Four years ago in 2010, Congress enacted new tax legislation that only recently came into effect. This article briefly discusses two additional U.S. tax regimes arising from such new tax legislation: (i) the 3.8% net investment income tax plus the additional 0.9% Medicare payroll tax; and (ii) the 30% withholding tax under the Foreign Account Tax Compliance Act. These additional tax regimes have the effect of increasing the effective tax rate of individual taxpayers, and creating additional administrative responsibilities for withholding agents with respect to identifying payees, withholding taxes on amounts paid to payees, and reporting payee information to the relevant tax authorities.
NET INVESTMENT INCOME TAX / ADDITIONAL 0.9% MEDICARE PAYROLL TAX
Summary
Net Investment Income Tax. The 2010 Affordable Care Act (the “Act”) imposed a new 3.8% tax beginning on January 1, 2013 on certain net investment income of individuals, estates and trusts that have income above certain prescribed threshold amounts. This tax was added by Congress in order to raise revenues to fund health care reform. As a result of the Act, a new Section 1411 was added to the Internal Revenue Code of 1986, as amended (the “Code”). Under Code Section 1411, the new 3.8% tax applies to single taxpayers with modified adjusted gross income in excess of $200,000, and to married taxpayers with modified adjusted gross income in excess of $250,000 (if they file a joint return) or $125,000 (if they file a separate return). For purposes of the 3.8% tax, “modified adjusted gross income” typically means a taxpayer’s adjusted gross income as determined and calculated on such taxpayer’s income tax return.
The 3.8% tax is imposed on “net investment income.” Under Code Section 1411, investment income includes, but is not limited to, interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading financial instruments or commodities, and from businesses that are passive activities to the taxpayer. Investment income does not include income such as wages and unemployment compensation.
The net investment income tax is reported on Internal Revenue Service Form 8960, which for individuals is filed with their personal income tax returns on Internal Revenue Service Form 1040.
Accordingly, the net investment income tax is paid with the filing of an individual’s personal income tax return.
Additional 0.9% Medicare Payroll Tax. The Act also imposed an additional 0.9% Medicare payroll tax (on top of the current 2.9% Medicare payroll tax, of which half (i.e., 1.45%) is paid by employers) on earned income exceeding certain threshold amounts (i.e., $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately and $200,000 for single taxpayers). The additional 0.9% Medicare payroll tax is withheld by an employer from an employee’s wages.
An employee is liable for the additional 0.9% Medicare payroll tax to the extent that the employer does not withhold the tax. Individuals must report this tax on their personal income tax returns on Internal Revenue Service Form 1040.
The net investment income tax and the additional 0.9% Medicare payroll tax do NOT both apply to the same item of income.
Taxpayer Impact. The net investment income tax and the additional 0.9% Medicare payroll tax essentially increase the tax burden and effective tax rate of individual taxpayers. For example, without giving effect to the net investment income tax, individuals would be subject to a maximum effective tax rate of (i) 39.6% on dividends, interest and short-term capital gains (i.e., capital gains with respect to the disposition of capital assets held for one year or less), and (ii) 20% on “qualified dividends” (i.e., dividends from shares in U.S. corporations and certain qualified foreign corporations which an individual taxpayer held for certain prescribed minimum time periods) and long-term capital gains (i.e., capital gains with respect to the disposition of capital assets held for over one year). As a result of the net investment income tax regime, however, the above tax rates have increased from 39.6% to 43.4% (i.e., 39.6% + 3.8%), and from 20% to 23.8% (20% + 3.8%).
Taxpayers with earned income meeting the thresholds described above for purposes of triggering the additional 0.9% Medicare payroll tax will now have an increased overall tax liability as a result of this tax. For example, if a single taxpayer earns $225,000, he or she will pay a 1.45% Medicare tax on the first $200,000 (the remaining 1.45% of the 2.9% Medicare tax would be paid by the employer), and then 2.35% (1.45% plus 0.9%) on the remaining $25,000 (i.e., $225,000 minus $200,000). The taxpayer’s employer will be required to withhold the extra 0.9%.
30% WITHHOLDING TAX UNDER FOREIGN ACCOUNT TAX COMPLIANCE ACT
Summary. The Foreign Account Tax Compliance Act, or FATCA, was enacted to prevent U.S. persons from evading U.S. tax through the use of non-U.S. entities, by requiring such entities to disclose U.S. account/owner information to the relevant governmental authorities. FATCA (which is codified in Code Sections 1471 through 1474 and the U.S. income tax regulations promulgated thereunder) imposes a 30% U.S. withholding tax on “withholdable payments” made to non-U.S. entities that do not comply with certain due diligence and reporting requirements prescribed by FATCA. “Withholdable payments” consist of (i) certain U.S.-source income, such as U.S.-source dividends, interest and rents, paid after June 30, 2014, and (ii) certain U.S.-source gross proceeds paid after December 31, 2016. For FATCA purposes, non-U.S. entities are categorized as (i) “foreign financial institutions” or (b) “non-financial foreign entities”. The distinction is relevant as that in turn drives the manner of FATCA compliance. A “non-financial foreign entity” is an entity that is not a foreign financial institution. A “foreign financial institution” is broadly defined and includes, for example, any non-U.S. entity that (i) holds, as a substantial portion of its business, financial assets (i.e., stock, partnership interests, notes, bonds and commodities) for the benefit of another, or (ii) holds itself out as a collective investment vehicle, mutual fund, exchange traded fund, private equity fund, hedge fund, venture capital fund, leveraged buyout fund, or any similar investment vehicle established with an investment strategy of investing, reinvesting, or trading in financial assets.
