This document contains amendments to 26 CFR Part 1 under sections 367, 954 and 956 of the Internal Revenue Code (Code). Final and temporary regulations (T.D. 9406, 2008-32 I.R.B. 287 [73 FR 38113]) (the temporary regulations) and a cross-reference notice of proposed rulemaking (REG-138355-07, 2008-32 I.R.B. 311 [73 FR 38162]) were published in the Federal Register on July 3, 2008 (the proposed regulations). On July 29, 2008, corrections to the final regulations (73 FR 43863) were published in the Federal Register. No public hearing was requested or held with respect to the proposed regulations. After consideration of the comments received, the proposed regulations are adopted, as amended by this Treasury decision.

Section 415(a) of the American Jobs Creation Act of 2004, Public Law 108-357 (118 Stat. 1418) (Jobs Act), repealed section 954(a)(4) and (f), the foreign base company shipping income provisions of subpart F. As a result of the repeal of these provisions, rents derived from leasing an aircraft or vessel in foreign commerce are included in subpart F income only if the rents are described in another category of subpart F income, such as foreign personal holding company income (FPHCI) as defined in section 954(c). Rents are generally included in FPHCI under section 954(c)(1)(A), subject to certain exceptions. One such exception is for rents received from unrelated persons and derived in the active conduct of a trade or business. See section 954(c)(2)(A).

For this purpose, rents derived by a controlled foreign corporation (CFC) are considered derived in the active conduct of a trade or business in certain circumstances, including circumstances whereby the rents are derived as a result of the performance of marketing functions by the lessor CFC with respect to the leased property (the marketing exception). §1.954-2(c)(1)(iv). Specifically, a lessor satisfies the marketing exception if the lessor, through its own officers or staff of employees located in a foreign country, maintains and operates an organization in the foreign country that is regularly engaged in the business of marketing, or of marketing and servicing, the leased property and that is substantial in relation to the amount of rents derived from leasing the property. For this purpose, whether an organization in a foreign country is substantial in relation to the amount of rents is determined based on all facts and circumstances; however, such an organization will be considered substantial if active leasing expenses equal or exceed 25 percent of the adjusted leasing profit (as defined in §1.954-2(c)(2)(iv)). §1.954-2T(c)(2)(ii).

The Jobs Act amended section 954(c)(2)(A) to expand the marketing exception with respect to rents derived from leasing an aircraft or vessel in foreign commerce. In particular, section 954(c)(2)(A) now provides that “rents derived from leasing an aircraft or vessel in foreign commerce shall not fail to be treated as derived in the active conduct of a trade or business if, as determined under regulations prescribed by the Secretary, the active leasing expenses are not less than 10 percent of the profit on the lease.” In addition, the legislative history to this provision states that the Secretary of the Treasury will make “conforming changes to existing regulations, including guidance that aircraft or vessel leasing activity that satisfies the requirements of section 954(c)(2)(A) shall also satisfy the requirements for avoiding income inclusion under section 956 and section 367(a).” H.R. Conf. Rep. No. 755, 108th Cong., 2d Sess. 402 (2004).

On July 3, 2008, the Treasury Department and the IRS published the proposed regulations providing guidance with respect to the treatment of certain income and assets related to the leasing of aircraft or vessels in foreign commerce under sections 367, 954, and 956 of the Code in light of the Jobs Act changes. These final regulations adopt the proposed regulations with the modifications described herein.

Under current regulations, to satisfy the marketing exception, the lessor must, among other things, maintain an organization that is regularly engaged in the business of marketing, or of marketing and servicing, the leased property and that is “substantial in relation to the rents derived.” §1.954-2(c)(1)(iv). The proposed regulations added a new marketing safe harbor for purposes of determining whether an organization is substantial in relation to rents derived from leasing aircraft or vessels (including component parts, such as engines, that are leased separately from an aircraft or vessel) in foreign commerce. This safe harbor provides that an organization will be considered substantial for purposes of §1.954-2(c)(1)(iv) if active leasing expenses equal or exceed 10 percent of the adjusted leasing profit. For this purpose, the rules in the current regulations for computing active leasing expense and adjusted leasing profit continue to apply. The proposed regulations also included a definition of when an aircraft or vessel is leased in foreign commerce, including defining when property is used predominantly outside the United States, that is consistent with the legislative history to the Jobs Act. See H.R. REP. NO. 108-548, pt. 1, at 210 (2004); H.R. CONF. REP. NO. 108-755, at 402 (2004). Finally, the proposed regulations also clarified that rents derived from certain finance leases and acquired leases are eligible for the active rents exclusion.

