates its business through the ownership of various U.S. and non-U.S. subsidiaries (Rhodes Group).

RSL owns directly 100 percent of the shares of RSI, a U.S. corporation. RSI owns 100 percent of the shares of various U.S. subsidiaries. On July 29, 2017, RSI made a $48 million cash distribution (the Distribution) to RSL. RSL did not transfer any shares in RSI back to RSI.

On that same day, RSI’s estimated current and/or accumulated earnings and profits (E&P), prior to taking into account any impact of the Distribution, was between $20 million and $50 million and RSL’s basis in RSI’s stock was at least $200 million. It is assumed that RSL meets the requirements under the U.S.-U.K. income tax treaty to qualify for the dividend exemption from U.S. tax. (See Article 10(3) of the 2001 Convention between the Government of the United States of America and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains, as amended.)

This common scenario invokes two separate U.S. taxing regimes: the rules relating to distributions paid to a non-U.S. person and, perhaps surprisingly, the rules relating to dispositions of U.S. real estate. Let’s tackle the latter first.

Dispositions of U.S. Real Estate

The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) resulted in the enactment of tax code Sections 897 and 1445, which generally impose U.S. federal income tax on dispositions of U.S. real property interests (USRPIs) by foreign persons. Tax code Section 897, in pertinent part, generally provides that (1) gain or loss of a foreign corporation from the disposition of a USRPI shall be treated as effectively connected taxable income; and (2) the foreign corporation is treated as if it is engaged in the conduct of a U.S. trade or business, and as if this gain or loss were effectively connected with the trade or business. (Tax code Section 897(a)(1).)

Generally, a USRPI is defined as an interest in real property in the U.S. or an interest in a U.S. corporation held by the foreign person. All interests in domestic corporations (other than solely as a creditor) are presumed to be USRPIs unless the taxpayer disposing of the interests in the domestic corporation establishes that the domestic corporation is not a U.S. real property holding corporation (USRPHC). (Tax code Section 897(c)(1)(A)(ii).) Under tax code Section 897(c)(2), a corporation is generally considered a USRPHC if, at any time during the shorter of (a) the five-year period ending on the date the shareholder disposes of the corporation’s stock, or (b) the time the shareholder held the stock, the fair market value of the corporation’s interests in the U.S. real property are at least 50 percent of the combined fair market value of all of the corporation’s real property interests (i.e., within and without the U.S.) plus any other assets that are held in its trade or business (the 50 percent test). That is, a domestic corporation would not be a USRPHC if less than 50 percent of the fair market value of the domestic corporation’s assets (with certain adjustments) consists of USRPI. Under an alternative test set forth under Treas. Reg. Section 1.897-2, if 25 percent or less of the book value of the domestic corporation’s assets consists of USRPI, the fair market value of the domestic corporation’s USRPI would be presumed to be less than 50 percent of the fair market value of the domestic corporation’s aggregate assets (the 25 percent test).

In situations in which a U.S. corporation is tested for USRPHC status (e.g., a first-tier domestic corporation) and the corporation holds 50 percent or more of the fair market value of all classes of stock in other corporations (e.g., a second-tier domestic corporation), the first-tier domestic corporation is deemed to own a proportionate share of each second-tier corporation’s assets (i.e., U.S. real property interests, interests in real property located outside the U.S., and assets used or held for use in a trade or business). Any asset so treated as held proportionately by the first-tier domestic corporation that is used or held for use by the second corporation in a trade or business should be treated as so used or held for use by the first-tier domestic corporation. (Tax code Section 897(c)(5) and Treas. Reg. Section 1.897-2(e).) This is a look-through approach disregarding the actual shares held in the second-tier domestic corporation and their value, so that the first-tier domestic corporation is treated as if it holds a proportionate share of the second-tier corporation’s assets. (Treas. Reg. Section 1.897-2(e)(3)(iii). The controlling interest rules of this paragraph (e)(3) apply, regardless of whether a corporation is domestic or foreign, whenever it is necessary to determine whether a corporation is a USRPHC.)

