As global economies become increasingly interconnected via the internet, U.S. companies continue to enter into more international arrangements. As a result, U.S. companies are plunged into a complex maze of overlapping legal jurisdictions and heightened compliance requirements, increasing the risk of cross-border disputes. When a cross-border dispute is resolved by court order or by settlement between the parties and results in a payment from the U.S. company to the foreign party, an often-overlooked issue is the tax consequences for the U.S. company of such payment. Without planning, the U.S. company may find itself on the hook for U.S. taxes that otherwise would have been borne by the foreign party.
In this article, we will provide an overview of some of the U.S. tax consequences of cross-border dispute payments and discuss strategies to reduce or eliminate tax exposure.
U.S. Withholding Tax Overview
Internal Revenue Code Sections 1441 and 1442, and the regulations thereunder, impose a 30 percent withholding tax on certain payments to foreign non-resident aliens and entities. Specifically, the withholding tax generally applies to (1) payments of “fixed or determinable annual or periodical” income (2) paid to foreign non-resident aliens or entities (3) that is sourced to the United States.[1] Each of these factors is discussed briefly below:
- Fixed or determinable annual or periodical (“FDAP”) income includes a broad range of items of income, such as interest, dividends, wages, annuities, and royalties, among other types of profits, gains, and income.
- The recipient’s status as a foreign non-resident alien or entity is determined by obtaining the appropriate documentation—generally, a withholding certificate such as a W-8BEN-E, W-8ECI, W-8EXP, and so on—from the payee. If no documentation is obtained by the payor, Treasury Regulations require, in certain circumstances, that the payor presume that the recipient’s status is foreign and thus subject to withholding tax on any U.S. source income.
- The determination of the payment’s source as U.S. or foreign income largely hinges on the character of the income. For example, service income is generally sourced where the services are performed, whereas royalty income is generally sourced where the underlying intangible rights or intellectual property are exploited.
Importantly, if the payor fails to withhold tax on a payment to a foreign entity subject to the 30 percent withholding tax, the payor is liable for such withholding tax, unless another entity is considered the withholding agent responsible for withholding the tax.
When acting in the ordinary course of business, obtaining appropriate withholding certificate documentation and the withholding of the tax is often built into the U.S. company’s payment process.
However, in the context of a cross-border payment for settlement or court damages (a “cross-border dispute payment”), which is distinctly outside of the ordinary course of business, the parties may fail to consider potential U.S. withholding tax consequences. In order to assess the withholding tax liability of a cross-border payment for settlement or damages, the payor would need to assess the three factors listed above: is the payment FDAP, is the payment made to a foreign recipient, and is the payment U.S. source.
The Origin of the Claim Doctrine
The analysis of a cross-border dispute payment is further complicated because such payments are not intuitively thought of as FDAP payments, because there is often not a contract or agreement between the parties made in the ordinary course of business that can be used to determine the character and source of the payment. In these circumstances, courts and the IRS have developed the “origin of the claim” doctrine to determine the taxability of cross-border dispute payments.[2]
Under the origin of the claim doctrine, the taxpayer determines the tax consequences by asking, “In lieu of what were the damages awards?”[3] In other words, the origin of the claim treats cross-border dispute payments as if they are payment for the loss or damages alleged by the injured party. For example, a settlement payment for alleged patent infringement of a foreign patent may be ultimately characterized as a foreign-source royalty payment relating to the use and exploitation of the patent.[4]
Specifically, the tax consequences, including characterization of any payments as FDAP or non-FDAP, are determined by looking to the underlying claims made that resulted in the cross-border dispute payment, considering all facts and circumstances. Often, the best evidence for determining what the payment was made in lieu of is found in the underlying complaint. Other evidence for the origin of the claim can include the settlement agreement (if any) and the negotiations between the parties.
Example Scenario
Consider the following simple scenario:
A citizen and resident of Country Z owns a U.S. patent (“Foreign Owner”). Foreign Owner sued a U.S. company, Unique Manufacturing, Inc. (“UMI”), alleging infringement of the patent by UMI within the United States. UMI and Foreign Owner agreed to settle the case for $30,000,000.