A foreign financial institution can avoid FATCA withholding if it registers its FATCA status with the Internal Revenue Service to obtain a special FATCA identification number called a “Global Intermediary Identification Number” (a “GIIN”), and (i) agrees to report U.S. account/owner information directly to the Internal Revenue Service or (ii) if the foreign financial institution is in a jurisdiction whose government has executed a “Model 1” FATCA intergovernmental agreement with the United States, such foreign financial institution reports U.S. account/owner information directly to its own government instead of the Internal Revenue Service (note, however, that a foreign financial institution located in a jurisdiction that has executed a “Model 2” FATCA intergovernmental agreement with the United States will be required to report U.S. account/owner information directly to the Internal Revenue Service). A non-financial foreign entity can avoid FATCA withholding if it provides to a withholding agent or to the Internal Revenue Service information regarding its “substantial U.S. owners” (i.e., certain U.S. persons that own 10% or more of the non-financial foreign entity). Additionally, both foreign financial institutions and non-financial foreign entities may avoid FATCA withholding if they fall within prescribed categories of persons that are treated as exempt from withholding under FATCA (i.e., certain non-U.S. pension trusts).
Taxpayer Impact. FATCA strives to foster transparency vis-à-vis the disclosure of U.S. taxpayers to the U.S. tax authorities, but this comes at an administrative burden and cost because of the additional due diligence and analysis that are now required in order to ensure compliance with FATCA and avoidance of the 30% withholding tax.
1. Withholding Agents. As a result of the enactment of FATCA, withholding agents that make any “withholdable payments” (i.e., dividends) have heightened due diligence, administrative and reporting obligations vis-à-vis their payees/customers/investors. For example, withholding agents must not only obtain U.S. tax certificates from payees/customers/investors certifying the latter’s U.S. or foreign status, as well as FATCA status (the certificates are typically Internal Revenue Service Form W-9 for U.S. persons, and an applicable Internal Revenue Service Form W-8 (i.e., Form W-8BEN/Form W-8BEN-E) for foreign persons, and are required to be signed under penalties of perjury), but withholding agents must carefully review and scrutinize such tax certificates (including verification that a GIIN is set forth on published lists of GIINs issued by the U.S. tax authorities) and follow up with payees/customers/investors for additional clarifying information. By way of illustration, if a withholding agent receives an Internal Revenue Service Form W-8BEN from an individual foreign payee, and such form shows any “U.S. indicia” (i.e., a U.S. address), the withholding agent is required under FATCA to obtain additional information from the payee to substantiate the payee’s claim of foreign status and to “cure” the U.S. indicia on the Internal Revenue Service Form W-8BEN. If a withholding agent concludes through its due diligence that a payee either provides information that does not evidence compliance with FATCA, or refuses to provide information, the withholding agent will need to withhold 30% under FATCA on any withholdable payments made to such payee.
In the wake of FATCA, withholding agents will need to establish a system and policy of (i) collecting and reviewing tax information from new payees/customers/investors, and (ii) reviewing and diligencing information obtained from current/pre-existing payees/customers/investors to determine the FATCA status of such persons and determine which of these persons are U.S. persons. Withholding agents should assess their reporting obligations, if any, that may arise from their FATCA due diligence. Withholding agents that fail to comply with FATCA face potential liability for the FATCA withholding tax, interest and penalties.
2. Payees/Customers/Investors. Taxpayers that receive withholdable payments will need to provide the relevant U.S. tax information (i.e., Internal Revenue Service Forms W-9 and W-8) certifying as to their U.S. or foreign status as well as their FATCA status. If the recipient of a withholdable payment is an entity such as a partnership, such recipient will need to conduct FATCA due diligence with respect to, and obtain the requisite tax information from, its partners, and provide such information upon request to a withholding agent. Payees/customers/investors should be aware that they may now be requested to provide such additional information as a payor/withholding agent may deem necessary in order to enable the payor/withholding agent to satisfy its due diligence obligations under FATCA. Furthermore, payees/customers/investors will likely be required to contractually agree (i.e., through subscription agreements, account-opening documents) to provide any and all information requested by a payor/withholding agent for purposes of FATCA compliance.
The foregoing discussion contains general information only, and is not intended to constitute tax advice. Each taxpayer should consult with his, her or its independent tax advisor as to the impact of the rules discussed above on such taxpayer, in light of such taxpayer’s particular circumstances.
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