Treasury and IRS issues guidance on 2% tax on payments US government makes to foreign persons under certain contracts

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1 27 April 2015 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date Treasury and IRS issues guidance on 2% tax on payments US government makes to foreign persons under certain contracts On 20 April 2015, the Department of the Treasury and the IRS issued proposed regulations (REG ) under Section 5000C (the Proposed Regulations). Section 5000C, enacted in early 2011 as part of the James Zadroga 9/11 Health and Compensation Act of 2010 (Act), imposes a 2% tax on payments foreign persons receive from the US Government for certain goods and services. The Proposed Regulations clarify the meaning of certain terms used in the statute; provide rules on the imposition of, and exemption from, the tax under Section 5000C; and provide guidance on reporting and paying the tax. On 21 April 2015, the IRS released a companion notice (Notice ), listing current US income tax treaties that may exempt certain persons from the tax. Detailed Discussion A. In General In general, Section 5000C applies to foreign persons that are party to certain contracts with the US Government. For foreign persons receiving a specified Federal procurement payment (a SFPP), Section 5000C imposes on the foreign person a tax equal to 2% of the amount of the SFPP (the Section 5000C tax). A SFPP is any payment made to a foreign person under a contract with the US Government entered on or after 2 January 2011, for either: (a) the provision of goods, if those goods are

2 manufactured or produced in a foreign country that is not a party to an international procurement agreement (an IPA) with the United States, or (b) the provision of services, if those services are provided in a foreign country that is not a party to an IPA with the United States. IRC Section 5000C(b). A SFPP received by a nominee or agent on behalf of a person that is a party to the contract with the US Government (contracting party) are considered to be received by that contracting party. Prop. Reg. Section C-1(b). Section 301(c) of the Act provides that Section 5000C shall apply in a manner consistent with US obligations under international agreements. B. The Proposed Regulations 1. Definitions The Proposed Regulations define a number of key terms not defined in the statute, including: US Government. US Government is defined to include certain executive and military departments, independent establishments, and wholly owned government corporations (e.g., the Department of Agriculture, the Department of the Army, and the US Export-Import Bank). The Proposed Regulations refer to a department or agency that is a party to a contract as an acquiring agency. Prop. Reg. Section C-1(c)(7). IPA. An IPA is either the World Trade Organization Government Procurement Agreement (within the meaning 48 CFR (a) (1)) or any Free Trade Agreement to which the United States is a party that includes government procurement obligations that provide appropriate competitive government procurement opportunities to US goods, services and supplies. A country that is merely an observer to an IPA is not treated as a party to the IPA for purposes of the Proposed Regulations. Prop. Reg. Section C-1(c)(8). Contract. A contract has the same meaning as provided in Section of the Federal Acquisition Regulation (FAR), which generally is contained within Chapter 1 of Title 48 of the Code of Federal Regulations, and does not include a grant or cooperative agreement. Prop. Reg. Section C-1(c)(2). 2. The Exemptions The Proposed Regulations identify five exemptions from the Section 5000C tax (collectively, the Exemptions). Thus, the Section 5000C tax does not apply to payments made in the following situations: Simplified Acquisitions Exemption, applies when the payment is for a purchase under the FAR Simplified Acquisitions procedures that does not exceed the simplified acquisitions threshold (as defined in the FAR). In general, those procedures apply when the US Government makes purchases of supplies or services of $150,000 or less. Prop. Reg. Section C-1(d)(1). Emergency Acquisitions Exemption, applies when the payment is made under the FAR Emergency Acquisitions procedures under a contract either: (a) awarded under the unusual and compelling urgency authority of 48 CFR (generally when the need for supplies or services is of such an urgency that serious injury to the US Government could result if the special procedures did not apply), or (b) entered into under the emergency acquisition flexibilities as defined in 48 CFR Part 18 (which include supplies or services that may be used to facilitate the defense against certain attacks against the United States and in response to Presidentially declared disasters). Prop. Reg. Section C-1(d)(2). International Agreement Exemption, applies when the foreign person that has contracted with the US Government (the foreign contracting party) is entitled to relief from the Section 5000C tax under an international agreement with the United States. The Proposed Regulations provide that this includes relief under a nondiscrimination provision of a qualified income tax treaty i.e., a US income tax treaty in force that contains a nondiscrimination provision that applies to the Section 5000C tax and prohibits taxation that is more burdensome on a foreign national than a US national (or in the case of certain income tax treaties, taxation that is more burdensome on a foreign citizen than a US citizen), 2 International Tax Alert

