In this Tax Alert we spotlight the tax provisions of two pieces of legislation, one to provide new job incentives and the other to radically reform healthcare. Both laws will have major tax legislation incorporated in them.
The Jobs Act
The President has signed a dual purpose bill, the "Hiring Incentives to Restore Employment Act of 2010" or "HIRE" (the "Act"). The Act incorporates tax measures previously introduced in the "Foreign Account Tax Compliance Act" ("FATCA"). The Act creates a new and complex withholding tax system for foreign financial institutions as well as a major tax compliance burden on U.S. taxpayers who have financial assets in foreign jurisdictions. The Act also imposes withholding taxes on foreign counterparties to swaps and other transactions based on U.S. equities.
The tax measures are projected to pay for the $13 billion of incentives to businesses who hire new workers. Because the offshore account provisions appear to conflict with proposed regulations issued by Treasury regarding reporting of foreign accounts held by U.S. persons (see our Tax Alert of March 2, 2010), we urge you to follow the developments carefully. We summarize below only the FATCA provisions of the new law. In many cases, a U.S. taxpayer will be subject to make two separate information reports for the same assets and income, and for one asset class (regulated foreign investment companies), a TRIFECTA of forms will be required. Penalties of as high as 90% of the value of the accounts could apply to the U.S. taxpayer who fails to file all of these forms and report all of the income that would have been reported if the forms had been filed in a timely and correct basis.
Compliance Burdens of Foreign Financial Institutions
A foreign financial institution will be required to enter into U.S. withholding tax agreements with the Internal Revenue Service ("IRS") and to enforce account holder verification and due diligence processes the IRS requires. This is likely to include information reporting similar to what is presently required on Form 1099. If the foreign financial institution does not comply and is unable to produce a withholding agreement with the IRS, every U.S. payor must collect a 30% withholding tax. If the foreign financial institution is compliant but the customer is not, the institution must collect the 30% U.S. tax on the "recalcitrant" customer. A "recalcitrant" customer is defined as any customer of the foreign financial institution who fails to comply with the U.S.-based requests for information about whether that customer is a U.S. taxpayer. The Act has no dollar value thresholds so that compliance costs can easily exceed any amount of U.S. taxes that may be due.
This new withholding tax regime is effective for payments made after December 31, 2012. Given the sweeping outline of the new regime and its extraterritorial scope (requiring foreign persons with no direct contact with the U.S. to enforce the U.S.'s income tax system) the effective date may well prove unworkable. The IRS has a great deal to get done by January 1, 2013 if taxpayers are to implement this new system, as the law leaves many critical elements to be defined by regulations. A further burden imposed upon the IRS is the duty to negotiate withholding tax agreements with foreign financial institutions.
The effect of this new regime is unclear. However, the legislation permits a foreign financial institution to bypass the tax if they certify that it has no U.S. customers. This may prove tempting to many foreign institutions, on the grounds that doing business with U.S. customers might be too much of an administrative burden.
Reporting of Foreign Assets
The second major portion of FATCA is a new regime imposed upon U.S. taxpayers with specified financial assets in foreign jurisdictions. Current rules require applicable U.S. taxpayers to file an annual report, the "FBAR," with the Treasury's FinCEN (financial crimes center) by June 30 of the year following the year in which the filing threshold occurred (generally, $10,000 in total for all foreign bank account and financial accounts). FATCA imposes a new reporting regime, in part at odds with the FBAR regime, applicable only to individuals and certain trusts, and with a $50,000 aggregate threshold, rather than the $10,000 figure for FBARs. The FATCA regime also covers investments in foreign entities, such as foreign hedge funds; whereas recently issued FBAR regulations would exempt investments in foreign hedge funds. Unlike the FBAR, which is a Treasury form, any form implementing FATCA will be included in the taxpayer's federal income tax return for the year the information return covers.
A similar information return will apply to U.S. investors in Passive Foreign Investment Companies (such as foreign hedge funds and publicly offered foreign investment companies). This reporting is likely to overlap with the FATCA reporting, as well as FBAR reporting that would be required by recently issued proposed regulations. The Act also imposes similar information returns and penalties in respect of foreign situs trusts that have U.S. beneficiaries who are not reporting their interests in such trusts.
