Commercial banks sometimes offer their larger accounts preferred treatment. One of these benefits is earning interest on the balance at the close of the business day. Typically the balances are combined and used to purchase interest bearing securities. The next business day the interest earned is credited to the customers account.

Under U.S. tax principles, a REPO is typically characterized as a collateralized loan where the purchaser of the underlying security is deemed to be a lender of funds to the seller in the amount of the purchase price. The seller of the security is treated as the borrower. The loan is for the period until the REPO matures, when the securities are sold back to the original seller (i.e. the cash borrower). Typically, the repurchase price exceeds the original sales price, giving rise to a charge consisting of financing interest.

If the financing interest is U.S. sourced and paid to a foreign person, it may be subject to NRA withholding. However, see the exception for certain short term obligations referenced in Treas. Reg. 1.1441-2(a). In addition, an examiner may find substitute payments (dividend or interest) made by the cash lender to the borrower as part of the REPO. These substitute payments are similar to those typically seen in securities lending transactions, whose sourcing is determined with respect to the underlying security for withholding and reporting purposes. See the Securities Lending section and IRC Section 1058 for more information.

There is no NRA withholding obligation on payments made under NPCs to foreign persons. See Treas. Reg. 1.1441-4(a)(3). If, however, these payments are ECI as to the foreign person, or are presumed so under the regulations, income reporting is required on Form 1042-S. See Treas. Reg. 1.1441-4(a). The ECI presumption may be rebutted by a withholding certificate representing that the payments are not effectively connected with the conduct of a U.S. trade or business. Instead of a withholding tax certificate, a payee may represent in a master agreement governing the transactions in NPCs between the parties that the counterparty is a U.S. person or a non-U.S. branch of a foreign person. Income on NPC’s that are regarded as embedded interest or recharacterized as certain other payments under U.S. tax principles might be subject to NRA withholding and reporting.

A syndicated loan results when financial institutions collectively participate in funding a single loan. Generally, one of the participants will act as an administrator and distribute the interest income to the other participants. The administrator will be the withholding agent. The following issues should be considered related to syndicated loans:

Reportable amounts that withholding agents pay to foreign intermediaries or foreign flow-through entities require specific treatment because intermediaries and flow-through entities are not beneficial owners of income. Examples of flow-through entities are foreign partnerships, simple and grantor trusts, and disregarded entities.

Foreign intermediaries and flow-through entities must provide the U.S. withholding agent a Form W-8IMY. This form indicates that account holder is not the beneficial owner of the reportable income. The form also indicates if the account holder has entered into an agreement with the Service to act as a withholding agent.

Foreign financial institutions can enter into an agreement with the Service to act as a Qualified Intermediary (QI). All foreign intermediaries, who do not have an agreement with the IRS to act as QIs are, by default, Non-Qualified Intermediaries (NQIs). See Rev. Proc. 2000-12.

Foreign partnerships, simple or grantor trusts, can elect to enter into an agreement with the Service become a Withholding Partnership (WP) or a Withholding Trust (WT). A foreign flow-through entity that has not become a Withholding Partnership or a Withholding Trust is, by default, a Non-Withholding Partnership (NWP) or a Non-Withholding Trust (NWT). See Rev. Proc 2003-64.

A bearer obligation is one that is not in registered form. The bearer obligation is foreign targeted when it meets the following three requirements:

An obligation is registered when it meets the requirements specified in Treas. Reg. 1.871-14(c). Among these requirements is that the withholding agent obtain a withholding certificate or documentary evidence that the beneficial owner of the payment is not a U.S. person. Such documentation must be provided before expiration of the beneficial owner’s limitation period for claiming a refund with respect to such interest. See Treas. Reg. 1.871-14(c)(3). This documentation requirement does not apply in cases of foreign targeted registered obligations, which have separate requirements. See Treas. Reg. 1.871-14(e).

The following are interest income payments that do not qualify for the portfolio interest exemption even when the interest is paid with respect to a registered or foreign targeted bearer obligation:

This first step requires the analysis of the vendor file to identify vendors that may be foreign persons. The vendor file is a listing of all vendors, including names and other pertinent information relating to the vendor. All vendors who meet one or more of the following criteria should be considered to be a possible foreign vendor:

The above are recommended indicators to determine that the vendor may be foreign. The examiner should review the vendor file to set any other criteria that may be used for the particular taxpayer.

Some of the vendors selected may be U.S. vendors. Therefore, it is recommended that this list of possible foreign vendors should be presented to the taxpayer for their review. If the taxpayer can establish that the vendor is not foreign, the name should be removed from further review.

In step two payments to foreign vendors are ascertained. Not all payments to the foreign vendors selected in step one would be FDAP income. The examiner should decide which payment would most likely result in FDAP income to the vendor. Some of the most common expenses paid by the taxpayer that may result in FDAP income payments to the vendors are:

It is recommended that the examiner should first test the accuracy of how expenses are categorized by the taxpayer before step two is performed. Often expenses are not accurately categorized by the taxpayer. For example, some portion of a large contract for computer hardware might pertain to training and maintenance functions. That portion would be personal service fees, which would be FDAP income if performed within the U.S. but the entire payment may have been incorrectly treated as computer hardware expense by the taxpayer.

Once the examiner has determined the validity of the categorization, the step two's analysis can be performed. The examiner should at least review material payments that may be FDAP even though the taxpayer did not correctly categorize them as such. The examiner should compile all payments of the selected expenses paid to the foreign vendors.

At this point the examiner has determined payments to foreign vendors which are FDAP income. The source of the income (U.S. sourced vs. Foreign sourced) should now be determined. See the summary of general sourcing rules from IRC Sections 861, 863, and 865 in Figure 4.10.21-3 below.

The regulations under Treas. Reg. 1.1441-2(a) require that the income payments be presumed U.S. source when the source is not known to the payer. Therefore, any FDAP income determined in step 2 that the source is unknown to the payer is presumed to be U.S. sourced and subject to a 30% withholding tax. The taxpayer has the burden of proof to overcome the presumption.

It is recommended that a modified three step audit be performed for payments made by departments other than the accounts payable department. The examiner should identify material payments made to foreign persons.

Some common examples of other payments which may be subject to withholding tax are:

Payments to related foreign entities may also not be made by the accounts payable department. Such payments may be identified based on, among other things, Forms 5471 and 5472 as described below.

Generally, the Form 5471 is required to be filed by a U.S. person having certain ownership interests in a foreign corporation. A separate Form 5471 is required to be filed with respect to each foreign corporation meeting these ownership rules. This IRM will focus on the Schedule M attached to the Form 5471. Schedule M is completed by a U.S. person who has controlling interest in a foreign corporation that is a Controlled Foreign Corporation (CFC). See IRC Section 957. Schedule M reports transactions between the taxpayer and its CFC and reports the following payments made by the taxpayer to the CFC, some of which may be U.S. sourced FDAP income to the CFC:

A separate Form 5472 is filed with respect to each foreign shareholder owning 25% or more of a U.S. taxpayer. Part IV of the Form reports the following payments by the taxpayer to the foreign corporation, which may be U.S. sourced FDAP income to the foreign corporation:

The examiner should determine if these amounts were subject to NRA withholding and reported on Forms 1042 and 1042-S. If not, an explanation should be provided by the taxpayer.