Suits for Refund
Taxpayer’s Burden of Proving the Impossible (?) – Chapter 3 and Chapter 4 (FATCA) Withholding Taxes Paid by Third Parties
The IRS has issued a Notice (Notice 2015-10) this year announcing its intention to modify the Treasury Regulations regarding tax refunds. This new series of rules, Guidance on Refunds and Credits Under Chapter 3, Chapter 4, and Related Withholding Provisions will complicate the lives of taxpayers significantly. 
Indeed, I have already seen and handled cases where the IRS asserts the taxpayer is not entitled to a tax refund, unless and until they can prove the third party who withheld and paid over the tax (issuing IRS Forms 1042 to all parties, including the IRS and the taxpayer) actually issued and deposited those payments.
These cases are like “proving a negative” since the withholding agent (typically a bank) who made and paid over the deposit, almost never makes single identifying payments for each amount of tax withheld. Typically, there are multiple taxpayers where the withholding tax was made and a single deposit made to the IRS. Those are indeed the specific rules set forth by the IRS. See, IRS Publication 515, withholding of tax on nonresidents
It gets even worse in Qualified Intermediary (“QI”) cases, where a large pool of withholding taxes are made. Typically, I have found the financial institution keeps detailed records of the payments and deposits (along with IRS Forms 1042s), but never has a payment specific to a particular taxpayer, as the deposit payments correspond to multiple taxpayers at once. Indeed, the IRS has acknowledged this treatment in this notice when it states:
Under the existing information reporting, withholding, and deposit procedures, a withholding agent does not indicate to which beneficial owner the deposit of tax relates, and such information is not reported on Form 1042 or 1042-S. Under the existing procedures, therefore, an amount deducted by the withholding agent with respect to a payment to the beneficial owner cannot be matched with an amount of tax deposited in the withholding agent’s Form 1042 account.
See page 5 of (Notice 2015-10).
There is a huge incentive for withholding agents to timely pay and deposit the taxes. There are harsh penalties levied against the withholding agent if they do not timely deposit and pay over the taxes, as follows:
Penalty rate. If the deposit is:
- 1 to 5 days late, the penalty is 2% of the underpayment,
- 6 to 15 days late, the penalty is 5%, or
- 16 or more days late, the penalty is 10%.
However, if the deposit is not made within 10 days after the IRS issues the first notice demanding payment, the penalty is 15%.
In short, the proposal in the form of modifying the regulations puts the burden on the nonresident taxpayer to prove the tax was withheld, before he or she will be entitled to a refund.
This is a new development in a series of developments where the IRS and Treasury simply issue regulations in areas of the law they do not seem to like. Further, it puts an unrealistic burden on nonresident taxpayers who are relying upon the third party withholding agent who makes the payment of taxes.
The long term affect of this rule, will be to force more taxpayers to file suits for refund in the Court of Federal Claims or U.S. District Court, which is necessarily complicated and costly.
More posts to come on this Notice 2015-10 and amendments to the Chapter 3 and Chapter 4 (FATCA) withholding tax regulations.