The Act imposes a 40% tax penalty on the underpayment of income tax by taxpayers who failed to report income from foreign financial accounts they did not disclose. The information return and tax penalty rules are effective for taxable years beginning after the date of enactment (March 18, 2010). (This appears to be in addition to the existing 50% penalty for not filing FBAR returns.) The Act also generally extends the statute of limitations for assessing taxes in cases where the taxpayer failed to report the income from foreign financial accounts, including a retroactive date for returns that have been filed but for which the statute of limitations for tax assessment has not expired.
Withholding Tax on Synthetic Dividend
Foreign recipients of U.S. dividends (an amount paid by a U.S. corporation to a shareholder out of certain after-tax profits), whether received directly or as a member of a partnership, are generally subject to a 30% U.S. withholding tax on the gross amount of the dividend. Where the foreign payee is entitled to the benefits of an income tax treaty, that rate is generally reduced to 15%. However, most foreign hedge funds are organized in a low-tax jurisdiction and must pay the full 30% tax. The tax is inapplicable in many transactions, including those where the foreign payee is a party to a notional principal contract ("swap") having periodic payments that are based on a notional dividend yield of U.S. equities.
The Act imposes U.S. withholding tax on any payment made under a swap that is determined, directly or indirectly by reference to a U.S. source dividend, and any payments made under a securities lending or similar transaction (a foreign shareholder authorizes a securities broker to transfer stock to a party that wants to sell the stock short). All of these types of transactions did not previously constitute an actual payment of dividends and were generally not subject to U.S. withholding taxes.
The definition of swap provides for a two-year transition period, during which only those swaps meeting specified criteria that are not generally employed, such as swaps where one party transfers to the other the underlying security (such as the basket of U.S. equities that the swap is based on). However, at the end of the period that is two years after the date of enactment (that is, March 18, 2012), all swaps will be covered unless the Treasury issues rules determining that this type of swap does not have the potential for tax avoidance.
The dividend withholding rules apply to payments on or after the date that is 180 days after the date of enactment (payments made on or after Tuesday, September 14, 2010 are covered).
The Health Care and Education Affordability Act of 2010 (the "Health Care Act")
This massive piece of legislation is to radically change our nation's healthcare system. Paying for this hugely expensive undertaking is a daunting task, to which Congress has responded with major tax legislation, incorporated in the Health Care Act.
"Medicare Tax"
The Health Act imposes a 3.8% income tax surcharge on taxpayers having certain thresholds of income, which is labeled a "Medicare Tax." Individuals are subject to an annual tax of 3.8% of the lesser of their net investment income or their modified adjusted gross income above a threshold amount ($250,000 for joint filers, $125,000 for married persons filing separately and $200,000 for all others). Carved out from net investment income are distributions from qualified retirement plans and certain business income. Trusts and estates are subject to a 3.8% tax on the amount of undistributed net investment income over the amount of taxable income at which the highest tax bracket for trusts and estates begins ($11,150 for tax year 2009).
The tax raised by the Health Care Act's provision may be allocated to the Supplementary Medical Insurance Trust Fund, which appears to be the reason for the label "Medicare Tax" although the 3.8% surcharge is clearly an income tax, not a Social Security tax. A taxpayer may be liable to the surcharge who has no earned income at all. The surcharge will be effective for taxable years beginning on or after January 1, 2013.
"Economic Substance Doctrine"
For tax-advantaged transactions, the Health Care Act requires a taxpayer to prove, if challenged, that a transaction has "economic substance" because the transaction: (1) changes the taxpayer's position in a "meaningful" way apart from the Federal income tax effects of the transaction; (2) is entered to a "substantial" purpose apart from its Federal income tax effects; and (3) has a potential for profit, after taking into account fees and other expenses and any applicable state, local and foreign taxes, that is "substantial" in relation to the net present value of the contemplated Federal income tax benefits. Very substantial penalties are provided where a taxpayer's underpayment of tax results from a transaction that runs afoul of this provision. This provision is effective for transactions after the date of enactment of the Health Care Act.
If you have any questions concerning this Tax Alert or any related matters, please contact Steven M. Etkind, 212-573-8412 (setkind@sglawyers.com) or Roger D. Lorence, 212-573-8413 (rlorence@sglawyers.com). We welcome your input.