No One Expects the Spanish Tax Deduction
“No one expects the Spanish Tax Deduction! Its chief attribute is surprise, confusion and surprise; two chief attributes: surprise, confusion and the prospect of lost firm revenue! Er, among its chief attributes are: surprise, confusion, lost firm revenue and near fanatical devotion to collecting taxes for the realm. Um, I’ll come in again….”
With apologies to Graham Chapman
& Monty Python, circa 1970
If you are a law firm CFO, the surprise, confusion, and prospect of lost firm revenue surrounding foreign tax withholding is usually communicated via a phone call or email from a partner who receives a communique from a new client in Spain (or China or India or any number of other foreign lands). The client has just informed the partner that its accounting department plans to deduct 24% for local taxes on the first invoice (and every invoice thereafter) to satisfy the country’s tax on foreign-based entities that provide services within their domain. The call or email you receive from the partner generally ends with the query, “What are YOU going to do about this?” (Important Rule to Remember: resist the urge to ask the obvious question: “So, YOU accepted an engagement to perform work for an overseas client without an understanding how the firm would be paid?”)
Dealing with International Transactions
The first time this happened to me, I was lucky to have a Big 4 CPA firm on retainer. A tax accountant whose specialty was international transactions explained what needed to be done:
- Step 1: Inform the client to delay paying the invoice until the firm provides the client with a Certificate of Residency from the IRS.
- Step 2: Provide the Certificate of Residency to the client, together with whatever additional information the client might think is helpful for them to skirt the foreign tax withholding issue on your behalf. Most overseas clients have a form letter they ask to be reproduced on firm letterhead attesting to the fact that the law firm has no physical office location within their country; no personnel working in country; and no plans to establish an office or have personnel working in country during the tax year. (Just like you need to explain to vendors the importance of completing a W-9 to avoid mandatory backup tax withholding on payments to them, my experience has been that foreign clients of US law firms have been through this drill before and are more than happy to help us to avoid the foreign tax withholding.)
Obtaining a Certificate of Residency for Clients
A Certificate of Residency (technically IRS Form 6166) is a letter printed on U.S. Department of Treasury stationery certifying that the individuals or entities listed are residents of the United States for purposes of US income tax laws. It is obtained by filing IRS Form 8802 and best accomplished by appointing a third party—preferably a CPA familiar with the process—to act on the behalf of the firm and “walk” the paperwork through the approval process. The third-party appointment is accomplished by filing IRS Form 8821 with the 8802.
The filing fee for an 8802 is currently $85 and it typically takes 3-4 weeks from the filing date until the Certificate of Residency is received by mail. The Certificate of Residency is valid for a single tax year, so if you expect recurring overseas client payments, it is important to promptly reapply annually to avoid delayed payments once the calendar advances past December 31. The IRS begins accepting 8802 applications for the following tax year on November 1st.
The efficacy of the Certificate of Residency is limited. It may not be effective beyond the 66 foreign states listed on Form 8802, and with respect to countries imposing Value Added Taxes (VATs), the Certificate of Residency is only proof of US tax residency. It may not be enough to satisfy other requirements needed to obtain a VAT exemption in a foreign country.
If a foreign-based client has already paid an invoice after deducting and remitting the local service tax, the Certificate of Residency may be useful in obtaining tax relief from the foreign government—but let’s hope you never need to go through that mishegoss.
Monitoring Client-Intake Reports for Foreign Clients
A word to the wise: If you are not currently applying for Certificate of Residency letters because your firm has no current foreign clients, you might consider monitoring client-intake reports to spot new foreign-based clients and get a jump on the application process. Obtaining the form early will cost you only $85 and you’ll have it in-hand (and be a hero) when you receive the portentous partner phone call or email asking you to help avoid the Spanish Tax Deduction and its ilk.
One final thought: If anyone has an idea how to incorporate the Dead Parrot Sketch dialogue into one of these law firm financial management blog posts, I’m open to suggestions.