As a general matter, payments to foreign persons of interest, dividends, royalties and certain other types of income are subject to a 30% withholding tax. The payor of such income is responsible for withholding and remitting the withheld tax to the IRS. However, under the new Section 1441 withholding regulations (discussed in the July 1999 edition of The Tax Advisor), the payor will not be required to withhold and remit any tax if it makes payment to a "qualified intermediary" that assumes primary withholding responsibility for the payment. A qualified intermediary is either:

  1. a foreign financial institution or clearing organization;
  2. a foreign branch of a U.S. financial institution or clearing organization;
  3. a foreign corporation for purposes of presenting claims of treaty benefits to its shareholders; or
  4. any other person who has entered into a withholding agreement with the IRS and who is deemed acceptable by the IRS.

In order for a foreign entity to become a qualified intermediary, it must comply with the application procedures set forth in Revenue Procedure 2000-12. These procedures became effective on January 24, 2000. In addition, the foreign entity must enter into a "Qualified Intermediary Withholding Agreement" with the IRS. Revenue Procedure 2000-12 contains a model Qualified Intermediary Withholding Agreement. The foreign entity must establish, to the satisfaction of the IRS, that it has adequate resources and procedures to comply with the terms of the Qualified Intermediary Withholding Agreement.

Questions About Recent Changes to Installment Sales Rules

The Ticket to Work and Work Incentives Improvement Act, signed into law on December 17, 1999, repealed the use of the installment method of reporting for most accrual basis taxpayers. This repeal has incited widespread criticism from the small business community because many closely-held corporations use the accrual method of accounting.

In general, under the installment method of reporting, taxpayers may defer taxable gains from the sale of property when the seller receives an installment obligation in lieu of cash. For example, before the repeal of the use of installment reporting, when a small corporation sold its assets in exchange for a five-year promissory note, the corporation could report gain from the sale incrementally, as it received payments, rather than reporting all at once at the time of sale. After the repeal, small corporations using the accrual method of accounting must report all of the gain up-front.

Critics of the repeal argue that it will have an especially detrimental impact on the sale of small businesses, which usually are structured as asset sales rather than stock sales. The repeal effectively will force a cash method taxpayer to report the gain from the sale of the assets of his or her business in the year of sale. In many instances, depending on the consideration for the transaction, the taxpayer will not have enough cash available to cover the resulting tax liability. As a result, buyers either will have to bring more cash to the table or will have to restructure the transaction as a stock sale. Critics argue that either method reduces the value of small businesses.

Reports indicate that a coalition of small business lobbying groups have been voicing their concerns to the Treasury Department. The Treasury Department has given off some hopeful signals that they will provide some form of regulatory relief. Even more significant is the fact that during the week of March 10, 2000, the House of Representatives passed a bill that includes a reinstatement of the installment method of accounting for accrual basis taxpayers. The bill provides a retroactive repeal of the new provision back to December 17, 1999.

Final Treasury Regulations Pertaining to Treatment of Changes in Elective Entity Classification are Issued

A partnership, limited liability company or corporation with more than one owner may elect to be classified as an association or partnership for federal income tax purposes. Where such an entity has only a single owner, the entity will be considered a "disregarded entity," (an entity that is disregarded as being separate from its owner) unless the owner elects to have the entity classified as an association. Under most circumstances, the owner or owners may elect to change an entity's classification. The regulations provide that if owners decide to elect a different classification, the change must follow a prescribed form. For example, when an entity that is currently taxed as an association for federal income tax purposes subsequently elects to be classified as a disregarded entity, the association is deemed to have distributed all of its assets and liabilities to its single owner in liquidation of the association. Assuming that these assets have appreciated in value, the government will tax the subsequent election.

Governor Ridge Approves Expanded Manufacturing Exemption

In the July, 1999, issue of The Tax Advisor we reported that the Pennsylvania Supreme Court had found that certain portions of the manufacturing exemption to the Pennsylvania capital stock and franchise tax (CSFT) may be unconstitutional. The Pennsylvania court reasoned that the tax discriminated against out-of-state manufacturing operations. See PPG Industries, Inc. v. Commonwealth of Pennsylvania Board of Finance and Revenue. As previously drafted, the manufacturing exemption (as applied by the Department of Revenue) gave companies the right to exclude from the apportionment formula assets, property, payroll and sales, attributable to manufacturing operations in Pennsylvania. In finding that the exemption discriminated against companies with out-of-state manufacturing operations (e.g., a company with all of its manufacturing operations in Pennsylvania would be exempt from the CSFT whereas a company with all of its manufacturing activities outside of Pennsylvania would be subject to the tax), the Supreme Court remanded the case to a lower court. In doing so, the Commonwealth had the burden to demonstrate that the manufacturing exemption advanced a legitimate local purpose that could not be served adequately by reasonably nondiscriminatory alternatives.

As it turns out, on remand, the Commonwealth failed to meet this burden. Accordingly, the lower court declared the exemption unconstitutional and ordered the legislature to take remedial action. In response to this ruling, Governor Ridge signed a bill expanding the manufacturing exemption to out-of-state manufacturing operations. Nevertheless, because the bill contains a one-year sunset provision, this issue will arise once again next year.

Ridge Announces Pennsylvania’s Budget for 2000

On February 8, 2000, Governor Ridge announced his 2000 budget for Pennsylvania. Other items included in the budget are proposed tax reductions and rebates. Below is a chart setting forth the proposed tax cuts.

PROSPOSED TAX REDUCTIONS & REBATES

(Dollar amounts on the right are in thousands)

School Property Tax:

 

Homestead Property Tax Rebate

$ -330,000

A rebate for school property taxes paid for each school district's 1999-2000 fiscal year will be granted to resident owners. An estimated 3.27 million, or 99% of those households, will receive the maximum $100 rebate.

 

Capital Stock and Franchise Tax:

 

Phase Out Tax

-256,100*

The tax will be phased out through a 2 mill reduction of the tax rate, retroactive to January 1, 2000, and subsequent 1 mill annual reductions of the tax rate until the tax is eliminated. The current total rate is 10.99 mills.

 

Eliminate Minimum Tax

-32,900

The minimum $200 annual tax will be eliminated for tax year 2000 and thereafter.

 

Personal Income Tax:

 

Expand Working Family Tax Cut

-16,200

An increase in the eligible income limit to qualify for full tax forgiveness under the special tax provisions is proposed. It may increase from $6,500 to $7,500 for each dependent, effective January 1, 2000. For example, a family of four will not owe any tax on taxable income up to $28,000. This proposal will save that family an additional $627.

 

Sales and Use Tax:

 

Personal Computer Tax Holiday

-8,300

Purchases of personal computers and connected equipment for non-business use will be exempt from the sales and use tax if purchased during the designated time periods.

 

TOTAL PROPOSED TAX REDUCTIONS AND REBATES

$ -643,500

*$256 million reduction in 2000-01 and an additional $130 million every year thereafter

Information contained in this publication should not be construed as legal advice or opinion, or as a substitute for the advice of counsel. The enclosed materials may have been abridged from other sources. They are provided for educational and informational purposes for the use of clients and others who may be interested in the subject matter.