US Investments – Tax Refunds Under Threat

In July 2020, the US Treasury conducted an audit of the IRS and the management of withholding/refunds for those who receive income on Forms 1099/1042-S.

The outcome of the audit was that better controls were needed with regards to the IRS data matching system, as refund were being paid out without any record of any withholding tax ever having been paid. This is changing, and all investors into the US need to take note.

For most private portfolios created in NZ, there is usually some element of US investing involved. For each client, a Form 1099 (US citizens) or Form 1042-S (non-US citizens) is issued at the end of the US tax year to report dividends, gains, and tax withheld.

These two forms serve the same purpose, but contain slightly differing information. In nearly all cases, the tax withheld on would be 30%, which is the standard non-resident US tax rate. However, this can be reduced to 15% or 0% for certain types of income with a correctly processed Form W-8-BEN, claiming NZ US tax treaty benefits. In practice, I find its very rare that the reduced tax rate is applied by the US withholding agent, usually due to concern about falling foul of their own US tax obligations.

In addition to this distinction between US persons and foreign persons, the type of identifying information is different:

• Social Security Number (SSN) is the Taxpayer Identification Number (TIN) for US citizens & Green Card Holders
• Individual Taxpayer Identification Number (ITIN) is the Taxpayer Identification Number for non-US persons
• Employer Identification Number (EIN) is the Taxpayer Identification Number for entities such as trusts or businesses (same for US and non-US entities).

For the vast majority of these cases:

• For US citizens, a 1042-S will be issued, which is the incorrect form, as 1042-S is only for non-US persons. No Social Security Number is reported on the 1042-S or 1099
• For non-US citizens, a 1042-S will be issued without an ITIN printed for the taxpayer (Individual Taxpayer Identification Number)
• For non-US citizens and entities, most do not possess any form of US TIN at all

The IRS operates a large data matching system, whereby the withholding agent reports the income and tax paid (for an investor) to the IRS through Forms 1099 & 1042-S, which is then matched against their TIN. When a 1042-S/100 is filed with the IRS without a TIN printed, the IRS essentially receives tax paid but without any knowledge of who has actually paid the tax (the name alone is insufficient). It’s a bit like paying tax to the IRD without an IRD number.

Previously, non-US citizens and US citizens alike had been able to report this income and US tax paid on a US tax return, and receive a refund of a portion (or all) of the tax withheld despite there being no TIN printed on the 1042-S/1099.

The end result of all of this was that the IRS would no longer pay out any refunds to US or non-US citizen taxpayers without a TIN having been recorded on the 1042-S/1099. This affects all who invest in the US, from those who may have a few hundred or a few thousand dollars through platforms such as Hatch, right up to those investing 6 or 7 figure sums.

Issues Created

With the IRS position on refunds without a TIN changing, this has left a huge amount of inbound investors with a significant shortfall in investment earnings due to the apparent inability to have the 30% non-resident withholding tax refunded.

This issue is twofold:

• For NZ citizens, the 30% tax withheld on US investments can’t be refunded and reduced down to 15%/0%, reducing investment gains
• For US citizens, they are required to report their worldwide income to the US each year on a US tax return. Without being able to claim any credit for the withholding tax already paid, they would be taxed again on the same income on the 1042-S, resulting in a tax rate of 45% on their US sourced income, again dramatically reducing investment gains

Solution

As mentioned above, the vast majority of non-US citizen individuals or entities which have US based investments do not have any form of US TIN. As a result, there is little to no hope of obtaining a refund of US withholding tax without a change of approach.

Action to Occur	US Citizens	Non-US Citizen Individuals	Non-US Entities
Prior to US investment		Obtain letter from US withholding agent, requesting ITIN for Federal Taxation Purposes (W-7 exception 1(d)
		Arrange appointment for ID verification with IRS Certified Acceptance agent, apply for ITIN on Form W-7	Apply for EIN number by fax, no letter needed
At inception of US Investment	Obtain client’s SSN, and communicate it to US withholding agent	Obtain client’s ITIN, and communicate it to US withholding agent	Obtain client’s EIN, and communicate it to US withholding agent
	Ensure client is issued 1099, with SSN recorded	Ensure client is issued 1042-S, with ITIN recorded in box 13e	Ensure client is issued 1042-S, with ITIN recorded in box 13e
Close of Tax US Year (Dec)	Report Income on US tax return, with refund for excess withholding tax	Non-resident tax return to be filed to the USA, claiming back excess withholding tax as a refund	Non-resident tax return to be filed to the USA, claiming back excess withholding tax as a refund

By following the above procedure, we’re able to ensure that the client is able to obtain their refunds, and ensure that investment gains are not affected by the excess non-resident withholding tax. In addition, for US citizen investors, it reduces the tax on their US investments down to 15% from 45%.

US Global Tax are able to assist both investors, and wealth managers.