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When the §1441 regulations were extensively overhauled in 2001, many thought them (especially the provisions dealing with the new Qualified Intermediary system) to be too long and complex. But, as is typically the case, after living with them for a few years (and, admittedly, after a number of IRS road shows to explain them), things have settled down and the overall reaction is that, for the most part, they are workable and fair. Admittedly, there's still more work to be done and the IRS will soon be publishing another round of regulations in this area.

One reason for the massive re-write of the §1441 regulations was that the prior system was, in some cases, broken and withholding agents were not uniformly applying the rules to the detriment of both the beneficial owners and, from a competitive point of view, the withholding agents themselves. The relatively new §1441 regulations have leveled the playing field in providing a distinctly concrete and uniform set of rules that can be relied upon by everyone.

This is also the intent of the proposed regulations¹ that address information reporting and withholding obligations with respect to distributions in redemption of stock of a corporation that is actively traded on an established financial market (within the meaning of Regs. §1.1092(d)-1). The proposed regulations establish an elaborate escrow procedure that may be used by certain withholding agents in the course of determining whether a distribution in redemption of stock is a dividend subject to withholding under §1441 or one that is free of withholding as a distribution in part or full payment in exchange for stock. So, once again, we have a somewhat complex procedure but one that is designed to level the playing field for foreign beneficial owners.

First, the basic background. As we know, certain U.S.-source fixed and determinable annual or periodical income (FDAP), such as dividends, is subject to withholding tax under §1441. However, under Regs. §1.1441-2(b)(2)(i), FDAP does not include gains derived from the sale of property. Nevertheless, under Regs. §1.1441-3(c)(1), any corporation or intermediary making a corporate distribution must withhold tax on the entire amount of the distribution unless an exception applies. One such exception applies under Regs. §1.1441-3(c)(2)(i)(B), pursuant to which a distributing corporation or intermediary may elect to reduce withholding on a distribution to the extent it represents a distribution in part or full payment in exchange for stock. Whether or not a non-liquidating corporate distribution is considered a dividend or a distribution in part or full payment in exchange for stock is governed by §302.

Section 302(a) generally provides that a corporate redemption will be treated as a distribution in part or full payment in exchange for stock if certain exceptions are met. The two most familiar are: (1) a complete termination of a shareholder's interest in the corporation under §302(b)(3); and (2) a substantially disproportionate redemption of stock in the corporation under §302(b)(2). Of course, the constructive stock ownership rules under §318 must be factored in as well in both cases. In the context of a corporate distribution by a publicly-traded corporation, however, it will be difficult, if not impossible, for a withholding agent or an intermediary, or the shareholder, to determine whether either of these exceptions applies to a particular shareholder, especially because of the application of the constructive ownership rules of §318. This is certainly the case at the time of the distribution when not all of the facts are known in order to make the relevant determinations.

As a result, the IRS notes, the election not to withhold has not been uniformly applied, with some withholding agents applying the election not to withhold but with many withholding agents not applying the election for fear of getting it wrong and underwithholding. It is this uneven application of the rules, and the perceived discretion granted by the regulations, that prompted the IRS to issue these proposed regulations.

As previously stated, the proposed regulations apply in the case of a distribution in redemption of stock of a corporation that is publicly traded within the meaning of Regs. §1.1092(d)-1, i.e., a corporation which is actively traded on an established financial market. The Preamble states that the proposed regulations contemplate a transaction in which a publicly-traded corporation offers to purchase stock from its shareholders (a self-tender) where the amount of the stock purchased and the shareholders involved in the transaction (the participating shareholders) depend on various factors, such as a shareholder's willingness to sell some or all of his/her stock and the terms of the offer. The Preamble further indicates that the proposed regulations would also apply to a transaction described in §304(a)(2), i.e., an acquisition by a subsidiary of stock held by a shareholder in the parent corporation.

The regulations establish an escrow procedure that can be followed by withholding agents with respect to payments made after December 31, 2008, of corporate distributions in redemption of stock made to foreign persons. In particular, the proposed regulations provide that a U.S. financial institution (withholding agent) can elect a procedure by which it must set aside in escrow 30% (or a lower treaty rate) of the amount of the corporate distribution (the so-called “§302 Payment,” i.e., a distribution by a corporation in redemption of its stock for which there is an established financial market).

At the same time, the withholding agent must provide certain information to the beneficial owner regarding the distribution, e.g., the total number of shares outstanding of the distributing corporation, both before and after the distribution, and a written explanation of the conditions under which a distribution would be treated as a dividend or as a payment in exchange for stock, including an explanation of how the §318 constructive stock ownership rules work. Finally, the withholding agent must request that the foreign beneficial owner provide it with a written certification within 60 days as to whether the shareholder believes the distribution to be treated as a dividend or as a §302 payment in exchange for stock.

