Individual Suggests Revisions to Proposed Rules on Interest Paid to Nonresident Aliens

I would like to begin by commending the IRS for their decision to strengthen the 2002 regulations that only require the reporting of bank deposit interest if the recipient is a U.S. person or a nonresident alien individual who is a resident of Canada. "Tax avoidance and evasion threaten government revenues around the world. The U.S. Senate estimates revenue losses amount to 100 billion dollars a year and in many European countries the sum runs into billions of Euros."¹ Due to the increasing mobility of capital, tax evasion and avoidance is an international problem that requires an international solution. I believe the IRS as acknowledged as much by expanding the scope of the regulation outside of the United States and Canada to include nonresident alien individuals who are residents of any foreign country, and applaud the proposed rule accordingly.

As this proposed rule correctly asserts, "[s]ignificant agreements have been reached on international standards for the exchange of information, including, for example, the understanding that information exchange will not be limited by bank secrecy or the absence of a domestic tax interest."² One such agreement is the European Union's 2003 Savings Directive.³ The Savings Directive provides for the automatic exchange of tax information between Member States of the European Union "at least once a year, within six months following the end of the tax year of the Member State of the paying agent, for all interest payments made during that year."⁴ However, due to the lack of required reporting of tax information within some Member States, the Savings Directive hasn't required every country in the European Union to exchange tax information. In those Member States that opt not to participate in the automatic exchange of tax information, namely Austria, Belgium and Luxemburg, a withholding tax is levied as an alternative "at a rate of 15% during the first three years of the transitional period, 20% for the subsequent three years and 35% thereafter."⁵ Member States levying withholding tax retain 25% of the revenue and transfer 75% of the revenue to the Member State of residence of the beneficial owner of the interest.⁶ As of 2011, the transitional period of the Savings Directive has expired, and those Member States choosing not to automatically exchange tax information with other Member States are required to levy a withholding tax of 35%.

The European Union has offered to allow other countries to participate in the Savings Directive, and specifically asked countries such as Singapore, Hong Kong, Macao, Bermuda and Barbados to do so, but they have thus far declined.⁷ I believe the United States is wise not to participate in the Savings Directive due to key flaws within it. However, many of the same key flaws are present in this proposed rule. By examining how individuals have managed to avoid the requirements of the European Union's Savings Directive over the last eight years, changes can be made prior to promulgating this rule to prevent similar avoidance in the United States. These same changes would help to clarify the rule and make it easier to understand by providing for fewer exceptions and having straightforward definitions.

For sake of comparison, Article One of the Savings Directive provides: "The ultimate aim of the Directive is to enable savings income in the form of interest payments made in one Member State to beneficial owners who are individuals resident for tax purposes in another Member State to be made subject to effective taxation in accordance with the laws of the latter Member State."⁸ Due to the definitions set forth in Article One, "savings income" is limited in definition to "interest," and "beneficial owner" is limited in definition to an "individual."⁹

By narrowly defining "savings income" as "interest," all other common forms of savings income escape the scope of the Savings Directive.¹⁰ Such common forms include dividends, capital gains, and royalties.¹¹ Individuals in the European Union have avoided the Savings Directive by holding assets which generate dividends, capital gains, and royalties rather than interest.¹² For example, rather than holding cash in a savings account, individuals can hold shares in a corporation which holds large sums of cash and distributes the interest the cash generates as dividends. The proposed rule suffers from the same problem. While the treasury regulations stipulate that the definition of interest is a question of substance rather than form (i.e. interest payments that are called "dividends" will still be treated as interest payments), the regulation doesn't address payments which truly are dividends by nature.¹³ In the case of a corporation paying out interest received, the disbursements would be dividends by nature. Thus, in order for interest payments disguised as dividends to be exposed, the proposed rule would have to require the reporting of all forms of payments made, including but not limited to interest, dividends, capital gains and royalties. This would also result in clarity, and the rule would be easier to understand. Rather than having to engage in an analysis of whether or not a payment is substantively interest, institutions would simply be required to report what they are paying out.

By narrowly defining "beneficial owner" as an "individual," all other ownership forms escape the scope of the Savings Directive.¹⁴ Such common forms include any recognized business entity such as a limited liability partnership or a trust. Individuals in the European Union have avoided the Savings Directive by holding assets as a limited liability partnership, trust or corporation rather than as an individual.¹⁵ The proposed rule suffers from the same problem. Since the proposed rule only requires interest to be reported if it is paid to an individual, it can be avoided by holding assets within a corporation, LLC, LLP, or trust which is controlled by the individual. The financial institutions are not required to report interest paid in that instance, which makes the task of proving noncompliance on the part of the receiver of the interest more difficult. Intuitively, those individuals most interested in avoiding tax are those in higher tax brackets. Higher earners tend to be more sophisticated at tax planning, and thus are willing and able to create an entity to receive interest payments on their behalf. If interest paid was required to be reported in all instances, it would represent a targeted effort to reduce tax avoidance and evasion by those who most often engage in the practice.

The proposed rule should be revised in order to address some of the flaws inherent in its current form. First, the revised rule should have an inclusive definition of "income" including all common forms of savings income such as interest, dividends, capital gains and royalties. This will prevent tax evaders from moving their investments into forms of investment not covered by the rule. The new standard should also define asset ownership to include any recognized business entities such as limited liability partnerships and trusts. This will prevent tax evaders from changing the nature of their asset ownership into ownership structures not covered by the rule. Both of these changes would also help to clarify the rule and make it easier to understand.