One commentator expressed concern that §1.954-2T(c)(2)(vii), which addresses finance leases, could be interpreted to limit the application of the marketing exception solely to finance leases. In response to this comment, the final regulations clarify that the marketing exception can apply to both operating leases and finance leases.

The same commentator also suggested that, for purposes of applying §1.954-2T(c)(2)(vi), the regulations should clarify that “remarketing functions” include remarketing for purposes of selling the leased property. The final regulations adopt this change.

In addition to these changes, the final regulations clarify that an aircraft or vessel is considered to be leased in foreign commerce if it is used in foreign commerce, and is used predominantly outside the United States. Finally, the language of §1.954-2T(c)(3) Example 6 has been modified to make it consistent with the other examples in §1.954-2(c)(3).

Section 956(c)(1)(A) provides that the term United States property (“U.S. property”) generally includes tangible property located in the United States. Section 956(c)(2) provides exceptions to the general definition of U.S. property, including any aircraft, railroad rolling stock, vessel, motor vehicle, or container used in the transportation of persons or property in foreign commerce and used predominantly outside the United States. See section 956(c)(2)(D). Prior to issuance of the temporary regulations, §1.956-2(b)(1)(vi) provided that, as a general rule, such transportation property will be considered to be used predominantly outside the United States if 70 percent or more of the miles traversed (during the taxable year at the close of which a determination is made under section 956(a)(2)) in the use of such property are traversed outside the United States or if such property is located outside the United States 70 percent of the time during such taxable year.

In Notice 2006-48, 2006-1 C.B. 922, the IRS and Treasury Department announced that regulations would be issued providing that an aircraft or vessel used in the transportation of persons or property in foreign commerce is excluded from U.S. property under §1.956-2(b)(1)(vi) if rents derived from leasing such aircraft or vessel are excluded from FPHCI under section 954(c)(2)(A) and such property is considered to be used predominantly outside the United States under §1.954-2(b)(1)(vi), determined by substituting “more than 50 percent” for the phrases “70 percent or more” and “70 percent.” The proposed regulations amended §1.956-2(b)(1)(vi) to provide that an aircraft or vessel is excluded from U.S. property if rents derived from leasing such aircraft or vessel are excluded from FPHCI under section 954(c)(2)(A) but inadvertently omitted the language from Notice 2006-48 concerning its use in the transportation of persons or property in foreign commerce and its predominant use outside the United States. Consistent with section 956(c)(2)(D), the legislative history of section 954(c)(2)(A), and Notice 2006-48, the final regulations modify the proposed regulations to clarify that an aircraft or vessel is excepted from the definition of U.S. property under section 956(c)(2)(D) only if the aircraft or vessel is leased in foreign commerce as that term is defined in §1.954-2(c)(2)(v), and the rents from the aircraft or vessel qualify for the exception to FPHCI under section 954(c)(2)(A). See §601.601(d)(2).

No comments were received and no changes other than the change described herein have been made to the section 956 provisions of the proposed regulations.

No written comments were received and no changes have been made to the section 367 provisions of the proposed regulations.

The Treasury Department and IRS continue to study and request comments on how to determine whether an aircraft or vessel is used predominantly outside the United States during a particular month for purposes of calculating depreciation recapture under section 367. Until further guidance is issued, taxpayers may continue to use any reasonable method to make this determination.

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. Ch. 6) does not apply. Pursuant to section 7805(f) of the Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.367(a)-2 is added to read as follows:

Par. 9. Section 1.954-2T is removed.

