Whistle While You Work: The Characterization and Sourcing of Whistleblower Awards

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By Edward Tanenbaum, Esq.

Alston & Bird LLP, New York, NY

With the continuing and expanding reach of the U.S. government's crackdown on cross-border tax evasion by U.S. persons, it is not surprising that the time had come to address the sourcing of awards paid to whistleblowers who seem to play an increasingly major role in the government's success.

Under §7623(a) of the Internal Revenue Code ("Code"), the IRS is authorized to pay appropriate sums "for detecting underpayments of tax or detecting and bringing to trial and punishment persons guilty of violating the internal revenue laws or conniving at the same." Section 7623(b) provides that, if the IRS proceeds with any administrative or judicial action described in §7623(a) based on information brought to the IRS's attention by an individual, such individual is entitled to receive an award of a certain percentage of the collected proceeds, depending on the extent to which the individual substantially contributed to such action.

PMTA 2011-002, issued on March 22, 2011, meticulously analyzes the characterization, sourcing, and withholding tax issues incident to the payment by the IRS of a whistleblower award to a nonresident alien.

With respect to the characterization of the award payment, the IRS opines that it is in the nature of compensation for services rendered, basing its opinion on the wording of the statute, i.e., that the individual is understood to "have brought to the Secretary's attention" certain information and that the amount of the award depends on the extent to which the individual "substantially contributed" to the action brought by the IRS, thus suggesting that the individual is performing an "affirmative act," or service, of providing information.

The IRS also cites Rev. Rul. 70-576, 1970-2 C.B. 331, as additional support for the fact that supplying information is providing an act or a service and that an award payment to an informant should be treated as compensation for services rendered.

The PMTA then, painstakingly, addresses why the whistleblower award is not to be characterized as the grant of an award governed by §74, the sourcing of which would be governed by Regs. §1.863-1(d)(1). As a brief background, §§861 and 862 clearly tell us that compensation for services rendered in the United States is U.S.-source income and compensation for services rendered outside the United States is foreign-source income. However, if the characterization of the whistleblower award is not in the nature of compensation for services rendered (and not otherwise specified in either §861 or §862) but, rather, in the nature of an award governed by §74, then its source is governed by Regs. §1.863-1(d) and, to the extent paid by the United States or an instrumentality or agency thereof, it would be entirely U.S.-source withholdable income.

However, Regs. §1.863-1(d)(1) provides that its provisions do not apply to amounts paid as salary or other compensation for services, clearly suggesting that some awards are in the nature of compensation for services rendered. Further, according to the IRS, while Regs. §1.863-1(d)(3) defines awards by referencing §74 and the regulations thereunder, that section does not include any award associated with services rendered other than a reference to certain employee achievement awards (as defined in §273(j)), suggesting that §74 is "not intended to cover a broad category of payments for performance of services generally."

Having dealt with the characterization issue, the rest falls somewhat easily into place. Thus, to the extent that the whistleblower services are performed in the United States, the compensation is U.S.-source under §861(a)(3), and foreign-source under §862(a)(3) to the extent the services are performed outside the United States. Of course, the allocation of the compensation paid for services rendered both within and without the United States must be determined on the basis that reflects the proper source of the income under the facts and circumstances of each particular case.  In the case of a whistleblower award, the individual will be required to adequately document what services were performed and where (which would include any services performed by an agent on behalf of the whistleblower).

To the extent of U.S.-source services rendered, the IRS will be required to withhold 30% of the amount paid for such services under the authority of Regs. §1.1441-4. Thus, in the case of a nonresident alien individual who is not able to benefit from an income tax treaty, 30% withholding applies to compensation for services rendered in the United States even though the income is considered effectively connected with a trade or business with respect to which withholding is not usually applicable.

However, in the case of individuals who can benefit from tax treaties, the whistleblower award will likely go untaxed in many cases. Thus, in the case of treaties with an Independent Personal Services article, the tax determination will be governed by the number of days spent by the individual in the United States and whether the individual has a fixed base available to him/her in the United States. In the newer treaties, this type of compensation will be regarded as business profits and the tax determination will be based on whether the individual has a fixed base or permanent establishment in the United States. In most cases, the whistleblower's presence and activities in the United States will not run afoul of any of these thresholds.

On balance, the overall result of the characterization and sourcing of the award is a positive one, certainly when weighed against its characterization as a §74-type award (rather than as compensation for services rendered), with the facts being easy to control and the rules being easy to apply.1

This commentary also will appear in the August 2011 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Blessing and Lubkin, 905 T.M., Source of Income Rules, Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, 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.

1But see Blanchard, "When Your Expert Witness Is a Nonresident Alien," 40 Tax Mgmt. Int'l J. 35 (January 2011), for the trials and tribulations of claiming treaty benefits for compensation for services rendered in the United States.

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