The proposed regulations outline what the contents of the shareholder certification should look like, i.e., it must set forth the beneficial owner's correct name, account number, and a certification as to whether the distribution to the shareholder is a dividend or a §302 payment in exchange for stock, including a certification as to the number of shares held by the foreign beneficial owner, actually and constructively, both before and after the distribution.

Consistent with the overall tenor of the §1441 regulations, the withholding agent is entitled to rely on the certification unless it knows or has reason to know that it is unreliable. If the withholding agent knows or has reason to know that it is unreliable, or if no certification is forthcoming within the 60-day period, then the withholding agent must treat the escrow amount as a tax withheld on the 61st day and make the appropriate deposit to the IRS.

The same procedure must be followed on a payment of the corporate distribution to a qualified intermediary (QI) or to a withholding foreign partnership/trust (WFP/WFT). Thus, although the former may elect to assume primary withholding responsibility, and the latter must do so, the escrow procedure does not provide an exemption for payments made to such intermediaries and, accordingly, in the case of a §302 payment, neither is entitled to receive such a payment from the withholding agent on a gross basis, and each must apply the procedures described in the proposed regulations and supply a certification to the withholding agent that details the appropriate rates of withholding tax for all amounts paid to either of them.

So, going back to Regs. §1.1441-3(c)(1) governing corporate distributions, the general rule would be that a corporation making a distribution or an intermediary making payment of such distribution must withhold on the entire corporate distribution unless it elects to reduce withholding under one of the various exceptions provided in Regs. §1.1441-3(c)(2)(i), e.g., to the extent it represents a distribution in part or full payment in exchange for stock. However, the proposed regulations dealing with such corporate distributions, Regs. §1.1441-3(c)(2)(i)(B), would add a sentence at the end thereof to the effect that the withholding exception for such corporate distributions will not apply to a public §302 distribution to which Regs. §1.1441-3(c)(5) applies, i.e., the escrow procedures described above.

Presumably, the theory of the proposed regulations is that in a public corporate distribution the necessary facts to make the relevant determination are not available to either the withholding agent or the corporation whereas in a closely held environment the facts are more well-known.

This is all well and good and a pro-taxpayer regulation, as cumbersome as it may be, especially if it helps prevent unnecessary overwithholding and if it cuts down on the uneven application of the withholding exception by corporate withholding agents. True, it means that foreign beneficial owners will be put to the test of having to determine answers to complex tax rules and regulations but that is certainly no different or worse than a beneficial owner who, in the context of furnishing a W-8BEN, must already certify that he/she is not a treaty shopper within the meaning of a limitation on benefits provision of a treaty and that he/she “derives” the item of income within the meaning of §894.

What is strange, however, is that, while a corporation making a public §302 distribution, or any intermediary making payment of such a distribution, must withhold on the entire amount unless the escrow procedures have been applied, the escrow procedures are only available to an intermediary that is a U.S. financial institution, i.e., not the corporation itself or a different type of intermediary. This disconnect seems strange unless one is prepared to accept the fact that all public corporate issuers typically make payments through a U.S. financial institution.

Moreover, it seems odd that the hallowed and trusted QI or WFP/WFT should not be able to assume primary withholding responsibility (in the case of a QI) or to carry out those inherent functions (in the case of a WFP/WFT) and receive the distribution from the corporate issuer or U.S. financial institution on a gross basis and then carry out its functions in accordance with the prescribed escrow procedure. Undoubtedly, the QI Agreement would need to be amended to incorporate these provisions but this should not be an insurmountable issue.

Finally, in establishing the contents of the required certification from the foreign beneficial owner, the proposed regulations provide three choices for the foreign beneficial owner to certify: (1) that the payment is a dividend; (2) that the payment is in exchange for stock because the owner's proportionate interest in the corporation has been reduced (although not terminated); or (3) that the payment is in exchange for stock because the beneficial owner's interest in the corporation has been terminated. There is no choice given for a payment which is not essentially equivalent to a dividend within the meaning of §302(b)(1) or for a payment in redemption of stock of a non-corporate shareholder with the distribution being made in partial liquidation of the distributing corporation. Nonetheless, because such payments are still considered public §302 distributions, neither the basic electing-out procedure nor the escrow procedure appears applicable. The regulations themselves are not clear on this point, however, and the gaps should be filled in.

Overall, the concept put forth in the proposed regulations is a good one, albeit a complex one. The IRS invites comments on alternatives.

This commentary also will appear in the February 8, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Tello, 915 T.M., U.S. Withholding and Reporting Requirements for Payments of U.S. Source Income to Foreign Persons, and in Tax Practice Series, see ¶7150, Withholding and Compliance.