Par. 10. Section 1.956-2 is amended by revising paragraphs (b)(1)(vi) and (e) to read as follows:

This document contains amendments to 26 CFR Part 31 under section 3402(t) of the Internal Revenue Code (Code). This document also contains amendments to 26 CFR Part 31 under sections 3406, 6011, 6051, 6071, and 6302 of the Code.

Section 3402(t) of the Code was added by section 511 of the Tax Increase Prevention and Reconciliation Act of 2005, Public Law 109-222 (TIPRA), 120 Stat. 345, which was enacted into law on May 17, 2006. Section 3402(t)(1) provides that the Government of the United States, every State, every political subdivision thereof, and every instrumentality of the foregoing (including multi-State agencies) making any payment to any person providing any property or services (including any payment made in connection with a government voucher or certificate program which functions as a payment for property or services) shall deduct and withhold from such payment a tax in an amount equal to 3 percent of such payment. Section 3402(t)(2) provides exceptions to withholding under section 3402(t).

Proposed regulations under sections 3402(t), 3406, 6011, 6051, 6071, and 6302 of the Code were published in the Federal Register on December 5, 2008 (REG-158747-06, 2009-4 I.R.B. 362 [73 FR 74082]).

After the issuance of the proposed regulations, section 1511 of the American Recovery and Reinvestment Act of 2009, Public Law 111-5 (ARRA), 123 Stat. 115, 355, extended the effective date of section 3402(t) withholding to payments made after December 31, 2011.

Notice 2010-91, 2010-52 I.R.B. 915, provided interim guidance on the application of section 3402(t) to payments by debit cards, credit cards, stored value cards, and other payment cards.

Written comments were received in response to the proposed regulations, and a public hearing was held on April 16, 2009. All comments are available at www.regulations.gov or upon request. After consideration of all the comments, the proposed regulations are adopted as amended by this Treasury decision.

The Treasury Department and the IRS received numerous comments in response to the proposed regulations, all of which were considered in formulating the final regulations. Commenters generally expressed concerns about the administrative burdens of compliance and the revenue effect on persons subject to section 3402(t) withholding. The final regulations are intended to balance the legislative intent to construct a withholding and reporting regime for payments by government entities for property and services (other than those specifically excepted under section 3402(t)(2)) with the goal of alleviating administrative burdens on both government entities required to withhold and persons receiving payments subject to withholding where appropriate.

As discussed in section VIII of the preamble, these final regulations provide an additional one-year extension from the revised statutory effective date of payments made after December 31, 2011. Thus, under the final regulations, section 3402(t) withholding and reporting requirements apply to payments made after December 31, 2012, subject to an exception for payments made under contracts existing on December 31, 2012, that are not materially modified (but see section VIII of this preamble for discussion of accompanying proposed regulations that would apply section 3402(t) withholding and reporting requirements to payments made under all contracts after December 31, 2013, regardless of whether the contract was existing on December 31, 2012, and had not been materially modified).

Section 3402(t)(2)(G) provides that section 3402(t) withholding does not apply to payments by a political subdivision of a State (or any instrumentality of that political subdivision) that makes less than $100,000,000 of payments for property or services annually (other than for payroll or of another type exempt from withholding under the regulations). Consistent with the proposed regulations, the final regulations provide as a general rule that eligibility for the exception for each calendar year is determined based on payments made during the accounting year ending with or within the second preceding calendar year. All payments for property and services during that accounting year, including payments that are less than the $10,000 payment threshold, must be considered except payments qualifying for any of the exceptions under §31.3402(t)-4(a) through (q) of the final regulations (for example, payments to the employees of the government entity that are subject to income tax withholding and thus excludable under §31.3402(t)-4(a) (such as salary payments) and payments to employees of the government entity with respect to their services as an employee that are excludable under §31.3402(t)-4(i) (such as payments of nontaxable fringe benefits)).

