The Internal Revenue Service's long-awaited changes to regulations governing how U.S. banks and brokerages calculate withholding of taxes on foreign investorswill benefit Uncle Sam but create a slew of operational problems for market players, tax specialists said.
How to deal with the new rules, some of which became effective last week, was the topic of a KPMG Peat Marwick conference in New York this month. More than 300 tax specialists from some of the world's largest banks and brokerages attended.
"While the industry's operating systems have been designed for one set of tax provisions, they must now be redesigned to accommodate the different rules," said Iris Goldman, director of information reporting in the New York office of French bank Paribas.
"It will obviously place a burden on banks because of year-2000 compliance," said Paul Heller, a tax attorney for Chase Global Investor Services, the global custody arm of Chase Manhattan Corp.
The new IRS regulations, most of which are effective for payments made after January 1999, come as foreign investors are pouring funds into U.S. markets. The agency is also responding to years of requests from U.S. banks and brokers to consolidate, clarify, and reduce documentation rules.
Generally, foreign investors are taxed on interest and dividends at a rate of 30% at the time of distribution, although the amount can be halved or eliminated in some circumstances.
The IRS collects an average of $2 billion a year in withholding taxes from foreign investors. But that falls short of what the agency says it might reap. Under current regulations, there is no way of knowing whether a foreign firm is providing correct information about buyers of U.S. securities.
Although U.S. global custodians and brokerages must obtain paperwork from foreign financial firms whose clients invest in U.S. securities, compliance for owners of bonds and of stocks differs.
For stocks, U.S. global custodians are allowed to rely on the address of the foreign financial intermediary to determine if the ultimate owners of the stocks are entitled to tax treaty benefits. The only exception to the rule is when there is "actual" knowledge that the beneficial owners do not live in the same country as the foreign financial intermediary.
For bonds the U.S. global custodian and brokerages must depend upon a variety of different documentation from the foreign intermediary bank indicating the tax status of the underlying investor. Some global custodians and brokerages, however, rely on a single form from the foreign financial institution that rarely provides a complete picture of the underlying investors-dangerous for those the IRS catches.
Several global custodians, who asked not to be identified, said they were fined by the IRS for the entire amount of the tax plus interest-all of which came to several million dollars.
"The dramatic change with the new regulations is that you now have a consistent set of rules for how to treat investors in debt and equity instruments," said Mr. Heller. "With the uncertainty in debt instruments before, many foreign investors could shop for banks with favorable interpretations to them. "In addition, the new regulations put much of the burden of compliance on the foreign institution, not the U.S. withholding agent."
The new regulations would eliminate the address rule requirements, so investors could not use the location of a foreign custodian or other entity that has a favorable home tax status. That means that as with bonds, the foreign intermediaries would have to disclose the names of their underlying investors in addition to paperwork proving their tax status.
But because many foreign firms hesitate to reveal their customers' names to global custodians and U.S. brokers, for competitive reasons, the IRS has granted a way out. Foreign financial institutions may use omnibus customer accounts by registering with the tax agency as a qualified intermediary (QI).
Suppose, for example, that the foreign firm wanted the U.S. withholding agent-bank or brokerage-to remain responsible for withholding taxes. The foreign firm would have to segregate client positions into separate categories, with each subaccount containing a group of investors with common tax characteristics.
If the foreign qualified intermediary assumed responsibility for withholding U.S. taxes, it would only have to file a statement with the custodian bank or U.S. broker that none of its clients are U.S. citizens and that all of the clients with assets in each subaccount are eligible for the same tax treatment.
Securities Industry NewsAmerican Banker.