On Twitter, Andrew Grossman mentioned Housden v. Commissioner, 63 T.C.M. 2063 (1992). Mr. Housden, a partner of famous Canadian architecture firm WZMH, got a loan from the Royal Bank of Canada. He later moved to the U.S. to operate a WZMH subsidiary, and made some payments on the loan from 1980 until 1983 — meaning that RBC earned interest income “from sources within the United States” within the meaning of 26 USC § 871(a)(1).
The U.S. Tax Court ruled that when an individual resident of the United States has borrowed money from a non-U.S. bank, the individual is supposed to be the withholding agent for the 30% tax on interest income earned by the bank under § 871(a). So Housden had to pay that 30% out of his own pocket and try on his own to get it back from RBC. The only relief for Housden was that he didn’t get hit with penalties for underpayment or failure to file required forms, since two famous nests of compliance condors — first Deloitte, later the now-defunct Laventhol & Horwath — failed to warn him about his withholding obligations until he was already being audited.
Brockers with local mortgages or credit cards are probably about to panic upon reading this. Fortunately, the IRS suggested in 1992 regulations that an individual interest payor should probably only be considered a “resident of the United States” if the individual meets the substantial presence test (SPT), regardless of citizenship. As Phil Hodgen pointed out two years ago, the IRS confirmed this view in (non-precedential) Chief Counsel Advice in 2012. So if you have lived in another country for your entire adult life, IRS lawyers do not seem to think they can reasonably interpret § 871 or its regulations to grab 30% of all your mortgage payments.
In other words, this is a tiny island of residence-based sanity in the citizenship-based “Internal” Revenue Code — well, almost. Nothing involving the U.S. tax system can ever be as simple as it sounds.
Let’s play a game of “gotcha!” with your money
The SPT can end up classifying you as a U.S. resident even in the tax year after you move out of the U.S., if you visit for thirty-one days during your first full year abroad. Confusingly, that’s less than the thirty-five days allowed by § 911’s Physical Presence Test, probably the only day limit with which any emigrants are familiar. Some exceptions to the SPT probably aren’t available to U.S. citizens. Worse yet, a later ruling extends this problem to certain non-U.S. businesses as well, if they foolishly made a “check-the-box” election in a vain attempt to reduce their U.S. Person owners’ other citizenship-based filing burdens.
And as I’ll discuss in later posts in this series, the source-of-interest rules of course require paperwork you’ve never heard of with crazy failure-to-file fines even when no tax is owed, many U.S. tax treaties do not fully exempt U.S.-source interest from withholding tax anyway, and the Chief Counsel Advice claims that the SPT should override the clear language of treaty provisions which direct the contracting parties to determine source of interest by referring to the payor’s residence as decided under treaty residence tiebreaker rules.
- Treatment of U.S. citizens
- Treatment of green card holders
- Substantial presence test vs. physical presence test
- The closer connection exception?
- Even worse if you have your own business
26 USC § 871(a)(1)(A) currently states:
(a) Income not connected with United States business—30 percent tax
(1) Income other than capital gains Except as provided in subsection (h), there is hereby imposed for each taxable year a tax of 30 percent of the amount received from sources within the United States by a nonresident alien individual as—
(A) interest (other than original issue discount as defined in section 1273), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income …
Back in the years at issue in Housden (1980 to 1983) that provision seems to have been the same, save for the reference to § 1273. The Tax Court didn’t bother mentioning the source-of-interest regulations, 26 CFR 1.861-2(a). That’s probably because they’re too circular to shed any additional light on the issue (portions quoted are the same as when first promulgated, save for the addition of the word “incurred”; see 40 FR 45429, 2 Oct. 1975):
(1) Gross income consisting of … interest from a resident of the United States on a bond, note, or other interest-bearing obligation issued, assumed or incurred by such person shall be treated as income from sources within the United States. …
(2) The term “resident of the United States”, as used in this paragraph, includes (i) an individual who at the time of payment of the interest is a resident of the United States …
Possibly motivated by some of the issues that Housden brought up, in April 1992 (57 FR 15242) the IRS promulgated the first draft of 26 CFR 301.7701(b)-1 regarding the definition of “resident alien”. With regards to citizens, that section stated then as it still does now:
Unless the context indicates otherwise, the regulations under §§ 301.7701(b)-1 through 301.7701(b)-9 apply for purposes of determining whether a United States citizen is also a resident of the United States. (This determination may be relevant, for example, to the application of section 861(a)(1) which treats income from interest-bearing obligations of residents as income from sources within the United States.)