Commenters stated that if the political subdivision’s or instrumentality’s yearly payments generally are near $100,000,000, but do not always equal or exceed $100,000,000, the entity could incur considerable expense and difficulty administering withholding in some years but not in others. In addition, providing for withholding in contracts would be problematic and uncertain. Other commenters noted that due to substantial unusual capital spending, a political subdivision or instrumentality could exceed the $100,000,000 threshold in one year, even though the entity usually makes annual total payments well below the threshold. The burden of applying section 3402(t) withholding for a single year because of one year of unusual spending could be considerable.

In response to these comments, the final regulations provide an optional rule under which a political subdivision or instrumentality may average the payments made during any four of the five consecutive accounting years ending with the accounting year that ends with or within the second preceding calendar year. An entity applying this optional rule must keep adequate records for each of the five years for the period of limitations for assessment applicable to the calendar year for which it claimed the exception. This rule is intended to provide a reasonable alternative method of determining expenditures for a political subdivision or instrumentality with an unusually high year of expenditures.

This optional rule will give greater predictability for future years and will allow political subdivisions and their instrumentalities to moderate the effect of unusual years of expenditures. The entity may apply the optional rule at its discretion for any given taxable year and is not required to file a form or otherwise indicate to the IRS that it is using the optional rule. Additionally, under the final regulations, if a political subdivision or instrumentality withholds under section 3402(t), pays (or deposits) the withheld tax, and reports this withholding on payments in any calendar year for which it does not qualify for the section 3402(t)(2)(G) exception under the general rule, but could have qualified under the optional rule, it will be deemed to have waived any right to use the optional rule for that year. Thus, an affected entity should decide before the beginning of the calendar year whether it will rely on the optional rule for that year.

One commenter requested a similar exception for Federal Government entities and State entities with total annual payments of less than $100,000,000. By its terms, section 3402(t)(2)(G) does not apply to the United States Government, States, or instrumentalities of the United States Government or States. Therefore, this comment was not adopted.

The proposed regulations requested comments on how to determine whether an organization is an instrumentality of a government entity. Commenters did not request a definition. The final regulations do not define the term instrumentality, but reserve the issue for future guidance. See §31.3402(t)-2(e). Although the Code contains multiple references to government instrumentalities, neither the Code nor the regulations define the term instrumentality. Several revenue rulings provide guidance on determining whether an organization will be treated as an instrumentality of a government entity for purposes of other Code provisions. See Rev. Rul. 57-128, 1957-1 C.B. 311 (adopting a six-factor test for use in determining what is an instrumentality of a State or a political subdivision thereof for purposes of an exception from the requirement to pay tax under the Federal Insurance Contributions Act (FICA)); Rev. Rul. 65-26, 1965-1 C.B. 444; Rev. Rul. 65-196, 1965-2 C.B. 388; and Rev. Rul. 69-453, 1969-2 C.B. 182. These rulings may be applied by analogy to determine whether an entity is an instrumentality for purposes of section 3402(t) withholding until final guidance is issued defining the term instrumentality for purposes of section 3402(t). See §601.601(d)(2)(ii)(b).

The final regulations reserve for future guidance the issue of the potential application of section 3402(t) withholding to payment card transactions (including payments by credit, debit, stored value, and other payment cards). See Notice 2010-91 and §31.3402(t)-3(e). The Treasury Department and the IRS continue to study whether payments by payment card should be subject to section 3402(t) withholding and, if so, in what manner the withholding should apply. As provided in Notice 2010-91, the section 3402(t) withholding requirements and the related reporting requirements will not apply to any payment made by payment card for any calendar year beginning earlier than at least 18 months from the date further guidance is finalized applying section 3402(t) withholding to payments by payment card. This relief does not apply to convenience checks issued in connection with payment card accounts.

Consistent with the proposed regulations, the final regulations provide that a payment subject to withholding arises when the government entity or its payment administrator pays a person for providing property or services. The final regulations adopt the rule in the proposed regulations that withholding will not apply to any payment that is less than $10,000 (subject to the anti-abuse rule described in section II.B.3 of this preamble).

