Commodity Contracts With Foreign Counter-parties: Responsibilities for U.s. Parties

• Publication year: 2003
• Pages: 69

32 Colo.Law. 69 Colorado Lawyer 2003.

2003, August, Pg. 69. Commodity Contracts With Foreign Counter-Parties: Responsibilities for U.S. Parties

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69

Vol. 32, No. 8, Pg. 69

The Colorado Lawyer
August 2003
Vol. 32, No. 8 [Page 69]

Specialty Law Columns
Tax Tips
Commodity Contracts With Foreign Counter-Parties Responsibilities for U.S. Parties
by Liane L. Heggy

This column is sponsored by the CBA Taxation Law Section to provide timely updates and practical advice on federal state, and local tax matters of interest to Colorado practitioners

Column Editors:
Larry Nemirow, Denver, of Davis, Graham & Stubbs LLP, (303) 892-7443, larry.nemirow@dgslaw.com; and John Warnick, Denver,
of Holme Roberts & Owen llp - (303) 861-7000, warnicj@hro.com

About The Author:
This month's article was written by Liane L. Heggy, Denver, Of Counsel with Davis Graham & Stubbs LLP - (303) 892-7236, liane.heggy@dgslaw.com.

To protect themselves from market risks, mineral producers and traders often enter into financial contracts on commodities they produce. This article describes how U.S. withholding tax and information reporting obligations could apply to these payments when the counter-party is a foreign person, and what documentation is required to minimize such obligations.

Mineral producers and traders often endeavor to protect themselves from market risks by entering into financial contracts on commodities they produce. As long as the contracts are entered into as part of the ordinary course of business, gains on such contracts generally are ordinary income and losses are ordinary losses.1 The same usually is true when the counter-party is a U.S. "person": an individual or entity that is resident in the United States for tax purposes.

When the counter-party is a foreign person, however, U.S. withholding tax and information reporting issues often are triggered. This situation is more likely when commodity contracts are used for purposes other than hedging production and market risks, such as to borrow money. The tax treatment of these types of transactions is not always clear. Thus, the participation of a foreign counter-party, although welcome as a business matter, presents additional tax risk to the U.S. party.

Even when the contract is of the "plain vanilla" variety, that is, a straightforward commodity-based contract used only to hedge market risks, the U.S. party may be at risk. To avoid problems, the U.S. party needs a clear understanding of how U.S. withholding tax applies to payments made to foreign parties and what documentation is required to eliminate the withholding and reporting obligations that could apply to any given payment.

This article first examines the general rules governing withholding tax and information reporting that apply to payments made to foreign persons, and provides guidance on how U.S. parties may ensure their own compliance with those rules. The article then discusses the tax treatment, as well as withholding and reporting obligations of a U.S. party, with regard to payments made to a foreign party under several "plain vanilla" commodity contracts. The article also discusses those points in the context of common variations, many of which may be treated as loans in disguise. The purpose of this article is not to discuss the proper tax treatment of these contracts, but to make U.S. parties aware of where they may be putting themselves at risk regarding withholding tax and information reporting obligations, and what they need to do to protect themselves from both of those risks.

General Rules

The United States taxes many types of income paid by U.S. persons to foreign persons by way of requiring the U.S. payor to withhold and pay over to the Internal Revenue Service ("IRS") a portion of the payment. In addition, information about such payments, regardless of whether they are subject to withholding tax, may be required to be reported to the IRS. The following discussion presents the general rules for withholding tax and information reporting on such payments.

U.S. Withholding Tax

Payments to foreign persons of U.S.-source income that is fixed, determinable annual or periodical gains, profits, or income (commonly referred to as "FDAP") are subject to 30 percent U.S. withholding tax, unless an exception or a lower treaty rate applies.2 The concept of FDAP is interpreted broadly and includes most interest, dividends, rents, royalties, and other types of income; however, it generally excludes capital gains and most other gains.3

A wide variety of U.S.-source payments that do not fit the specific FDAP categories must satisfy a specific exception to avoid withholding tax. Many payments, such as interest and dividends, are sourced by the residence of the payor. For example, dividends paid by a U.S. company normally would be U.S. source. Gains generally are sourced by residence of the seller/payee,4 so normally would not be subject to withholding tax when paid to a foreign person because they would not be U.S. source (and even if FDAP, would not be subject to withholding tax).