(“§§ 301.7701(b)-1 through 301.7701(b)-9” are the substantial presence test and its exceptions, which I discuss further below.)
However, the treatment of green card holders under those regulations appeared to be much worse: they said that people who held green cards in even one day of a year should be treated as residents of the U.S. for the full year for all tax purposes, regardless of whether or not they met the substantial presence test, and without any specific exception for source-of-interest rules:
(b)Lawful permanent resident –
(1) Green card test. An alien is a resident alien with respect to a calendar year if the individual is a lawful permanent resident at any time during the calendar year. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned.
And thus did the IRS create one of the more infamous “gotchas” of “citizenship-based” taxation: the “green card for tax purposes but not for green-card purposes” rule which said that for want of a single Form I-407, you still had to pay tax as a U.S. resident even if you had moved out of the country, physically cut all your ties there, and let your green card expire years ago.
However, two decades later in CCA 201205007 IRS lawyers seem to have partially changed their minds and decided that green card holders should not be treated worse than citizens under the source-of-interest rules. Instead they chose to apply the substantial presence test to everyone. At page 5:
(3) Interest paid by lawful permanent residents
There is a question as to how interest should be sourced if it is paid by a lawful permanent resident who lives outside of the United States at the time of payment. The emphasis that section 861 and its related regulations place on an individual’s residence, rather than the individual’s legal or immigration status in a particular country or jurisdiction, suggests that sourcing of interest payments by an individual should be based on the individual’s place of physical residence. Therefore, we believe that interest paid by lawful permanent residents should be sourced in the same manner as interest paid by U.S. citizens. By analogy to the rules for interest paid by U.S. citizens, interest paid by a lawful permanent resident who would satisfy the substantial presence test at the time of the interest payment should be treated as U.S. source income. Interest paid by a lawful permanent resident who would not satisfy the substantial presence test at the time of the interest payment should be treated as foreign source income.
If you’re a U.S. citizen who moved abroad last year and this is your first full tax year abroad, and you know about the Foreign Earned Income Exclusion, then you’ve probably come to the conclusion that you can visit the U.S. for up to 35 days per year (or 36 days in leap years!) without any additional negative tax consequences thanks to the “physical presence test” of 26 USC § 911(d)(1)(B), or even longer if you meet the “bona fide residence test” of (d)(1)(A). Unfortunately, that’s not quite true. If you spend more than 30 days in the U.S. in a given year, then you have to use the substantial presence test of 26 CFR 301.7701(b)-1(c) to assess whether you are a U.S. resident for the source-of-interest rules.
Basically, for every day you spent in the U.S. during the tax year for which you’re trying to figure out your residence, give yourself one full demerit point; for every day in the year before that, give yourself a third of a point, and for every day two calendar years before that, give yourself a sixth of a point. If you score 183 or higher, with thirty-one or more demerit points coming from the latest year, you are a U.S. resident under the SPT. To maximise taxpayer confusion, the government calls these demerit points “days”, as in CCA 201205007 at page 4:
An individual is treated as a resident of the United States under the substantial presence test if he or she has been present in the United States for more than 30 days during the current year and on at least 183 days during a three-year look-back period that includes the current year.