Commenters generally approved of the concept of a threshold, and many commenters approved of the proposed $10,000 threshold level. However, numerous commenters requested that the threshold be raised, and some commenters requested that the threshold be adjusted each year based on changes in the cost of living.

The final regulations adopt the payment threshold of $10,000, which corresponds to a minimum withholding of $300. This $10,000 threshold level strikes a reasonable balance between alleviating administrative burdens and preserving the legislative intent that the withholding requirement apply broadly. The final regulations do not adopt an annual cost-of-living adjustment to the threshold. Computer processing and transaction systems are becoming increasingly cost-effective so that increasing the threshold annually is not warranted.

Some commenters requested that the payment threshold apply cumulatively rather than to individual payments. Under this suggestion, section 3402(t) withholding would begin to apply when the payee receives payments totaling $10,000 in the aggregate from the government entity during the calendar year, and then apply to all subsequent payments to the payee during the remainder of the year. The final regulations do not adopt this suggestion. As other commenters noted, one section or division of a government entity may not be able to coordinate its billing with another section’s or division’s billing on a real-time basis. Thus, a requirement to withhold immediately upon reaching an annual minimum payment threshold would require the establishment of new systems to track and coordinate payments.

The $10,000 threshold applies on a payment-by-payment basis; therefore, if a government entity makes a single payment of $10,000 or more for multiple items of property or services, the entity must withhold on the payment. For example, if a person bills a government entity $5,000 each day for seven days of daily services, but the entity pays the bills by making one $35,000 payment, the payment threshold is applied to the $35,000 payment.

Consistent with the proposed regulations, the final regulations provide that multiple payments by a government entity to a payee generally will not be aggregated in applying the $10,000 threshold. The final regulations also adopt the anti-abuse rule in the proposed regulations providing that if a payment is divided into multiple payments primarily to avoid the payment threshold, the payments will be treated as a single payment made on the date of the first payment for purposes of applying the threshold. For example, if a government entity is scheduled to make a contractual payment for landscaping services of $15,000 on July 2, 2013, but divides the payment into payments of $7,000 and $8,000 on July 1, 2013, and July 2, 2013, respectively, to avoid withholding, the government entity will be treated as having made a single payment of $15,000 on July 1, 2013. This anti-abuse rule will not apply if the primary reason for making multiple payments is unrelated to section 3402(t).

Some commenters expressed concerns about the anti-abuse rule. Some argued that it was too subjective and would lead to conflicts between government entities and payees. Commenters noted that in many cases, the payee controls the billing and the government entity cannot determine whether the payee manipulated the billing to avoid the threshold or engaged in a normal business practice. Commenters also requested guidance on which entity (the payor or the payee) determines whether the anti-abuse rule applies. Commenters asserted that theoretically every payment below $10,000 will need to be examined to determine whether the anti-abuse rule applies.

An anti-abuse rule is necessary because the parties could potentially avoid the threshold by manipulating the amount of each payment. Because the government entity is responsible for withholding and may not have sufficient information regarding the payee’s billing process, the final regulations provide that the anti-abuse rule applies only if the government entity knew or should have known that the payment had been divided (whether by the government entity or as a result of divided billing) with the primary purpose of avoiding the withholding requirements. The final regulations further provide that in determining whether the anti-abuse rule applies, a significant factor is whether the government entity has exhibited a pattern or practice of intentionally dividing payments (or intentionally permitting divided billing) to avoid withholding. Thus, the anti-abuse rule is intended to apply only in a limited number of cases.

Additionally, the final regulations permit a government entity and a person providing services or property to that government entity to contractually agree that the government entity will or may withhold in accordance with the rules governing withholding under section 3402(t), on specified payments not subject to section 3402(t) withholding, including payments below $10,000. Therefore, the parties could contractually agree to permit the government entity to apply, in its discretion as it deemed appropriate, the anti-abuse rule. This type of contractual provision would enable the parties to avoid disputes about whether the anti-abuse rule applies. This provision in the final regulations permitting additional withholding does not apply to payments already subject to section 3402(t) withholding notwithstanding the contractual provision, including amounts subject to section 3402(t) withholding solely due to the anti-abuse rule.