In the case at hand, solely cash was distributed. Generally, cash constitutes property in its own right. (Tax code Section 317(a) defines the term property as money, securities and any other property, except that such term does not include stock in the corporation making the distribution.) Thus, RSI’s distribution of cash to RSL should be treated as a distribution of property to which tax code Section 301 applies. Tax code Section 301(a) provides generally that a distribution of property made by a corporation to a shareholder with respect to its stock should be treated in accordance with its character. Tax code Section 301(c)(1) provides that the portion of the distribution that is a dividend (as defined in tax code Section 316) should be included in gross income. (Tax code Section 316 provides that the term dividend means any distribution of property made by a corporation to its shareholders out of its E&P accumulated after Feb. 28, 1913, or out of its E&P of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of E&P at the time the distribution was made. A distribution is made out of E&P to the extent thereof and from the most recently accumulated E&P.) Tax code Section 301(c)(2) provides that the portion of the distribution that is not a dividend should be applied against and reduce the distributee’s adjusted basis of the stock held in the distributing corporation. Lastly, tax code Section 301(c)(3) provides that to the extent the portion of the distribution that is not a dividend exceeds the adjusted basis of the stock, it should be treated as gain from the sale or exchange of property.

The U.S. generally does not levy a tax on capital gains realized by nonresidents. Thus, a nonresident shareholder generally would not be liable for U.S. tax on a distribution that constitutes a capital gain.

As an exception to this general rule, the U.S. levies a tax on a capital gain if the U.S. corporation is a USRPHC. (Tax code Section 897(a).) If the shareholder is a corporation, the gain is subject to tax at corporate tax rates for calendar year 2018 of up to 21 percent. (For calendar year 2017, there were rates up to 35 percent.) Thus, a nonresident shareholder will be liable for U.S. tax if the nonresident shareholder receives a distribution from a USRPHC and this distribution constitutes, in part, a capital gain. (The tax is collected via a withholding mechanism, as discussed below.) In addition, the nonresident shareholder must file a U.S. tax return (e.g., Form 1120-F, U.S. Income Tax Return of a Foreign Corporation) to account for any tax due or overpaid.

As discussed above, all interests in domestic corporations are presumed to be USRPIs unless it is established that the domestic corporation is not a USRPHC.

General Distribution Withholding Requirements

A corporation that makes a distribution to a nonresident shareholder is generally obligated to withhold tax on the distribution under tax code Sections 1441, 1442 and/or 1445 of the Code.

The regulations under tax code Section 1441 require a distributing U.S. corporation to treat the entire amount distributed to foreign shareholders under tax code Section 301 as if it were all a dividend under tax code Section 301(c)(1) and, thus, fully subject to U.S. withholding of tax at the statutory rate of 30 percent or the applicable treaty rate. (Treas. Reg. Section 1.1441-3(c)(1), Section 1.1441-1(b)(1) and Section 1.1441-3(c)(4)(i)(A).)

A dividend paid to a foreign corporation from a source within the U.S. is subject to federal income tax at a rate of 30 percent (tax code Section 881(a)(1)), provided no applicable tax treaty provides a lower rate. Recent tax reform provisions did not change this 30 percent rate. A dividend paid by a U.S. corporation generally is from a source within the U.S. (Tax code Section 861(a)(2).) As noted above, tax code Section 301(c)(1) treats a portion of the Distribution as a dividend from RSI to RSL to the extent of RSI’s E&P. That amount therefore is income from U.S. sources subject to tax at a rate of 30 percent, unless a tax treaty provides a lower rate.