3 regardless of its residence. On 21 April 2015, the IRS released a companion notice, Notice , which lists the qualified income tax treaties presently in force. Prop. Reg. Section C-1(d)(3). US-Activity Exemption, applies when the goods are manufactured or produced, or the services are provided, in the United States. Prop. Reg. Section C-1(d)(4). IPA Exemption, applies when the goods are manufactured or produced or the services are provided in a foreign country that is a party to an IPA. Prop. Reg. Section C-1(d)(5). 3. Rules for identifying the country where goods or services are produced or provided Solely for purposes of Section 5000C, the Proposed Regulations provide rules to identify the country in which goods or services in question were produced or provided, respectively. Goods are considered to be manufactured or produced: (a) where the property has been substantially transformed ; or (b) where there has been assembly or conversion of component parts into the final product (involving activities that are substantial in nature and that are generally considered to constitute the manufacture or production of property). Prop. Reg. Section C-1(e)(1). Services are considered to be provided in the country where the individuals performing the services are physically located. Prop. Reg. Section C-1(e)(2). Special rules apply where the goods are manufactured or produced or services are provided in multiple countries and one or more of the countries are not a signatory to an IPA. Prop. Reg. Section C-1(e)(3). 4. The anti-abuse rule The Proposed Regulations contain a broad anti-abuse rule to prevent circumvention of the Section 5000C tax. Specifically, if a foreign person engages in a transaction (or series of transactions) with a principal purpose of avoiding the Section 5000C tax, the transaction (or series of transactions) may be disregarded or the arrangement may be recharacterized (including disregarding an intermediate entity), in accordance with its substance. Prop. Reg. Section C-5. If the anti-abuse rule applies, the foreign person remains liable for any tax (including any tax obligation unsatisfied as a result of underwithholding), and the IRS retains all other rights and remedies under any applicable law available to collect any Section 5000C tax imposed on the foreign contracting party. 5. Withholding and reporting rules The Proposed Regulations generally require an acquiring US Government agency to deduct and withhold an amount equal to 2% of an SFPP. Prop. Reg. Section C-2(a). The Proposed Regulations enumerate certain steps to be followed by an acquiring agency in determining its obligation to withhold with respect to a SFPP. See Prop. Reg. Section C-2(b). For example, the acquiring agency must determine that a payment is under a contract for goods or services, that the contract is with a foreign person, and that no Exemption applies. Id. Importantly, if the US Government fails to withhold an amount equal to the tax under Section 5000C, the foreign person must file a US return and pay the tax due. Prop. Reg. Section C-4(b). The acquiring agency makes such determinations in part on the basis of information that the foreign contracting party provides on a Section 5000C Certificate, newly introduced by the Proposed Regulations, or new Form W-14, Certificate of Party Receiving Federal Procurement Payment, expected to be introduced by the IRS. See Prop. Reg. Section C-2(d). In general, a foreign contracting party must submit a Section 5000C Certificate to the acquiring agency as early as practicable, but in no event later than the date of execution of the contract. Prop. Reg. Section C-2(d)(8). The Proposed Regulations include a model Section 5000C Certificate. See Prop. Reg. Section C-2(d)(7). In addition, the Proposed Regulations modify the regulations under Section 6114 so that a foreign contracting party that submits a Section 5000C Certificate claiming the benefit of a nondiscrimination provision of a qualified income tax treaty is relieved of its usual obligation under Section 6114 to disclose that treaty-based return position on Form Prop. Reg. Section (c)(1)(ix). International Tax Alert 3

