Withholding tax on foreign mortgages.

Under Sec. 861, interest paid by a U.S. resident is generally deemed U.S.-source income and thus subject to withholding tax under Secs. 1441-1442. The Tax Court in Housden, TC Memo 1992-91, has recently rendered a decision that could have important ramifications for intercompany transferees assigned to the United States who retain ownership of a permanent residence abroad that is financed by a foreign lender. Although the interest on the mortgage in many instances will continue to be deductible against the personal income of the individual, if the mortgage bank is a resident in a jurisdiction with either no income tax treaty with the United States or the withholding tax on interest is not eliminated by the treaty, the U.S. resident individual could be obliged to withhold tax on such interest payments.

In Housden, the taxpayer was a practicing architect licensed in England and Canada. In 1980, he entered the United States to organize various U.S. architectural entities. Between 1980 and 1983, the taxpayer made interest payments to the Royal Bank of Canada for the repayment of a personal loan. The taxpayer did not withhold any sums under Sec. 1442 from the payments to the Royal Bank of Canada nor did he file any forms to qualify for exemption from withholding.

On examination, the IRS issued a deficiency notice and determined that the taxpayer was liable for withholding taxes on the interest payments.

The Tax Court concurred with the Service's view and held that the individual had control over the interest payments made to the Royal Bank of Canada and thus was required to deduct and withhold U.S. income tax.

This problem can be particularly severe for executives from nontreaty countries or countries where the treaty does not eliminate withholding tax on interest (e.g., Australia, Belgium, Canada, Italy and Japan). For such individuals presently in the United States, little can be done to reduce the U.S. tax exposure for interest payments made by such individuals to their foreign lenders.

However, for employees who will be transferred in the future, there may be several alternatives that can alleviate this problem.

The first planning suggestion concerns the U.S.-source rules. Generally, under Sec. 861(a)(1)(A) and (c)(1), not all interest paid by a U.S. resident individual is necessarily from U.S. sources. When an individual resident pays interest, those payments can be excluded from U.S. sources if at least 80% of the gross income of the individual for the requisite testing period is active foreign business income. This requisite testing period is a three-year period ending with the close of the individual's tax year that precedes the year of paying the interest.

Another possible exception to this decision would occur when, at the time of payment, the individual has not yet become a resident of the United States (under Sec. 7701 (b)) or has been a resident for less than one tax year and the 80% requirement has not been satisfied. In this situation, no U.S. withholding obligation would exist, since the interest would not be considered U.S. source,

In lieu of paying the mortgage interest during the impatriate's U.S. stay, it may be less costly from a tax equalization standpoint to prepay the interest for the individual. Alternatively, an arrangement may be set up, under which an escrow agent would serve as the agent of the borrower to satisfy payments in a purely offshore context. In any event, taxpayers faced with this problem must not only consider the U.S. tax consequences on their mortgage payments, but also the tax consequences of the foreign jurisdiction and the terms of the mortgage indebtedness.

If tax has to be withheld, the taxpayer should file Forms 1042 and 1042S with copies to the lender. In most cases the lender should be able to claim a foreign tax credit in its home jurisdiction. Even if the interest is exempt from U.S. withholding tax under the applicable treaty, the impatriate should file Forms 1042 and 1042S showing no tax payable.