In order to determine the U.S. tax consequences of the parties’ settlement, UMI will need to consider, “in lieu of what” was this settlement paid for? In this scenario, the settlement constitutes an amount paid for the right to use the patent. In other words, the settlement is a royalty payment from UMI to the Foreign Owner.
The settlement payment from UMI would likely be subject to U.S. withholding tax because (1) a royalty payment is considered an “FDAP” payment; (2) the Foreign Owner is a nonresident alien; and (3) the royalty payment is a U.S. source because the patent was used and exploited within the United States. Thus, the resulting withholding tax due would be $9,000,000. If UMI fails to withhold the $9,000,000 from the payment to Foreign Owner, UMI will itself be liable for the tax.
While this is a simple example of tax exposure resulting from a cross-border settlement, significantly more complex scenarios can arise depending on the facts. For example, if the lawsuit is a class action lawsuit rather than a single individual or entity, it may be more difficult to determine the foreign status of the parties. Additionally, as countries continue to enact more expansive laws around data breaches, online privacy, and similar regulations, questions will inevitably arise regarding whether the cross-border dispute payment made for breaches of those laws would be considered an FDAP payment subject to U.S. withholding taxation.
3 Proactive Tax Considerations
So, what should U.S. companies do in a cross-border dispute scenario to ensure they are not on the hook for U.S. withholding tax?
1.he parties should determine if the payment is subject to a lower rate of tax or fully exempt under the relevant double tax treaty (if any) between the United States and the relevant jurisdiction. Tax treaties often provide reduced tax rates or exemptions for certain types of income, such as dividends, interest, royalties, and business profits. However, determining whether parties can benefit from a tax treaty requires significant analysis under the relevant treaty.
- If a tax treaty reduction or exemption is available, the U.S. entity should ensure that it has, or will obtain, the required documentation to prove (1) the recipient’s foreign status, and (2) the recipient’s treaty benefits claim.
- The parties should directly address the withholding tax consequences, including who bears the burden of paying the tax and what documentation must be provided, and include these items directly in the settlement agreement.
Conclusion
Without proactive planning, cross-border dispute payments can pose a significant risk of tax exposure to U.S. companies. While this exposure may be reduced under a double tax treaty, significant analysis and documentation is required to ensure the requirements are met to be entitled to such benefits. Additionally, any tax exposure not reduced or exempted by a tax treaty can become the liability of the payor if not properly withheld at the time payment is made. When companies are paying damages or settling disputes in a cross-border dispute, they should discuss the potential tax consequences of the payments with an experienced tax attorney. For more information on how to proactively plan for tax consequences of cross-border disputes, please contact Nicholas A. Marler (206-344-7498; [email protected]), Jennifer C. Leve (416-777-4043; [email protected]), or another Dickinson Wright tax attorney.
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About the Author:
Nicholas Marler is an associate in Dickinson Wright’s Seattle office, where he focuses his practice on real estate finance and transactional tax matters. Drawing on prior experience advising multinational businesses on federal and international tax issues, Nicholas counsels lenders, investors, developers, and businesses on complex financing and transactional matters, providing practical, business-minded guidance.
[1] Other factors may also affect a foreign entity’s withholding tax liability under section 1441, such as if the foreign entity is engaged in a United States trade or business that is subject to tax on its effectively connected income. A discussion of effectively connected income and similar regimes is beyond the scope of this article.
[2] For examples of court decisions, see, e.g., United States v. Gilmore, 372 U.S. 39 (1963); United States v. Patrick, 372 U.S. 53 (1963). For examples of IRS decisions, see, e.g., Rev. Rul. 85-98, 1985-29 I.R.B. 5 (July 22, 1985); Field Service Advisory, 1996 WL 33107731 (Oct. 8, 1996).
[3] Raytheon Production Corp. v. Comm’r, 144 F.2d 110, 113 (1st Cir. July 28, 1944).
[4] See Rev. Rul. 64-206, 1964-2 C.B. 591 (Jan. 1, 1964).