The impending expiration and changes to the Tax Cuts and Jobs Act require Congress to reconsider tax reform. One item that probably won’t be at the top of Congress’s list – but should be – is reducing the high U.S. withholding tax rate on payments of fixed or determinable annual or periodic income (FDAP).

Sometimes withholding tax is an advance payment or a means of ensuring tax payment. Think of the withholding tax that an employer deducts from wages.

In the international context, there is the withholding that a partnership takes on effectively connected income attributable to foreign partners, or that a purchaser takes on the sale of a partnership interest under section 1446(f) of the Tax Code or a U.S. real estate interest under section 897. The tax rate applied in this type of withholding affects cash flow but not the ultimate tax liability.

FDAP is different. The 30% tax rate imposed by Section 871(a) on payments to non-U.S. individuals and by Section 881 on payments to non-U.S. corporations is intended to provide a final settlement of the tax liability.

A recipient outside the United States rarely files a U.S. federal income tax return. Rather, the payer withholds taxes because the recipient usually resides outside the United States and the IRS has no way to require the recipient to file a tax return and remit taxes.

The FDAP withholding system makes conceptual sense. Allowing U.S. citizens to make tax-free payments to non-U.S. citizens can create undesirable incentives and disincentives. But setting the FDAP withholding rate too high simply creates other undesirable distortions, such as discouraging non-U.S. citizens from investing in or licensing intellectual property to U.S. companies.

So why are FDAP withholding rates the same as they were in 1954, despite all the changes in U.S. tax rates and rules over the past 70 years? The various justifications for these high rates do not stand up to scrutiny.

One reason for the high tax rates is to protect the federal income tax base. This rationale is incomplete at best. It could justify a withholding tax on deductible payments, but not on nondeductible payments such as dividends.

Another argument is symmetry. A US citizen would have to pay tax on the payment, and if it could be made tax-free to a non-US citizen, US tax rules would favor payments to non-US citizens.

This rationale justifies a withholding tax, but cannot explain the current U.S. withholding tax rate. Rarely, if ever, would a U.S. citizen have a net income tax liability equal to a gross basis tax of 30%.

An additional justification sometimes given is that high US withholding taxes strengthen the position of US negotiators when it comes to enforcing withholding tax reductions for US taxpayers in double taxation agreements.

Even if this is true, it is not a satisfactory explanation. The United States does not enter into agreements with countries where there is no significant, unmitigated double taxation. So, under this reasoning, countries that do not impose a withholding tax can never achieve a reduction in the US withholding tax.

The obvious answer to the 30% rate is inertia. Cutting taxes for non-US citizens will never be a popular political slogan or bumper sticker. And many non-US citizens manage to avoid the 30% rate by using workarounds and exemptions.

For example, a non-U.S. investor who wants to avoid U.S. withholding tax on dividends can purchase shares of domestic companies that do not expect to pay dividends before the investor sells the shares. If the domestic company is not a U.S. real estate company—and the investor does not trade or do business in the U.S. and does not spend too much time in the U.S.—the gain from the sale of the shares is not subject to U.S. income or withholding tax.

Similarly, with non-portfolio investments, the domestic entity can often be liquidated, generating tax-free profit and no dividend income. When cash needs to be withdrawn from the domestic entity, the non-U.S. citizen can finance the domestic entity with loans to facilitate tax-free capital withdrawals.

With respect to interest payments, many non-U.S. persons can avoid the 30% withholding tax on interest by taking advantage of the portfolio interest exemption under sections 871(h) or 881(c). For non-U.S. persons residing in treaty territories, the applicable U.S. income tax treaty typically reduces or eliminates U.S. withholding tax on FDAP.

Finally, if a non-U.S. citizen determines that doing business through a U.S. corporation or branch is more tax-efficient than pursuing the FDAP program, he or she may do just that.

Therefore, non-US citizens who wish to avoid or reduce FDAP withholding have the opportunity to do so. However, these avoidance measures may affect the form or amount of the investment and result in artificial (and sometimes aggressive) structures just to avoid FDAP withholding.

The US criticises other countries for imposing digital taxes and other taxes that it sees as targeted and discriminatory against US companies. But withholding tax rates that exceed the effective tax rate for domestic taxpayers do the same thing.

Withholding taxes on cross-border flows of money clearly play a role. Nevertheless, any withholding tax should be set at a rate consistent with its objectives. Reducing the US withholding tax, for example to no more than the US corporate tax rate, may not be popular with the public. But it is tax reform.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Information about the author

John Harrington is co-head of Dentons’ U.S. tax practice and advises on transactions, compliance, and international and domestic tax matters.

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