The terms FDAP (Fixed, Determinable Annual and Periodical Income) and ECI (Effectively Connected Income) are expansive terms. They are the backbone behind the tax withholding, and reporting requirements imposed on US Banks with respect to outbound payments. Many of the individuals that are responsible for ensuring compliance with the rules applicable to the US Financial Institutions are not familiar with the rules, or not aware of the consequences for lack of compliance.
Enforcement of reporting and tax withholding obligations is a focus of IRS collection efforts. FATCA (Foreign Account compliance Act) is a US Federal Law enacted in 2010 with the purpose of combating tax evasion by US persons holding accounts and other financial assets offshore. FATCA imposes requirements on Foreign Financial Institutions and certain other non-financial foreign entities to report on the foreign assets held by their US account holders or be subject to withholding on withholdable payments.
Although FATCA is more burdensome for Foreign Financial Institutions, US Banks must develop their own “best practices” for ensuring US side compliance. It is imperative that the US Banks have procedures in place that will properly classify outbound payments and their source of the related income. US Bank Accounts Payable Departments happen to be where most of these payments are issued. US Banks ought to have a process in place to ensure proper withholding direction, and a process for easy access to the right department (whether compliance, legal or tax) for analysis and resolution if needed.
The first step for US Banks is to determine the status of the payee (person to whom money is paid). Is it a US citizen, Permanent Resident or a Foreign Person? A Foreign Person would be a Non-Resident Alien (NRA), a Foreign Corporation, Foreign Partnership or Foreign Trust.
After the status of the payee or beneficiary is established, the second step is to look at related payee documentation. What are we looking for? Witholding Certificates (W-8 series) that are completed and accurate. The Withholding Certificates are critical for determining the documentation status of the payee. To this date, many clients of US Banks give the Banks pushback against requests to provide W-8’s. Proceeding with a client if a Bank does not have valid and properly executed paperwork leaves it vulnerable to IRS sanctions.
The third step applies to the Foreign Person payee. US Banks generally don’t have withholding issues with a US person. Most of the confusion for the US Banks starts when they are trying to distinguish between FDAP and ECI. The identification of type of income (ECI versus FDAP) is what determines the withholding responsibility of the Bank. The good news is that if you are an NRA, the IRS only wants to collect tax on the money that you made in the US. IRS has identified two broad categories of NRA income that are subject to US taxes: FDAP and ECI. Generally, there is no witholding on ECI if the Payor (in this case the US Bank), has received form W-8ECI. This is income that is effectively connected with a US trade or business activity. When income is “effectively connected” with a US trade or business, the income is taxed at graduated rates, just like a US person. So, if you have a job in the US, or if you run your own business, then that income is recognized as “effectively connected” to a US trade or business. Examples are: maintaining a fixed office with employees, storing goods for sale to US buyers, soliciting orders through a dependent agent, providing logistics support for an export business, or management of a US real estate business.
FDAP, on the other hand, is meant to capture everything that isn’t ECI. FDAP income (must be US sourced) is generally known as: passive investment income, such as interest or dividends. However, it can also include other sorts of income, such as: compensation for personal services, rent, royalties, pensions, annuities, alimony and social security. FDAP income is taxed at a flat 30 percent rate on a gross basis. A lower treaty rate may possibly apply.
Why is all this important? A US Bank is required to withhold 30% of FDAP payments to NRAs absent proper withholding certificates – the W-8 series. The US Bank is responsible for remitting the withheld taxes to the IRS. Besides withholding, (if necessary), and remitting to the IRS, the US Bank also has to report FDAP payments to NRAs by filing Form 1042 and related Forms 1042-S.
In sum, for a US Bank to be ahead of the FATCA game, it must master international tax compliance. It has to:
- Identify the payee
- Determine status of Payee documentation
- Determine source of income
- Determine type of income
- Determine the tax residency status
- Create audit trails
- File Forms 1042-S
- Stay on top of international tax and immigration issues
Don’t be a victim of your own making. US Financial Institutions must ensure that they have the right Accounts Payable processes in place. Consult your tax specialist now.