Generally, tax code Section 1445 governs withholding on dispositions of U.S. real property interests. tax code Section 1445(e)(3) provides that certain tax code Section 301 distributions from a USRPHC that are not made out of E&P are subject to 15 percent withholding on the realized amount. (If the distribution to the foreign shareholder gives rise to a dividend under Section 301(c)(1), withholding under Section 1445(e)(3) does not apply to the distribution and withholding under Section 1441 or Section 1442 may apply.) Under tax code Section 1445(e)(3) and Treas. Reg. Section 1.1445-5(a), a domestic USRPHC is required to withhold tax upon non-dividend distributions to its foreign interest holder. Relief from potential double withholding under tax code Sections 1441 or 1442 and tax code Section 1445 on distributions from domestic corporations is granted under Treas. Reg. Section 1.1441-3(c)(4). (Discussion on the coordinating withholding obligations is beyond the scope of this article.)

More specifically, Treas. Reg. Section 1.1445-5(e)(1)(i) establishes that a domestic corporation that distributes any property to a foreign person that holds an interest in the domestic corporation must withhold 15 percent of the fair market value of the property distributed if: (i) the foreign person’s interest in the domestic corporation constitutes a USRPI under tax code Section 897(c); and (ii) the domestic corporation distributes the property in redemption of stock under tax code Section 302 or in liquidation of the corporation, or with respect to stock under tax code Section 301(c)(2) and (3) (i.e., return of capital and/or capital gain distributions).

If the domestic corporation is not a USRPHC, the regulations require that it follow certain procedures to demonstrate that it is not a USRPHC, and thus be able to prove that no withholding was due on the transfer of an interest in the domestic corporation or distribution, as the case may be. In determining that no withholding applies to a distribution to foreign persons holding interests in domestic corporations that are not USRPIs, Treas. Reg. Section 1.1445-5(e)(3)(i) refers to Treas. Reg. Section 1.897-2(h). In particular, Treas. Reg. Section 1.897-2(h)(1)(i) establishes that a domestic corporation must, within a reasonable period after receipt of a request from a foreign person holding an interest in it, inform that person whether the interest constitutes a USRPI. The determination will be valid for the five-year period ending on the date specified by the interest holder’s request, or if no date is specified in the request, the determination will be as of the date of the request. (Treas. Reg. Section 1.897-2(h)(1)(ii).)

Once the statement is issued, dated, and signed by an officer of the domestic corporation under penalties of perjury, it must be filed with the IRS on or before the 30th day after the statement is mailed to the foreign person interest holder that requested it. (Treas. Reg. Section 1.897-2(h)(2)(vi).)

According to the facts assumed, RSI was not a USRPHC. RSI made a distribution to its parent, and no shares in RSI were transferred (i.e., no interest in the domestic corporation was transferred). As a result, RSI should be eligible to claim that it is not subject to the withholding of tax under tax code Section 1445 on any non-dividend distribution.

Distribution Following Acquisition

Now, let’s expand on our common scenario just a bit and assume that RSL acquired RSI in September 2014 (the Acquisition). Prior to the Acquisition of RSI and its subsidiaries (the Group), the Group was held by a private equity fund. The investors in the private equity fund were exclusively U.S. tax residents. Therefore, historically, RSI had not been required to assess its status as a USRPHC. Once the Acquisition was completed, the Group’s tax team continued to manage the day-to-day tax matters. As a result, when the Distribution took place, the Group’s tax team, now part of the Rhodes Group, did not have the tax technical experience to identify that the Distribution could be subject to the FIRPTA rules to the extent the Distribution exceeded the current and accumulated E&P of RSI as of the close of the 2017 calendar year, as more fully described below.

On July 29, 2017, RSI legally declared and effectively made the $48 million Distribution to its sole owner and parent, RSL. At the time of the Distribution, RSI had accumulated E&P of nearly $21.8 million. Moreover, there was an expectation by RSI’s management that the current E&P for calendar year 2017 (estimated as of the close of the calendar year) would significantly increase RSI’s total E&P to cover the entire amount of the Distribution. Furthermore, RSL had a tax basis in the RSI shares of at least $200 million. Therefore, based on initial estimations, all or a significant portion of the Distribution was expected to be treated as a dividend under tax code Section 301(c)(1), and only a limited amount of the Distribution, if any, would be treated as a tax code Section 301(c)(2) return of basis of the stock held by RSL. In all events, no taxable gain was expected to arise under tax code Section 301(c)(3).