4 The Proposed Regulations provide that the Section 5000C tax is generally to be administered in a manner similar to the administration of taxes under Chapter 3 with respect to fixed, determinable, annual, or periodic (FDAP) income. Prop. Reg. Section C-3(a). As such, a foreign contracting party remains liable for the Section 5000C tax unless its liability is fully satisfied by an acquiring agency s withholding. Prop. Reg. Section C-4(b). If the liability was not fully satisfied by withholding, the foreign contracting party must file a tax return using the applicable form (e.g., a Form 1120-F, or such other form as the IRS prescribes in the future) and pay the tax due with that return. Prop. Reg. Section C-4(b)-(d). Refund claims for overwithheld amounts are made under the procedures described under chapter 65. Prop. Reg. Section C-4(e). 6. Effective dates, interest, and penalties The Proposed Regulations would become effective 90 days after they are published as final regulations in the Federal Register. Prop. Reg. Section C-7. In addition, the preamble to the Proposed Regulations provides that contracting parties and acquiring agencies generally may rely upon the proposed rules in the Proposed Regulations prior to that date. The preamble also contains several important statements regarding the effect of the Proposed Regulations. To the extent that a SFPP received on or before 22 April 2015, would have been eligible for an Exemption under the Proposed Regulations that would have eliminated the Section 5000C tax, the foreign contracting party is not required to take any other action, and the requirement to furnish a Section 5000C Certificate or disclose a treaty position under Section 6114 (if any) is waived. If a foreign contracting party has a Section 5000C tax liability with respect to a SFPP received before the date the Proposed Regulations are finalized, and that liability has not been satisfied by withholding, the foreign contracting party should file a tax return and pay the tax due. If the liability is fully satisfied before the date that the Proposed Regulations are finalized, penalties will not be asserted on those payments. Interest on underpayments, however, would apply. Implications Helpfully, the Proposed Regulations define a number of the terms contained in Section 5000C itself, provide a number of exemptions, and set forth withholding and reporting procedures (including introducing a model Section 5000C Certificate). Moreover, the Proposed Regulations provide more detail on the application of Section 5000C, which must be applied consistent with US obligations under international agreements. The International Agreement Exemption, although it appears in Section 301(c) of the Act, does not appear in the statutory language and there was some uncertainty as to the manner in which this provision would apply. The Simplified Acquisition and Emergency Acquisitions also do not appear in the statutory language. These exemptions should reduce burdens on both acquiring agencies and foreign contracting parties. The Proposed Regulations clarify that whether the Section 5000C tax applies is determined based on the contract with the contracting party. Thus, if an exemption applies because, for example, the contracting party is a US person or a foreign person eligible for treaty benefits, the Section 5000C tax does not apply. When determining whether a payment is subject to the tax, however, consideration should be given to the broad anti-abuse rule, as well as to the rules regarding agents and nominees. Foreign contracting parties may rely on the Proposed Regulations prior to the date they become effective/ applicable as final regulations. Foreign contracting parties with outstanding Section 5000C tax liabilities should file a tax return and pay the tax due prior to the date the regulations become final in order to avoid penalties and halt the accrual of interest on those liabilities. 4 International Tax Alert

5 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington, DC Peg O Connor margaret.oconnor@ey.com Arlene Fitzpatrick arlene.fitzpatrick@ey.com Allen Stenger allen.stenger@ey.com John Parcell john.parcell@ey.com Ernst & Young LLP, International Tax Services, Chicago Gunnar Haugen gunnar.haugen@ey.com International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Central Mark Muktar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City Central America - Ernst & Young, S.A. Rafael Sayagues, San José South America - Ernst & Young Serviços Tributários S.S. Gil F. Mendes, São Paulo International Tax Alert 5

6 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. International Tax Services About Ernst & Young s International Tax Services practices Our dedicated international tax professionals assist our clients with their cross-border tax structuring, planning, reporting and risk management. We work with you to build proactive and truly integrated global tax strategies that address the tax risks of today s businesses and achieve sustainable growth. It s how Ernst & Young makes a difference EYGM Limited. All Rights Reserved. EYG No. CM5390 This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com