The primary strength of the proposed rule is its unconditional requirement that tax information be reported. For sake of comparison, the primary weakness of the Savings Directive is the withholding tax option it provides as an alternative to reporting tax information. The proposed rule must therefore continue to insist that tax information be reported, and not be amended to provide any alternatives to tax information reporting. To illustrate why providing for an alternative to reporting tax information would be such weakness, consider parties to the Savings Directive such as Sweden. In 2010 the top personal income tax rate amounted to 37.5%, on average, in the European Union.¹⁶ By providing the option to withhold tax at 35% (and retain 25% of the withheld tax) rather than reporting tax information, the Member State of residence would only receive an effective tax rate of 26.25%,¹⁷ well below the 37.5% average top marginal tax rate in the European Union. As a result, while the withholding tax is intended to be a viable alternative to tax information reporting, Member States of residence stand to lose an average of 11.25%¹⁸ in tax otherwise owed to them making the withholding tax seem less viable to those Member States Intuition would suggest that the vast majority of individuals receiving interest payments from foreign countries are subject to the top personal income tax rate in their Member State of residence. The primary benefit of holding assets in an outside jurisdiction is the reduction in tax liability owed to the jurisdiction of residence. Therefore, the lower the personal income tax rate is in the jurisdiction of residence, the lower the benefit derived from holding assets in an outside jurisdiction. The same logic would suggest that the vast majority of beneficial owners are from Member States with top personal income tax rates greater than 37.5%. Even at 37.5%, beneficial owners stand to save 2.5% in tax by subjecting themselves to the thirty-five percent withholding tax rather than their Member State of residence top personal income tax rate. Depending on the amount of assets being held in the outside jurisdiction, 2.5% in tax savings alone could justify holding assets in an outside jurisdiction. However, residents of Sweden, which imposes a top personal income tax rate of 56%,¹⁹ would stand to save 21%²⁰ in tax on interest income by holding their assets in an outside jurisdiction. Likewise, Sweden would stand to lose 29.75%²¹ in tax which would otherwise be owed by accepting their portion of the withholding tax rather than receiving the reported tax information. While the withholding tax may make tax evasion less attractive, tax evaders still stand to realize substantial tax savings by opting for the withholding tax rather than automatic information exchange; thus the withholding tax is not truly a viable alternative to required reporting of tax information.

I believe the United States is wise not to accept the European Union's invitation to participate in the Savings Directive for the reasons outlined above. The Savings Directive has essentially served as a case study for regulations regarding the reporting of tax information. By closely examining the Savings Directive and its flaws, the IRS can make necessary changes to the terms of this promulgated rule prior to implementing it. The changes would also help to clarify the rule and make it easier to understand. By making the changes recommended above, the IRS can achieve their objective of receiving information about interest payments made within the United States while avoiding the many pitfalls inherent in such regulations.

² Guidance on Reporting Interest Paid to Nonresident Aliens, 76 Fed. Reg. 5 (proposed Jan. 7, 2011) (to be codified at 26 C.F.R. pts. 1 &31).

³ Council Directive 2003/48, 2003 O.J. (L 157) 38 (EC).

⁴Id. art. 9, at 43.

⁵Id. art. 11, at 43.

⁶Id. art. 12, at 44.

⁷ TAX JUSTICE NETWORK, BRIEFING WITH POLICY RECOMMENDATIONS -- EUROPEAN UNION SAVINGS TAX DIRECTIVE § 2.4 (2008), http://www.taxjustice.net/cms/upload/pdf/European_Union_Savings_Tax_Directive_March_08.pdf

⁸ Council Directive 2003/48, 2003 O.J. (L 157) 38 (EC), art. 1, at 39 (emphasis added),

⁹Id.

¹⁰ TAX JUSTICE NETWORK, BRIEFING WITH POLICY RECOMMENDATIONS -- EUROPEAN UNION SAVINGS TAX DIRECTIVE §§ 8.2.3-4 (2008), http://www.taxjustice.net/cms/upload/pdf/European_Union_Savings_Tax_Directive_March_08.pdf.

¹¹Id.

¹²Id. at §§ 8.2.4-5

¹³ Treas. Reg. § 1.6049-5(a)(3) (as amended in 2006).

¹⁴ TAX JUSTICE NETWORK, BRIEFING WITH POLICY RECOMMENDATIONS -- EUROPEAN UNION SAVINGS TAX DIRECTIVE §§ 8.2.1-2 (2008), http://www.taxjustice.net/cms/upload/pdf/European_Union_Savings_Tax_Directive_March_08.pdf.

¹⁵Id.

¹⁶ EUROPEAN COMMISSION, TAXATION TRENDS IN THE EUROPEAN UNION 8 (2010), available at http://ec.europa.eu/taxation_customs/resources/documents/taxation/gen_info/economic_analysis/tax_structures/2010/2010_main_results_en.pdf.

¹⁷ 35% x 75% = 26.25%

¹⁸ 37.5% - 26.25% = 11.25%

¹⁹ Sweden has the highest top personal income tax rate of any European Union country. See EUROPEAN COMMISSION, TAXATION TRENDS IN THE EUROPEAN UNION 8 (2010), available at http://ec.europa.eu/taxation_customs/resources/documents/taxation/gen_info/economic_analysis/tax_structures/2010/2010_main_results_en.pdf.

²⁰ 56% - 35% = 21%

²¹ 56% - 26.25% = 29.75%