The IRS announced in Notice 2015-10 that the agency plans to issue regulations that will deny refunds to individuals subject to the foreign withholding rules under IRC §§1441-1443 (chapter 3) or §§1471 and 1472 (chapter 4) if the withholding agent fails to deposit the taxes that are withheld. The IRS justifies this change by noting that the IRS is aware some withholding agents have failed to pay the taxes due and that because the party from whom the tax was withheld and, in some cases, the withholding agent, are outside the United States, the IRS may not be able to recover the taxes if it pays the refund.
The rule generally affects taxes reported to claimants on Form 1042-S as taxes withheld. Various IRC provisions require withholding, and the revisions enacted in the Foreign Account Tax Compliance Act added to those situations.
The Notice indicates that the IRS plans to revise the regulations under Reg. §§1.1464-1(a) and 1.1474-5(a)(1) to restrict the allowance of a refund or credit for taxes withheld only to the extent the taxes in question are actually deposited with the IRS by the withholding agent. If a withholding deposits a portion but not all of the tax due, the claimant will be allowed a proportional amount of the tax shown as withheld on the Form 1042-S based on the ratio of total withholding reported on all Forms 1042-S to the amount of taxes actually deposited by the withholding agent.
The IRS provides the following example of the partial allowance:
As an example, consider a case in which a withholding agent pays a $100 dividend to each of ten nonresident aliens and withholds tax at 30 percent from each dividend under chapter 3. The withholding agent is required to deposit $300 of tax, but instead deposits only $225 of tax that it withheld. The withholding agent reports on a Form 1042-S issued to each nonresident alien and filed with the IRS that it paid to that nonresident alien a $100 dividend and withheld$30 of tax. In this case, the withholding agent’s deposit percentage is 75 percent ($225, the amount of deposits reflected in the withholding agent’s Form 1042 account, divided by $300, the amount reported as withheld on all Forms 1042-S filed by the withholding agent). If one nonresident alien properly claims that, under an income tax treaty with the United States, he is entitled to a 15 percent withholding tax rate and claims a $15 refund, he is allocated $22.50 of the deposit (the $30 reported as withheld on the claimant’s Form 1042-S, multiplied by the withholding agent’s deposit percentage of 75 percent). Since the nonresident alien withholding tax rate is 15 percent, he has a $15 tax liability. Therefore, there is an overpayment of $7.50, and the nonresident alien will be entitled to a refund or credit for that amount.
The IRS goes on to explain that the agency does not believe it would be administratively feasible to allow claimants to “trace” payments made by the withholding agent to the tax withheld from their payment, though the agency does ask for comments on the feasibility of developing and implementing such a program.
The IRS is also considering some exceptions to these proposed rules, including a potential de minimis rule (underpayments below a certain threshold would not cause a reduction in credit) and/or exempting withholding from a withholding agent that has a demonstrated history of compliance. Presumably such an exception would allow claims related to Forms 1042-S from such agents would be processed without confirming actual withholding, while those from “uncertain” withholding agents (including new ones) would be held for actual confirmation of withholding amounts.