The Tax Cuts and Jobs Act’s looming expirations and changes necessitate a comprehensive review of US tax policy. Amid these considerations, the reduction of the high rate of US withholding tax on payments of fixed or determinable annual or periodic income (FDAP) warrants attention. Despite the significance of this issue, it remains overshadowed by more prominent discussions in Congress.
US withholding tax has long been a mechanism to ensure compliance with tax liabilities, especially in the international realm. For example, withholding applies to effectively connected income distributed to foreign partners by partnerships, or to a buyer’s payments related to the sale of partnership interests under Section 1446(f) of the tax code. However, the rate of FDAP withholding tax, currently at 30% under Sections 871(a) and 881, significantly impacts non-US individuals and corporations, often acting as a final tax payment rather than a prepayment.
This system, conceptualized for equitable tax enforcement, discourages non-US investments and intellectual property transactions with US companies. Despite substantial modifications in US tax regulations over the past seven decades, FDAP withholding tax rates have remained static since 1954 ( source).
The rationale for maintaining these high rates includes arguments for protecting the federal income tax base and ensuring symmetry in tax treatment between US and non-US persons. However, these justifications often fall short. Directly comparing this withholding tax to the potential net income tax liabilities of US persons reveals disparities, as the gross basis tax of 30% rarely aligns with the net income taxes faced by US individuals or corporations.
Moreover, high US withholding taxes purportedly provide leverage in negotiating tax treaty concessions. However, this approach excludes countries that do not impose their own withholding taxes from benefiting from reduced US withholding rates in treaties.
The persistence of the 30% rate appears largely driven by inertia rather than substantial policy reasoning. Lowering the tax on nonresidents is not a politically advantageous stance, and as such, reform has been overlooked. As a consequence, many non-US persons resort to legally permissible workarounds to mitigate their FDAP tax liability. These methods range from selective investment strategies to using portfolio interest exemptions under Sections 871(h) or 881(c), and leveraging tax treaties for reductions.
These avoidance strategies often distort investment structures, causing inefficiencies. The US has criticized other nations for imposing taxes on digital services perceived as targeting US companies, yet the high withholding tax rate creates parallel disincentives for non-US investors.
Reevaluating the withholding tax rate, potentially reducing it to align with the US corporate tax rate, may not capture public enthusiasm but represents a necessary facet of tax reform conducive to a more rational and equitable international tax policy. The consideration of this issue, as discussed by John Harrington of Dentons, emphasizes the need for a forward-thinking approach to tax legislation (Bloomberg Tax article).