IRS releases transition rules for new withholding requirements.

On Jan. 8, 2001, the IRS published Notice 2001-4, which contains transition rules applicable to the new withholding regime under Sec. 1441 et. seq., that took effect on Jan. 1, 2001. The transition rules substantially ease the timing requirements for required documentation under the new rules, and should permit many withholding agents and foreign intermediaries to comply more timely and accurately.

Generally, the new withholding regime draws a distinction between beneficial owners of income and intermediaries, with different rules applicable to payments by U.S. withholding agents to each. An intermediary can also enter into an agreement with the Service to be a "qualified intermediary," which allows the use of simplified withholding rules.

The transition rules include the following significant provisions:

* Foreign intermediaries that have applied for qualified intermediary (QI) status, but whose applications have not yet been finalized by the IRS, may function as QIs for six months following the date their application is submitted (or June 30, 2001, whichever is later). The Service will issue "QI-EINs" to all applicants in order for them to properly complete Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding. Withholding agents will be able to rely on an assertion of QI status (without the need to inquire whether QI status is presumed under the transition exception or is final) unless they know (or have reason to know) that the assertion is false.

* Documentation transition rules will allow QIs to use the withholding rate pooling method of reporting to U.S. withholding agents prior to obtaining the required documentation from the ultimate beneficial owners for the first year of the new QI agreement. This will be implemented via the required external QI audit. Under the transition rule, the Service will not audit the QI's first-year practices if the QI is in "substantial compliance" with the requirements during its second year and "all but an insignificant number of its accounts" have proper documentation. (QIs not in substantial compliance by year two will be subject to retroactive penalties for underwithholding.)

* QIs will be allowed to treat the beneficiaries of a foreign simple trust or the grantors of a foreign grantor trust as direct account holders (and thus include them in the "pooling" system) if:

1. The QI is required under its country's "know-your-customer" rules to determine the identities of the beneficiaries or owners of such trusts;

2. The QI obtains the know-your-customer documentation specified in its QI agreement for such beneficiaries/owners (other than a Form W-8, Instructions for the Requesters of Forms W-8BEN, W-8ECI, W8EXP, and W-8IMY); and

3. The QI obtains a valid Form W-8 from the beneficiaries/owners. The documentation transition rules described above will apply to this documentation.

* A company in the business of providing fiduciary services as a trustee and subject to approved know-your-customer rules may obtain QI status. (The trust company can also use the trust rule for simple and grantor trusts.)

* A QI that combines directly owned (proprietary) interests with interests held as an intermediary in a single clearing organization account may combine the interests for pooling reporting purposes, notwithstanding Section 1.01 of the QI agreement.

* QIs will not be required to seek IRS approval before assuming primary Form 1099 and backup withholding responsibility.

* For calendar year 2001 only, a foreign partnership may use the pooling method for reporting withholding obligations on a Form W-8IMY in lieu of the normal requirement applicable to nonqualified intermediaries. The partnership must associate the documentation from each of its partners to the Form W-8IMY; however, documentation for foreign corporate partners or exempt U.S. recipients can be provided to the withholding agent at any time during 2001 (not necessarily at the time of the payment). A Form W-9, Request for Taxpayer Identification Number and Certification, must be provided for non-exempt U.S. recipients at the time of payment.

* A documentation transition rule is also provided for U.S. withholding agents. The Service will permit withholding agents to continue to rely on "old" forms (e.g., Forms 1001, Ownership, Exemption, or Reduced Rate Certificate; 1078, Certificate of Alien Claiming Residence in the United States; 4224, Exemption From Withholding of Tax On Income Effectively Connected With the Conduct of Trade or Business in the United States; 8709, Exemption From Withholding On Investment Income of Foreign Governments and International Organizations; or the prior Form W-8) obtained under the prior regulatory regime after 2000 (when such forms expired), provided the U.S. withholding agent has made "good faith efforts" to obtain the required "new" Form W-8 or W-9.

* Forms W-8 that list a post office box as a permanent residence address can be relied on (contrary to the regulations), if the withholding agent does not know (or does not have reason to know) that the person providing the form is a U.S. person and that a street address is available.

* For audit purposes, calendar year 2001 will be treated as a "transition year" for U.S. withholding agents (see, e.g., Notices 98-16 and 99-25).

* Income from sources within a U.S. possession exempt from tax under Sec. 931, 932, 933 or 935 will not be subject to reporting on a Form 1099, if the payor reasonably believes that the income is to be paid to a resident of a U.S. possession. The regulations will be amended to reflect this change.

* The regulations will also be amended such that U.S. payors may rely on documentary evidence (in lieu of a Form W-8) for payments made to offshore accounts in U.S. possessions.

* Until further notice, a U.S. payor will not be required to report income paid for services on Form 1099 (and, therefore, the income will not be subject to potential backup withholding) if:

1. The payee is an individual;

2. The payor does not know that the payee is a U.S. citizen or resident;

3. The payor does not know (and has no reason to know) that the income is (or may be) effectively connected income; and

4. All of the services for which payment is made are performed by the payee outside the U.S.

* Withholding agents may rely on the October 1998 versions of Forms W-8BEN, Certificate of Foreign Status of Beneficial Ownership for United States Tax Withholding, W-8IMY, W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding, and W-8ECI, Certificate of Foreign Person's Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States, received before 2002.

* The term "know your customer" as used in the regulations, refers only to "the capacity of financial institutions to determine whether their customers are U.S. persons, and, if their customers are non-U.S. persons claiming the benefits of an income tax treaty, whether these customers are residents of the applicable treaty country." The term does not include or have the same scope as other know-your-customer concepts relating, for example, to money laundering.

FROM DAVID RYAN, J.D., LL.M., WASHINGTON, DC