As tax information reporting specialists, we build divergently different processes for account holders who are U.S. persons versus those who are not. If a customer falls into the U.S. bucket, there is Form 1099 processing (and possibly FATCA reporting if your institution is offshore); for those who do not (nonresident aliens or NRAs in tax parlance), we have the more intricate Form 1042-S mish-mash of matching recipient statuses with income types, applicable tax rates and exemption codes. But we forget sometimes that U.S. and NRA statuses are not immutable.
A case in point. Last month, the IRS issued a revenue procedure that provided relief for NRAs who may end up staying in the U.S. too long due to COVID-19 travel-related challenges. Staying in the U.S. “too long” (that is, meeting what is called the “substantial presence” test) can turn a non-U.S. person into a U.S. person for U.S. tax purposes. This then has the unfortunate consequence for the erstwhile NRA in question of falling into the U.S. tax net and being taxed by in the U.S. (at least for the year) on the whole of her worldwide income.
For banks and brokers where such person may have a financial account, the situation is no less odious since such a tax status change would likely require modifications to both withholding and tax reporting. Different tax withholding rules, different classification and reclass procedures for income, different form types, different deadlines. A mess really. But that is part of the job of the withholding agent in the tax reporting world: to be able to account for such changes in circumstance or CICs.
In the case of substantial presence, an NRA can become a U.S. person for tax purposes based on a quantitative formula that looks to see if an individual has been present in the U.S. at least 31 days during the current year and, if so, whether the individual has been in the U.S. for 183 days in aggregate during the 3-year period that includes the current year and the two years immediately preceding the current year. This is based on a special formula. In doing the calculation, days of presence in the current year are counted in full, while only a third of the days in the immediate prior year and only a sixth of the days in the second year preceding the current year are counted. (By the way, NRAs in the know generally make it a rule of thumb not to exceed 121 days of presence in the U.S. for any calendar year since that prevents them from tripping substantial presence based on the three-year formula.)
The IRS in Rev. Proc. 2020-20 in April provided COVID-19-related relief for NRAs with respect to the substantial presence testing. Under the Rev. Proc., NRAs present in the U.S. between February 1 and April 1, 2020 may select a consecutive 60-calendar-day period that begins within this window to exclude from the substantial presence calculation. The intended result is to reduce the number of potential tax status changes for NRAs present in the U.S. in 2020 due to unexpected extensions of U.S. stays during the coronavirus pandemic. This should provide relief both for NRAs in question and to withholding agents that would otherwise need to account for the NRA status changes.
But if nothing else, the Rev. Proc. and its highlight of the substantial presence trigger remind us not only that tax status is not fixed, but that, when changes in circumstance happen as will occur sometimes, there needs to be processes to account for them. And the CIC issue is broader than simply substantial presence.
CICs with respect to tax status can occur in various scenarios. One is NRA to U.S. tax resident, as noted above, due to the substantial presence test. In this case, absent actual knowledge of the CIC, the bank or broker can generally rely on previously provided tax documentation (e.g., Form W-8BEN) until the account holder updates the financial institution with a Form W-9. But other CICs that result in changes in status can be more subtle. An update to an NRA account to add a U.S. mailing address can trigger a status change if the financial institution does not follow-up to obtain supporting documentation to “cure” the new bit of U.S. indicia. Forms can also expire; in many cases, Forms W-8 expire at the end of the third full calendar year after having been signed and provided by the account holder, but other forms subject to transition rules might have shortened or extended expiration dates. Banks and brokers may in addition need to be aware of changes in addresses provided by NRA accounts that claim tax treaty benefits, since such claims may be rendered ineligible unless certain residence conflicts are resolved.
Status CICs can also occur with entity accounts. For entities, while their tax mobility may be much less than in the case of individuals, there are other issues such as FATCA-status related changes, to wit, a failure to monitor termination of a global intermediary identification number (GIIN) provided by a foreign financial institution via an annual GIIN check. Or certain statuses may have a time expiry date due to regulatory provisions (e.g., qualified securities dealer status is scheduled to sunset at the end of 2022 under section 871(m) transition rules).
Under tax regulations, banks and brokers are in many cases tasked with monitoring and/or adjusting withholding and tax reporting processes due to CICs. Even if change is not constant, there is always the possibility of change. This the recent Rev. Proc. reminds us. And it is a reminder also for financial institutions of the need to review their processes for handling potential CICs.
Is your customer still who you think they are, tax-technically speaking of course?