For example, if you spent all of 2014 in the U.S. (365 days, or 605⁄6 “points” for SPT purposes), a bit more than nine months in 2015 (274 days, or 911⁄3 “points”), and 31 days in 2016 (31 “points”), then you meet the “substantial presence test” for 2016. In simpler terms, if you moved out of the U.S. any later than September last year, and spent more than a month in the U.S. this year, you may have problems.
Mercifully, this problem disappears by the second full year abroad: given the days mentioned in the last paragraph, in 2017 your two prior years (2015 and 2016) would total only to 56 “SPT points”. You’d have to spend another 127 days in the U.S. in 2017 in order to get caught by the SPT for your 2017 taxes, and most people (besides those who travel frequently for business) should be able to avoid spending that long. And also, if you spend 30 or fewer days in the U.S. in a given year, the SPT does not apply — you are automatically deemed a non-resident for the source-of-interest rules.
(Strange coincidence: I forgot how to write fractions in HTML, and so had to resort to a quick search engine query to look it up. The very first tutorial that popped up was written by the same guy who owns xmlprettyprint.com. As we noted previously, the IRS used to recommend that FFIs work around a bug in IDES by sending FATCA data totally unsecured to xmlprettyprint.com for reformatting prior to IDES submission, though fortunately they withdrew that recommendation sometime in early 2016.)
26 CFR 301.7701(b)-2 provides for the “closer connection exception” (CCE) to the SPT. U.S. citizens who find themselves classified as U.S. residents for the purpose of the source-of-interest-income rules might be able to use the CCE to fight that classification; 301.7701(b)-1(a) said that “the regulations under §§ 301.7701(b)-1 through 301.7701(b)-9 apply” in this case, and the CCE is certainly in that range.
However, some of the factors listed in subsection (d) that the IRS looks at when deciding on the CCE could make life rather difficult, especially if you are not living in your other country of citizenship but a third country entirely (which would thus tend to divide the remaining non-problematic factors between the two countries):
- “(iv) The location of social, political, cultural or religious organizations with which the individual has a current relationship” — hope you haven’t joined any Homeland-based organisations which are trying to get the Homeland to stop mistreating you!
- “(v) The location where the individual conducts his or her routine personal banking activities” — hope you haven’t had to resort to opening a State Department Federal Credit Union account in the world’s best tax haven after your local bank threw you out the door due to FATCA!
- “(viii) The location of the jurisdiction in which the individual votes” — hope you didn’t think you could exercise your rights of U.S. citizenship without that exercise being held against you!
- “(x) The types of official forms and documents filed by the individual, such as … Form W-9 (Payer’s Request for Taxpayer ldentification Number)” — hope you didn’t think you could comply with the U.S. tax system without that compliance being held against you!
It’s also not clear whether a U.S. citizen could strike off days of presence under 26 CFR 301.7701(b)-3. In particular, the rules for classification as an “exempt individual” (e.g. as a student or trainee) make reference to presence in the U.S. as a nonimmigrant — except in the case of professional athletes or foreign government-related individuals. The IRS apparently reserved judgment on this issue even for non-citizens; see CCA 201205007, Note 14 (at page 6):
We do not know whether the Customers include any alien individuals who would be residents under the substantial presence tax but for the fact that their days of presence are excluded pursuant to Treas. Reg. § 301.7701(b)-3. If there are such Customers, please contact us for additional advice.
With regards to the “foreign government-related individual” exception: although it is State Department policy not to receive U.S. dual citizens as ambassadors to Washington D.C., there have been numerous cases of duals representing their other country at the United Nations in New York. (The most recent one I know of is Camillo Gonsalves of St Vincent & the Grenadines; he later renounced U.S. citizenship anyway, though not until after his term at the UN came to an end.) If they borrow money from non-U.S. lenders — for example, because U.S. banks are extremely reluctant to deal with them — should their interest payments be treated as U.S.-source (and thus subject to U.S. withholding) or not?
