MEMORANDUM

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To:	Client
From:	Robert L. Sommers
Re:	Questions Concerning Withholding Required on Repatriation of Funds to Non-U.S. Citizens.

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You have requested advice regarding the federal and California tax withholding requirements with respect to funds that will be repatriated to a resident and citizen of Thailand. These funds are currently held in your law firm’s trust account on behalf of the client. There is no income tax treaty with Thailand; therefore, the Internal Revenue Code provisions apply. Although your law firm will be repatriating the funds to the client, that does not automatically make it the "withholding agent" for purposes of federal and California tax law; therefore, this memo will discuss the withholding requirements in general terms and will not attempt to determine who should be considered the withholding agent.

I. General Principles Regarding Taxation and Withholding on Funds Transferred to Non-U.S. Residents and Citizens:

Under Federal law, foreign taxpayers are taxed at a flat 30% on their U.S.-source "fixed or determinable, annual or periodic income" ("FDAP"). IRC Code Section 861(a)(1). This type of income usually consists of interest, dividends, rents, royalties and personal services. IRC Sec. 871(a)(1). It is usually income that is passive in nature and has a high gross-to-net ratio. In other words, FDAP income generally does not have business-type deductions associated with its production. The payment of this tax is enforced through a withholding procedure in which the person making the payment to the foreign person is obligated to withhold the tax and pay it directly to the U.S. government. IRC Code Section 1441. A foreign person is not entitled to apply for a refund on FDAP income.

Example: A corporation invests in General Motors stock and receives $1,000 in dividends. It pays a flat tax of $300.00. The tax is withheld at the source by the agent for the corporation.

California requires withholding on all payments over $1,500 per year on California-source income, including rents received on property located in California, if those payments are made to a non-California resident. Revenue and Taxation Code Sections 18805 and 26131. The rate is a flat 7% of the gross amount received. Unlike federal law, this is merely a withholding of a potential tax. If the actual tax is lower, the taxpayer may apply for a refund. California has a procedure to lower the withholding rate to 2% if significant overwithholding will occur at 7%.

When a foreign taxpayer is engaged in a trade or business in the U.S. ("ETB"), that taxpayer is treated as though he or she were a U.S. taxpayer with respect to the income that is effectively connected to the trade or business. Effectively connected income (ECI") is income which is effectively connected with a trade or business operated by a foreign taxpayer in the U.S. IRC Section 871(b). Foreign individuals who are ETB are taxed at regular individual rates on their ECI.

Example: If an individual conducts business in the U.S. and earns $1,000 in income and has $400 in deductions, he or she pays regular corporate tax under IRC Section 1 on $600 of profits.

With respect to the sale by a foreign person of real property located in the United States, the federal tax code requires withholding of 10% of the purchase price on the sale of real property located in the United States. IRC Section 897(a)(1) and 1445. California requires a withholding of 3.3% from the amount realized on the sale of real property located in California.

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II. Responses to the questions posed in your letter:

1. Approximately $400,000 received as settlement payments in connection with a fraud judgment.

Response: The withholding requirements depend on the nature of the underlying cause of action. Generally, contract damages would be considered ordinary income subject to withholding, but tort damages usually involve compensation for a non-monetary loss and would not be subject to withholding. Also, damages representing a return of capital would be tax-free. Interest earned on the judgment would follow the underlying cause of action: interest on tort damages would not be subject to withholding, but interest on contract damages would be subject to withholding. There could be a 30% tax at the federal level and 7% withholding at the state level, depending on the nature of the damages and whether those damages are sourced in California.

2. Approximately $50,000 in rental income from condominiums owned in San Francisco and Baltimore.

Response: Rental income is FDAP and is subject to a 30% federal tax and 7% state withholding. Under IRC Section 871(d), a taxpayer may elect to be treated as ETB with respect to their rental of U.S. real property and if this election is made, the taxpayer would file as though he or she was a U.S. resident or citizen with respect to the ECI and would pay tax at regular rates. If such an election is made, then there would be no withholding on the federal level. California would require withholding at 7%; I do not know whether Maryland would require withholding.

3. Approximately $150,000 in proceeds from the sale of the San Francisco condominium.

Response: Federal law requires withholding of 10% of the sales price under FIRPTA (IRC Section 897) and California requires withholding of 3.3% of the sale price. There are exceptions to this withholding requirement, depending on the circumstances. For instance, if the purchaser plans to use the property as a principal residence and the sales price is $300,000 or less, there is no withholding requirement.

4. Incidental interest on various accounts.

Response: Generally, interest earned on deposits with persons in the banking business, including savings and loan businesses, are not subject to tax under IRC Section 871(i); consequently, there is no withholding requirement. Conversely, non-bank interest is usually subject to withholding. The withholding rate would be 30% for federal and 7% for state. One must ascertain the identity of the debtor (payor) to determine whether this exception applies. Depending on the source of the interest payment, there could be a 7% withholding requirement imposed by California.