Pursuant to tax code Section 316(a), the term “dividend” means any distribution of property made by a corporation to its shareholders out of its E&P of the taxable year (computed as of the close of the taxable year without diminution by reason of any distribution made during the taxable year), without regard to the amount of the E&P at the time the distribution was made. Therefore, at the time of the Distribution, it was impossible for RSI and/or RSL to accurately determine the amounts that would have been treated as dividend distributions under tax code Section 301(c)(1) and the amounts, if any, that would have been treated as a return of basis under tax code Section 301(c)(2).

As previously mentioned, although the overall character of the Distribution could not be determined by RSI’s tax team prior to the close of the 2017 tax year, more relevant to this scenario is the fact that RSI’s tax team was not aware of the potential application of the FIRPTA rules if part of the Distribution were to be treated as a return of basis under tax code Section 301(c)(2). It likely would have been during a meeting between the broader Rhodes Group’s tax department (which included members of RSI’s tax department) and outside tax advisors that the potential applicability of the FIRPTA rules would come to light, particularly if a portion of the Distribution were to be treated as a tax code Section 301(c)(2) return of basis. Let’s assume that this meeting took place in December 2017, after the Distribution was made.

As a result of that meeting, the outside tax advisors were engaged to perform a study to determine whether RSI would be treated as a USRPHC and, consequently, whether the RSI stock that RSL held would be considered a USRPI. The FIRPTA determination was concluded by the outside tax advisors quite quickly. The results from the outside tax advisor’s analysis were that RSI was not and had not been, for the relevant determination dates and the period during which RSL has owned the stock, a USRPHC.

The outside tax advisors also made RSI’s management aware that even if the findings from the FIRPTA determination concluded that the company was not a USRPHC, to the extent that a portion of the Distribution was treated as a tax code Section 301(c)(2) return of basis, the procedures under Treas. Reg. Section 1.897-2(g)(1)(ii) would need to be followed, including filing a statement with the IRS certifying that the stock of RSI was not and had not been a USRPI for the relevant determination dates and the period during which RSL has owned the stock (the FIRPTA Statements).

After making that determination, the final aspect of the analysis was to determine whether in fact a FIRPTA event had occurred—i.e., whether a distribution under tax code Section 301(c)(2) (not out of E&P) had taken place. It would not be until after closing its 2017 tax year that RSI’s tax department would first be able to accurately quantify the current E&P for the 2017 tax year. (The E&P study is documented on IRS Form 5452, Corporate Report of Nondividend Distributions, which RSI would include as a part of its tax year 2017 U.S. corporate income tax return filing.)

Let’s assume that it was determined that the current E&P for calendar year 2017 totaled $4.8 million. Therefore, at the close of the taxable year, RSI had current and accumulated E&P of approximately $37.38 million, which was computed without diminution by reason of distributions made during that year. Therefore, $37.38 million, not the entire Distribution of $48 million, should be treated as a dividend under tax code Section 301(c)(1), with the appropriate tax consequences.

Consequently, the remaining amount of the Distribution (i.e., approximately $10.62 million) should be treated as a return of basis under tax code Section 301(c)(2), subject to the FIRPTA rules. No taxable gain whatsoever arose under tax code Section 301(c)(3).

There was a failure to file the FIRPTA Statements on a timely basis for two main reasons:

(1) At the time of the Distribution, RSI’s tax department did not know that FIRPTA obligations could arise as a result of the Distribution (because part of the Distribution could be treated as a return of basis under tax code Section 301(c)(2)). It was only after meeting with outside tax advisors that management learned FIRPTA obligations could arise. Once it learned of this obligation, it did not have the knowledge and resources available to determine whether RSI was a USRPHC. However, when RSI learned of the potential FIRPTA exposure, the company immediately engaged outside tax advisors to make the determination and assist with any procedures relevant to meet the tax code Section 897 rules and requirements.