Suppose you have recently moved to another country and formed a “foreign” corporation, i.e. a corporation in the country where you actually live. Being a dutiful U.S. tax subject, you are well aware of the decision you now face: if your corporation is not a per se corporation under 26 CFR 301.7701-2(b)(8)(i) you can elect for your corporation to be treated as a disregarded entity or partnership and reduce your paperwork burdens to a “mere” Form 8858 or 8865, at the cost of giving up deferral of U.S. tax on corporate profit.
If you do not, your business will be deemed either a “controlled foreign corporation” and thus subject to Form 5471 filings and the whole Subpart F mess if U.S. shareholders are in the majority, or possibly a PFIC and thus subject to Form 8621 filings if U.S. shareholders are in the minority. If you’re not the CEO of a giant multinational corporation which can afford to shove the whole pile of garbage off on Deloitte and let them deal with it, the “disregarded entity” choice can look superficially attractive.
So the IRS decided to drop an anvil on your head: CCA 201447030.
Pursuant to Treas. Reg.§ 301.7701-2(a), the activities of a business entity that has made the election to be treated for federal tax purposes as a disregarded entity are treated in the same manner as a branch or division of its sole owner. (Certain provisions of the Treasury regulations provide that an entity that has made this election will be treated as an entity separate from its owner for limited purposes; sourcing of interest payments is not one of the limited purposes.)
In other words, if you do meet the substantial presence test and your business elected to be treated as a disregarded entity for U.S. tax purposes, then your business must withhold tax on your share of the interest due to the lender and hand it to you so you can forward that tax to the U.S. Treasury. Have fun breaking the news to your business partners and your bank.
Of course, your bank will never accept this: from their perspective, they made a loan to a local corporation. Whatever personal tax problems one of the owners might have are supposed to be separate — particularly if that owner falls below the relevant local threshold (e.g. 10% or 25% ownership) which would require the bank to ask about that owner for AML and KYC purposes in the first place.
So you’d likely pay that interest tax out of your own pocket. If you really did try to embezzle that money out of the business’ pocket and send it off to a foreign government, both your business partners and your bank would take you to court. But partners and banks who learn that this is even a possibility will respond by taking the path of least risk. They won’t read three-thousand-word screeds on U.S. source-of-interest and disregarded entity rules to try to understand when interest paid by a U.S. citizen isn’t actually U.S. sourced, let alone pay Deloitte hundreds of dollars an hour to repeat all this analysis and give it a “professional” imprimatur.
They’ll simply kick you out of the business so that your U.S. taint doesn’t affect their loans.
The “Internal” Revenue Code is full of crazy traps for people who move between countries. Ordinary human beings have no idea these traps exist. Even most accountants and tax lawyers don’t seem to know: Deloitte clearly missed this withholding tax issue back in the 1980s. Aside from Phil’s blog post, literally the only times anyone on the Internet has even mentioned CCA 201205007 are a brief comment from Andrew Mitchel back when it was published and a more recent LinkedIn post by Virginia La Torre Jeker. CCA 201447030 looks to have inspired even greater silence.
I’m three thousand words in, and I’ve barely scratched the surface. I haven’t even dug into the most offensive parts of these rules: the fines which individual interest payors could face for failure to handle all the red tape even when no tax is owed, the use of regulatory authority to create exceptions for businesses but not for individuals who have far fewer resources to comply, and the IRS’ attempts to ignore the clear wording of tax treaties. Much more to come, unless someone screams at me to stop because they can’t take it anymore.
Those of you who have placed your hopes on a U.S. transition to residence-based taxation, keep in mind: this is how the U.S. actually does “residence-based” right now. Don’t expect sanity. Expect some dangerously incomprehensible scheme that that only a compliance condor could love: a mish-mash of paperwork, hidden traps, and eye-watering fines, which will succeed only at scaring ordinary human beings away from attempting to use it.