Commenters objected to applying the threshold to the payment amount where the government entity chooses for its convenience to make one payment for different “unrelated transactions” (which they termed “bundling” the payment), causing the payment to meet the $10,000 threshold. Commenters suggested that if a single payment covers more than one “unrelated” transaction, the threshold should apply separately to each transaction, invoice, or billing item, rather than to the full payment amount. According to these commenters, applying the threshold to bundled payments makes the threshold difficult to program into accounts payable systems because the threshold amount cannot be applied at the time of the transaction but only at the time the payment is processed.

The final regulations adopt the proposed rule applying the threshold on a payment-by-payment basis rather than a billing item basis. A billing item approach would require formulating a method for identifying a billing item or a similar term, which may not be easily identifiable in every case. As a result, disputes would likely arise about the number and amount of valid billing items, raising both compliance issues for government entities and enforcement issues for the IRS. A billing item approach also would require the government entity to maintain records of the items covered by a particular payment, and the supporting documentation justifying the separate billing item treatment, increasing the administrative burden. This approach could also facilitate abuse by parties seeking to avoid the threshold by dividing billing items.

Consistent with the proposed regulations, the final regulations provide that, if a government entity or its payment administrator makes a payment to a person that is subject to section 3402(t) withholding, no subsequent transfer of cash or property by that person to another person is treated as a payment for section 3402(t) purposes. Therefore, if the government entity contracts with a prime contractor for property and services, and that prime contractor separately contracts with subcontractors for delivery of certain property and services, section 3402(t) withholding applies only to payments by the government entity or its payment administrator to the prime contractor, and does not apply to successive payments by the prime contractor to its subcontractors.

Also consistent with the proposed regulations, the final regulations apply to payments made by the government entity or its payment administrator. A payment administrator is any person that acts with respect to a payment solely as an agent for a government entity by making the payment on behalf of the government entity to a person providing property or services to, or on behalf of, the government entity. The government entity is liable for the required withholding and responsible for all related reporting regardless of whether the government entity or its payment administrator makes the payment. Transfers of funds from a government entity to a payment administrator to be used by the payment administrator, on the government entity’s behalf, to pay persons for providing property or services are not payments subject to section 3402(t) withholding. However, if the government entity pays the payment administrator a fee for its services, the fee is a payment subject to withholding.

Many commenters requested additional guidance on the application of section 3402(t) to prime contractors, subcontractors, and payment administrators to specific factual situations. The final regulations adopt the rules in proposed regulations without change. These rules provide general guidance that can be applied to various specific situations and it is not practicable to describe all those situations explicitly in the regulations. However, the Treasury Department and the IRS may issue other forms of guidance in the future if it is determined that such guidance is necessary to assist with particularly problematic situations.

Commenters requested guidance on whether section 3402(t) withholding applies to any of the following payments that are made before the final delivery and acceptance of service by the government entity: contract financing payments, performance-based payments, commercial advance payments, interim payments, progress payments based on cost, progress payments based on a percentage or stage of completion, or interim payments under a cost-reimbursement contract. Commenters requested exceptions for these types of payments because withholding would detrimentally affect the cash flows of contractors and could result in price increases for government contracts. Commenters also argued that in some cases withholding is unnecessary because amounts are already withheld from contract payments until the completion of a contract. Finally, commenters suggested that government entities are protected from loss through other provisions such as the Miller Act (40 USC 3131-3134, discussed in greater detail in section III.E.1 of this preamble).

Commenters specifically requested that section 3402(t) withholding apply to contract financing payments on the date the government entity accepts the services or property provided under the contract. Under Federal Acquisition Regulations (FAR), a contractor is not entitled to liquidate contract financing payments until the government entity has accepted the property or services. On this basis, a commenter asserted that contract financing payments are not payments for property or services until the contract is settled and the property or services are “accepted” by the government entity. The commenter maintained that the payment date for section 3402(t) purposes should be the acceptance date because interest under the Prompt Payment Act (31 USC 3903) for late payments under a contract does not begin to run until the acceptance date.