(2) Even after outside tax advisors determined RSI’s status as a non-USRPHC, it could not conclude until after the end of the taxable year (i.e., at the time the character of the Distribution was determinable) whether the tax code Section 897 rules would require RSI to file the relevant FIRPTA Statements. Determining what amount of the Distribution would be treated as tax code Section 301(c)(1) and/or (c)(2) and, therefore, whether a portion of the Distribution would be subject to the tax code Section 897 rules, could not be accomplished when the Distribution was made, but rather had to wait until after the end of the taxable year closed (i.e., after Dec. 31, 2017). Therefore, neither RSL nor RSI had the ability or the information required to determine (1) whether a portion of the Distribution would be treated as a tax code Section 301(c)(2) or (c)(3) distribution, potentially subject to the rules under tax code Section 897 and, consequently, (2) whether the filings under Treas. Reg. tax code Section 1.897-2(h) would be required.

RSI’s failure to timely file the FIRPTA Statements therefore should be correctible. Revenue Procedure 2008-27 spells out the simplified method to be followed, allowing a late filing of the FIRPTA paperwork.

Withholding Tax on Dividends

Having dealt with the real estate tax regime, let’s turn to the other U.S. taxing regime that applies to corporate distributions. Provided RSL qualifies for full treaty benefits, which we have assumed, RSI’s Distribution ultimately should not be subject to withholding of tax under tax code Section 1442. As stated previously, under tax code Sections 1441 and 1442, a U.S. payor must generally withhold tax on certain types of payments. These payments include dividends. (Tax code Section 1441(b).) Tax code Section 1442(a) requires withholding agents to deduct and withhold the tax liability of a foreign corporation pursuant to tax code Section 881. A withholding agent means any person, U.S. or foreign, that has the control, receipt, custody, disposal, or payment of an item of income of a foreign person subject to withholding. (Treas. Reg. Section 1.1441-7(a)(1).) Therefore, under tax code Sections 1441 and 1442, RSI must withhold a tax on the Distribution. The withholding rules generally provide that a corporation making a distribution with respect to its stock is required to withhold on the entire amount of the distribution, unless it elects to reduce the amount of withholding under Treas. Reg. Section 1.1441-3(c).

An election is made by the withholding agent by reducing the amount of the withholding at the time that the payment is made. (Treas. Reg. Section 1.1441-3(c)(2)(i).) The amounts with respect to which a distributing corporation may elect to reduce the withholding include distributions to the extent not paid out of accumulated E&P or current E&P, based on a reasonable estimate. (Treas. Reg. Section 1.1441-3(c)(2)(i)(C).) A reasonable estimate for these purposes is a determination that the distributing corporation makes at a time reasonably close to the date of payment regarding the extent to which the distribution should constitute a dividend. (Treas. Reg. Section 1.1441-3(c)(2)(ii)(A).)

Absent treaty relief, the U.S. payor must withhold the tax liability at a rate of 30 percent. Here, under the circumstances that are assumed for purposes of this article, the U.S.-U.K. income tax treaty exempts RSL from this withholding tax. Article 10(3) of the U.S.-U.K. treaty provides that the U.S. may not impose tax on a dividend that a U.S. resident pays to a U.K. resident if the U.K. resident is a corporation (i) that is the beneficial owner of the dividend, (ii) that directly owns stock representing at least 80 percent of the voting power of the corporation paying the dividend, and (iii) that the stock so held has been owned by the U.K. recipient corporation for a 12-month period ending on the date of distribution, and the appropriate conditions of Article 23 (Limitation on Benefits of the Convention) are satisfied.