The U.S. payor making a payment of U.S.-source FDAP to a foreign party is responsible for withholding tax of 30 percent of the payment and ultimately transmitting such funds to the IRS,5 or obtaining from the foreign payee proper documentation to support an exemption from withholding tax (usually IRS Form W-8ECI or W-8BEN). The most common exemption is interest that qualifies as portfolio interest, discussed further below.

Generally, for interest to be treated as portfolio interest and exempt from withholding tax, the payee must provide appropriate documentation of its foreign status and certain other requirements must be satisfied.6 A U.S. payor that fails to obtain appropriate documentation establishing an exemption or relies on documentation it knows or has reason to know is not valid, is liable for any tax it fails to withhold.7

It would be difficult for U.S. parties to find foreign counter-parties willing to enter into commodity contracts with them if they were to apply 30 percent withholding tax in lieu of collecting proper documentation, even where the tax ultimately may be refundable. The alternative of grossing-up the payment to cover the cost of the withholding tax would make the transaction costs prohibitive for the U.S. party.

FDAP payments to a foreign party that operates a business in the United States through a branch (or disregarded entity)8 generally are not subject to U.S. withholding tax when the payments are treated as being connected with that U.S. business. Such income is "effectively connected income" ("ECI") and is taxed at the regular U.S. rates applicable to net income. Any foreign person claiming U.S.-source FDAP payments to it are ECI, and therefore exempt from withholding, generally must provide to the U.S. payor an IRS Form
W-8ECI, complete with a U.S. taxpayer identification number. In signing the Form W-8ECI, the payee certifies that the payment it is receiving is ECI and is taxable to the payee as such.

IRS Information Reporting Requirements

All payments on which tax has been withheld must be reported to the IRS.9 Even where no withholding tax applies, however, information reporting may be required. All FDAP payments to a foreign person treated as ECI must be reported.10 Many other payments of U.S.-source FDAP to a foreign person must be reported, including amounts that are the type of payment that could be subject to withholding, even if the withholding does not apply to a payment to a particular payee.11 All such reporting is required to be made by filing a return on IRS Form 1042-S for each foreign payee.12 In addition, for any payment required to be reported, the payor must provide a copy of Form 1042-S to the foreign payee.13

Barring a specific exception, information reporting also generally applies to non-U.S.-source FDAP payments.14 Payors are required to report to the IRS payments of non-U.S.-source FDAP, unless they hold appropriate documentation or other information on which they can rely to treat the payee as an "exempt recipient" or to treat the payment as one that is not subject to the reporting requirements.

Corporations are exempt recipients for most types of payments that are not subject to withholding. A foreign person whose name indicates that it is an entity on the list of per se corporations can be treated as a corporation for purposes of information reporting;15 payments to such an entity that are not subject to withholding generally also are not reportable.16 Financial institutions are exempt recipients for certain types of payments.17 Generally, a payor may determine that a payee is a corporation or financial institution if its name indicates that it is such, without receiving any additional information or documentation. For example, a payee may treat Bayer AG (with an address in Germany) as an exempt recipient because its name and address indicate that it is a German Aktiengesellschaft (an entity that is a per se corporation for U.S. tax purposes).

Regarding payments for which a financial institution is an exempt recipient, the payor also may rely on the payee's name alone if it "reasonably indicates" the payee is a financial institution, such as a bank, savings and loan organization, or credit union. Nevertheless, the U.S. payor has the obligation to report any reportable payment or to obtain information or documentation on which it can rely to avoid reporting. Although penalties attributable to improper reporting are not high, they can add up quickly where numerous payments to numerous payees are improperly reported.18

Typical Commodity Hedging Contracts

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