Tax Treatment of Deposits for Foreign Members
By Styskal, Wiese & Melchione
On April 19, 2012, the IRS finalized new regulations changing the tax reporting treatment for interest payments to nonresident alien depositors. The Final Rule can be found through the Federal Register. This change in the law clarifies documentation and reporting processes for credit unions, but also adds an additional reporting requirement for those credit unions with nonresident alien members.
As a basic principle, bank deposit interest and credit union dividend (here “deposit interest”) income to nonresident aliens is not subject to U.S. tax (I.R.C. 871(i)(2)(A)), U.S. tax withholding, or (until 2013 payments) subject to information reporting if the payment is not “effectively connected” with the conduct of trade or business in the U.S. While the definition of “effectively connected” income is complex, credit unions can take comfort that, unless they have reason to know a foreign member is engaged in business in the U.S., the credit union can rely on certifications by their members to determine whether this tax exemption applies. However, regardless of the status of foreign members, the reporting requirements for deposit interest payments to nonresident aliens will change for payments made after January 1, 2013. The new regulation will require that 1042-S forms (the nonresident alien equivalent to a 1099-INT) be filed by credit unions each year for payments over $10 made to nonresident aliens. While this adds an additional reporting requirement, in many ways it differs little from the 1099 reporting credit unions must already perform for U.S. members.
As mentioned above, this change in reporting requirements also clarifies a nuance of tax reporting for foreign members of which many credit unions may not be aware. Credit unions are generally well aware that they must obtain a W-9 certification from U.S. members at account opening, and that those certifications include a statement that the member is not subject to backup withholding. For the select credit unions that have foreign members, however, additional processes and procedures may be required to prevent sizable penalties from the IRS.
Nonresident aliens cannot (truthfully) complete a W-9. They must instead complete a form of W-8, usually a W-8BEN, provided the member is not doing business in the U.S. The operational difficulty for credit unions arises with the expiration of a W-8—the form expires after three years, with a limited exception if the member supplies a TIN, the credit union pays dividends every year, and reports on a 1042-S every year. After a W-8’s expiration, for the IRS’s purposes, a credit union no longer has a reliable way to verify that the member is a nonresident alien, and so no way to verify that the tax and withholding exemption for nonresident aliens is in effect. In the absence of valid documentation (read, valid W-8 or W-9 documentation), the default presumption for natural person members is that the member is a U.S. person and is subject to tax withholding, as clarified by I.R.S. Regulation 1.6049-8(a).
In light of these presumptions, with the expiration of a W-8, credit unions would need to take several steps: (1) request a new certification (whether W-8 or W-9) pursuant to Publication 1281, (2) begin backup withholding on deposit interest payments over $10 or which when annualized exceed $10, and (3) at the end of the tax year, file forms 1096, 1099, and 945. The best practice is to prevent a circumstance where your credit union has an expired W-8 without a replacement on hand. To do so, credit unions should carefully track their foreign members and request new W-8s prior to expiration. Alternatively, credit unions may wish to file 1042-S forms for any paid deposit interest, regardless of the usual $10 limitation, in order to take advantage of the expiration exception and minimize the W-8s that expire.
Regardless, it is a dangerous practice to merely mark foreign members as “do not report” in a core system without tracking W-8s to ensure that you have valid, unexpired forms on file. Starting for tax year 2013, due to the Final Rule, “do not report” will no longer be a prudent option for any natural person member accounts, foreign or domestic. While nonresident aliens in certain countries remain exempt from reporting, it will ease a credit union’s compliance burdens to report on all foreign members.
Failure to backup withhold when obligated to can result in an institution being primarily liable for the amount that should have been withheld, plus up to 15%. Failure to file 1099s and other information returns properly can result in penalties up to $100 per form, or more for intentional disregard of the reporting requirement. Over several years, failures to comply with these reporting and withholding requirements can cause significant problems for a credit union’s earnings and balance sheet.
If your credit union has questions about tax reporting for foreign members, or information returns in general, contact Tim Oppelt for assistance.