To benefit from this exemption, RSL must be the beneficial owner of the dividend, be a resident of the U.K. and hold 80 percent or more of RSI’s stock for a 12-month period ending on the date of the distribution. In addition, RSL must be considered a “qualified person” under Article 23 (Limitation on Benefits of the Convention, as amended), which is documented per RSL’s W-8BEN-E (Certificate of Foreign Status of Beneficial Owner for U.S. Tax Withholding). The U.S.-U.K. treaty does not define the term “beneficial owner,” which generally is used in U.S. tax treaties to describe the person who (1) has to take into account the item of income under the laws of the source country, and (2) is subject to tax on it in the residence country. RSL’s Form W-8BEN-E certifies that RSL meets the requirements of the limitation on benefits (LOB) provision under the U.S.-U.K. treaty. An LOB discussion is beyond the scope of this article.

Thus, if RSI has sufficient E&P to result in a dividend to RSL, the treaty should reduce the U.S. tax on that dividend from the statutory tax rate of 30 percent to 0 percent, provided RSL (as assumed herein) qualifies for treaty benefits.

It should be noted that to qualify for the tax exemption under the treaty, RSL must comply with various procedural requirements. Among others, before the Distribution, RSL should provide RSI with a Form W-8BEN-E, showing its entitlement to the treaty-based tax exemption. (Treas. Reg. Sections 1.1441-1(b)(7), 1.1441-1(e) and 1.1441-1(c)(16).) Furthermore, if RSL is ultimately treated as receiving a dividend from RSI, RSL may have to file a U.S. tax return, Form 1120-F, to which it attaches a Form 8333, disclosing a treaty-based return position. Tax code Section 6114 and the regulations thereunder. Corporations may be subject to a significant monetary penalty for each failure to file Form 8833. A discussion of exceptions to the general filing requirements is beyond the scope of this article.

Under Treas. Reg. Section 1.1461-1(b)(1), every withholding agent (such as RSI) must file an information return on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, to report amounts paid during the preceding calendar year (2017) that are described under the section, Amounts Subject to Reporting (e.g., dividends). RSI must file Form 1042-S even if RSI did not withhold tax because the income was exempt from tax under a U.S. tax treaty or the tax code. Treas. Reg. Section 1.1461-1(c)(2)(i)(A).

If Form 1042-S is required to be filed, the withholding agent, RSI, must also file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. Form 1042 and Form 1042-S should be filed with the IRS by March 15, 2018. The Form 1042-S must be delivered to RSL by March 15, 2018, as well. If RSI needs an extension of time to file Form 1042, it must file a Form 7004, Application for Extension of Time to File Certain Excise, Income, Information, and Other Returns. Form 7004 does not extend the time for payment of tax. A separate Form 8809, Application for Extension of Time to File Information Returns, is used to request an extension of time to file Forms 1042-S. To request a 30-day extension to file Form 1042-S, RSI must file Form 8809 before the March 15 due date of the Form 1042-S. When Form 8809 is timely filed, an automatic 30-day extension will be granted. If RSI needs more time, a second Form 8809 must be filed before the end of the initial extension period. A further extension is granted only at the discretion of the IRS and only if RSI can show extenuating circumstances that prevent filing of the Form 1042-S within the first 30-day extension.

At the end of the day, a simple cash distribution had been paid by a U.S. subsidiary up to its foreign parent corporation. However, the character of the distribution needed to be ascertained (e.g., would it be treated for U.S. federal income tax purposes as a dividend, or as something else?); two separate regimes for the withholding of tax applied to it (income tax withholding on the dividend portion and FIRPTA withholding on the non-dividend portion); and a myriad of tax-related calculations and paperwork were required to be prepared and filed.

Stephen F. Jackson and Julia Tonkovich are with Ernst & Young LLP, National Tax Department.

The views expressed are those of the authors and do not necessarily represent the views of Ernst & Young LLP or any other member firm of the global EY organization.