Aerospace & Defense Tax Alert: Government Withholding Tax Update—Section 3402(t)
Unless Congress enacts legislation to further delay the application of withholding tax on government payments, certain payments for products and services made after December 31, 2012 by the federal government and by all state and local governments (other than local governments with less than $100 million of annual expenditures) will be subject to a three percent withholding tax on the gross payment amount. Section 3402(t), imposing this 3% withholding tax requirement on governments, was enacted into law on May 17, 2006 and was originally to be effective for certain payments made after December 31, 2010. The effective date was subsequently postponed to payments after December 31, 2011 in connection with the passage of the American Recovery and Reinvestment Act of 2009. On May 6, 2011, the Internal Revenue Service issued final regulations implementing the 3% withholding requirement and further delaying the effective date to payments made after December 31, 2012. Under the final regulations, contracts that are subject to a binding agreement entered into on or before December 31, 2012, will not be subject to withholding. However, under proposed regulations that were also issued on May 6, 2011, the exception for payments made under existing binding contracts would not apply to payments made on or after January 1, 2014.
Summary of Provision
Pursuant to the Code and final regulations, payments subject to withholding typically include any payment for property or services of more than $10,000 directly by the government payor (or its payment administrator) to any individual, corporation, partnership, trust, estate, and association. The withholding requirement applies to all units of the executive, legislative, and judiciary branches of the federal government as well as all agencies and units of each state government, including all administrative agencies and state-controlled organizations such as public university systems. Withholding would not apply to subsequent transfers by the payment recipient to another person (i.e., a subcontractor). Payments exempted from withholding include, but are not limited to, payments to any tax-exempt entity, payments to a nonresident alien or foreign corporation (if the payment is for sales of goods or services derived from sources outside the U.S.), payments for real property (including payments for the purchase or leasing of land or a completed building, but not for construction of buildings and public works projects or improvements thereto), payments for interest, payments subject to backup withholding, and payments to passthrough entities owned 80% or more by governments subject to the requirements of section 3402(t), foreign governments or tax-exempt entities. Amounts withheld are to be reported to taxpayers on Form 1099-MISC by January 31 of each calendar year and allowed as a credit against taxpayers’ income tax liability.
Legislative Proposals for Repeal
While three different bills have been introduced by the current Congress that would repeal section 3402(t) and a hearing was held, approval of repeal may be unlikely without a revenue or spending offset. An offset may be necessary because even though section 3402(t) has not yet been implemented, there is a projected revenue loss if the provision is repealed. Further, a Congressional Research Service report issued July 18, 2011 concluded that verifiable data does not currently exist to objectively compare the costs with the benefits of implementing the withholding tax.
House Ways & Means Committee Chairman Dave Camp (R-Mich) said in early March that he wants to explore the repeal of 3% withholding, but that immediate action is unlikely. Any potentially successful proposal for repeal would probably need to be attached to a larger tax legislative vehicle, although tax legislation discussions remain extremely fluid.
Impact and Considerations
Assuming section 3402(t) is not repealed, businesses across many industries will be affected if they engage in business with any level of government, including government-owned schools, universities, hospitals, etc. In addition to payments on procurement contracts, Medicare payments to health care providers, Farm payments, and certain grants to for-profit companies would all be subject to the withholding as well.
Companies will need to implement systems to track withholdings and confirm amounts reported on the Form 1099-MISCs received. In addition, companies will require capabilities to access this information on a current basis in order to reduce estimated tax payments for the amounts withheld. For companies receiving numerous government payments per year across multiple locations, tracking withholding amounts will be administratively challenging.
For many government contractors, a 3% withholding significantly affects cash flow, especially if government projects are successfully bid on thin competitive margins, the company subcontracts a significant portion of the contract, or both. The requirement to withhold, however, is based on gross payments made by governments to the prime contractor with no relation to the recipient’s taxable income or on-payments made to subcontractors. Prime government contractors will need to carefully consider the impact of this withholding on its competitive bids as well as the impact on its dealings and agreements with subcontractors. In addition, companies that rely on the full amount of the gross payment to fund day-to-day operations may be forced to seek alternative methods to ensure regular cash flows necessary for operations.
Fiscal year taxpayers should be aware that they’ll be entitled to take a credit for taxes withheld under section 3402(t) only in a taxable year ending after the calendar year in which the amount was withheld. For example, if amounts were withheld under section 3402(t) from a June 30 fiscal year taxpayer during the period from January 1, 2013 to December 31, 2013, the taxpayer will be entitled to take credit for the withheld tax on its income tax return for the fiscal year ending June 30, 2014.
In light of the uncertainties surrounding whether the withholding requirements under section 3402(t) could be further delayed, repealed, or become effective January 1, 2013 in accordance with the recently released final regulations, companies that may be impacted need to consider addressing currently the impact of section 3402(t) withholding. Effected companies should begin by focusing on:
- implementation needs for necessary tracking systems;
- cash flow planning and evaluation of needs for alternative or supplemental financing of daily operations;
- payment arrangements with subcontractors on existing and upcoming long-term contracts;
- affect on competitive bids on long-term contracts where either binding agreements could be entered into on or after January 1, 2013 or payments would be received on or after January 1, 2014;
- and estimated tax payment planning.
If you have any questions regarding the alert, please contact your local Deloitte Tax practitioner or contact:
U.S. Tax Managing Partner, Consumer & Industrial Products
Deloitte Tax LLP
Consumer & Industrial Products | Tax Clients & Markets
Deloitte Tax LLP
Please download the attached article to learn more about additional contacts.