IRC Chapter 4: Withholding and Reporting Requirements

Internal Revenue Code (IRC) Chapter 4 was established by the Foreign Account Tax Compliance Act (FATCA) in 2010 to address tax evasion by U.S. individuals using offshore accounts. The goal of Chapter 4 is to increase transparency regarding financial accounts held by U.S. taxpayers in other countries. The provisions, found in IRC Sections 1471 through 1474, compel foreign financial institutions and certain non-financial foreign entities to report on the foreign assets of their U.S. clients. This system provides the Internal Revenue Service (IRS) with the data needed to ensure U.S. persons meet their tax obligations and effectively enlists global financial institutions to combat offshore tax evasion.

The Chapter 4 Withholding Obligation

A central enforcement mechanism of Chapter 4 is a 30% withholding tax on certain payments from the United States, designed to compel compliance with reporting requirements. The responsibility for this withholding falls upon the entity making the payment, known as a “U.S. Withholding Agent.” A withholding agent can be any U.S. or foreign person that has control, receipt, or custody of a covered payment.

The 30% tax applies to “withholdable payments,” which include U.S. source fixed, determinable, annual, or periodical (FDAP) income. Common examples of FDAP income are interest, dividends, rents, and royalties. The withholding is triggered when the agent cannot properly document the foreign status of the payee. If a foreign entity fails to provide the necessary FATCA certification, the U.S. payer must withhold 30% of the payment. A non-compliant entity is generally not entitled to a refund of the withheld amount.

Key Entity Classifications

Chapter 4’s effectiveness relies on its system for classifying foreign entities, which determines their obligations. Every foreign entity is categorized as either a Foreign Financial Institution (FFI) or a Non-Financial Foreign Entity (NFFE). An FFI is broadly defined to include banks, custodial institutions like mutual funds, investment entities such as hedge funds, and certain insurance companies with cash value products.

FFIs are further divided into subcategories based on their FATCA compliance. A “Participating FFI” (PFFI) has an agreement with the IRS to perform required due diligence and reporting. A “Deemed-Compliant FFI” is considered compliant without a formal agreement. A “Nonparticipating FFI” is an institution that has not agreed to comply and is therefore subject to the 30% withholding on payments it receives.

Non-Financial Foreign Entities

An entity that does not meet the definition of an FFI is classified as a Non-Financial Foreign Entity (NFFE). NFFEs are typically companies engaged in active trades or businesses and are split into two groups: Active and Passive.

An “Active NFFE” is an entity where less than 50% of its gross income from the prior year is passive income, and less than 50% of its assets are held for the production of passive income. Passive income includes dividends, interest, rents, royalties, and annuities. These entities are considered lower risk and have simpler certification requirements.

A “Passive NFFE” is any NFFE that does not meet the active criteria. These entities are subject to stricter rules because they could be used by U.S. persons to hold financial assets. A Passive NFFE must identify its “substantial U.S. owners” to the withholding agent. A substantial U.S. owner is a specified U.S. person who owns more than a 10 percent interest in the entity, and failure to provide this owner information results in the 30% withholding tax being applied.

Documentation and Due Diligence Requirements

To avoid the 30% withholding tax, foreign entities must provide documentation to U.S. withholding agents to certify their status under Chapter 4. The primary tools for this are the IRS Form W-8 series. The most common form for entities is Form W-8BEN-E, “Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities).” This form requires the foreign entity to identify its specific Chapter 4 classification, such as a Participating FFI, Deemed-Compliant FFI, Active NFFE, or Passive NFFE. This selection determines which subsequent parts of the form must be completed.

Completing the Forms

If an entity identifies as a Participating FFI or certain Deemed-Compliant FFIs, it must provide its Global Intermediary Identification Number (GIIN). The GIIN is a unique reference number issued by the IRS confirming the FFI’s commitment to comply with FATCA. If an entity classifies itself as a Passive NFFE, it must complete a specific section certifying that it has no substantial U.S. owners or listing the name, address, and Taxpayer Identification Number (TIN) of each one. The form is generally effective for the year it is signed plus the next three full calendar years.

Withholding Agent Due Diligence

Upon receiving a Form W-8, the U.S. Withholding Agent must perform its own due diligence. A key step is to verify an FFI’s GIIN using the publicly available FFI List maintained by the IRS. The agent must also review the form for completeness and ensure the information is not contradictory. If the withholding agent knows or has reason to know that the information on the form is incorrect, they cannot rely on it and must apply the 30% withholding tax.

Annual Reporting Obligations

After a calendar year, entities in the Chapter 4 system have annual reporting duties to the IRS. These obligations ensure that information collected throughout the year is formally transmitted to tax authorities. The requirements differ based on whether the entity is a U.S. withholding agent or a foreign financial institution.

U.S. Withholding Agent Reporting

A U.S. Withholding Agent that made withholdable payments must report the totals to the IRS using two forms. Form 1042, “Annual Withholding Tax Return for U.S. Source Income of Foreign Persons,” is used to report the total payments and tax liability withheld under Chapter 4. The second form is Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding.” A separate Form 1042-S must be filed for each foreign recipient, detailing the income paid and tax withheld, and this form is also sent to the income recipient.

FFI Reporting

Participating FFIs and those in certain jurisdictions have direct reporting obligations using Form 8966, “FATCA Report.” This form provides the IRS with information on the U.S. accounts they maintain, including the account holder’s name, address, TIN, account balance, and income. For Passive NFFEs, the FFI reports the information it collected on the entity’s substantial U.S. owners. This direct reporting provides the IRS with account-level data from foreign sources.

The Role of Intergovernmental Agreements

To address challenges from domestic laws like bank secrecy, the U.S. Treasury Department developed Intergovernmental Agreements (IGAs). These bilateral agreements between the U.S. and other countries facilitate FATCA implementation. An IGA allows a partner government to integrate FATCA compliance into its own legal framework, simplifying the process for its financial institutions.

There are two primary types of IGAs: Model 1 and Model 2. Under a Model 1 IGA, FFIs in the partner country report U.S. account information to their local tax authority, which then exchanges the information with the IRS. This keeps the information flow within government-to-government channels.

Under a Model 2 IGA, the partner jurisdiction directs its FFIs to report information directly to the IRS. The foreign government ensures its FFIs comply with this direct reporting, and the agreement includes provisions for the IRS to make specific requests for information through the partner government when needed. Operating in a country with an IGA can alter an FFI’s specific procedures, making it a factor in navigating Chapter 4 obligations.