The final regulations do not adopt these suggestions. Treating the acceptance date as the payment date would add administrative complexity to section 3402(t) withholding, as would any attempt to distinguish between payments in advance of performance by the contractor, interim payments for partial performance, and other designated payments for property or services. Treating the date the funds are disbursed as the payment date ensures that there will be funds upon which to withhold. For these reasons, the final regulations provide that payment is made and withholding applies when the funds are disbursed and not when the contract is settled and the services or property accepted.

The proposed regulations provided that, unless otherwise excepted, utility payments are subject to section 3402(t) withholding on the same basis as payments for other property and services. Commenters requested that utility payments be exempted from the withholding requirement on the ground that utilities are already subject to regulation and that government entities might lose utility services if forced to withhold on payment of the utility bill.

There is no statutory exception for utility payments. In addition, all persons receiving payments subject to section 3402(t) withholding, including utility companies, are paid the full amount charged, albeit in the form of a combination of a cash payment and a deposit of tax made to the IRS. Thus, unless otherwise excepted, utility payments are subject to section 3402(t) withholding.

Commenters requested exemptions from withholding or lower rates of withholding based on a particular industry’s profit margin or a particular payee’s expectation that it will not have any income tax liability (because, for example, the payee had net operating losses). Commenters also requested exemptions for payees that are current in their Federal tax payments. The final regulations do not adopt these suggestions because differing rates for differing industries or taxpayers are not contemplated by the statute and would raise administrative complexities.

In addition, many commenters requested guidance on whether certain types of payments or designated portions of payments are payments for property or services subject to section 3402(t) withholding. The final regulations do not adopt most of these suggestions because the general rules provide sufficient guidance. For example, commenters requested guidance on certain amounts that typically are part of a payment for a specific service or property, but generally are stated separately in invoices to government entities, such as fuel surcharges. The final regulations do not except separately stated costs (other than the optional rule permitting sales, excise, and value-added taxes to be excepted from the amount subject to section 3402(t) withholding). In general, separately stated items such as fuel surcharges are treated as part of the payment for property or services by the government entity, and therefore are subject to section 3402(t) withholding unless an exception applies. For example, the amount subject to withholding includes late payment fees (that are not interest) and shipping and handling costs in connection with the purchase of property that is subject to section 3402(t) withholding.

Commenters also requested guidance on determining the amount subject to withholding when a portion of one payment is subject to withholding, but the remainder of the payment is excepted from withholding. Commenters asserted that it would be difficult to identify which portion of the payment was excepted and to apply withholding only to the remainder. In response to these administrative concerns, the final regulations permit government entities to withhold on the full amount of a payment that combines an amount subject to withholding and an amount excepted from withholding, provided the payee has consented to this additional withholding.

Commenters requested guidance on determining the amount of withholding when a payment for property or services to a person is subject to offsets for the person’s outstanding debt or other amounts owed to the government entity. Because there is no exclusion or other provision under section 3402(t) for offsets, the payment to which the section 3402(t) withholding applies is not reduced by offsets. Rather, the amount of the payment subject to section 3402(t) withholding includes any portion of the payment that is offset to pay debt owed to the government entity or other offsets.

Consistent with the proposed regulations, the final regulations except from section 3402(t) withholding payments to other government entities required to withhold, to foreign governments, and to tax-exempt organizations as provided in section 3402(t)(2)(E). A commenter asked whether the exception for payments to tax-exempt organizations extends to payments that are included in determining the organization’s unrelated business income that is subject to income tax. A payment to a tax-exempt organization is excepted from section 3402(t) withholding regardless of whether it is treated as unrelated business income.

Consistent with the proposed regulations, the final regulations exempt payments to Indian tribal governments. Because Indian tribal governments are not subject to United States income tax, subjecting payments made by government entities to Indian tribal governments to section 3402(t) withholding would be unduly burdensome. In response to comments, the final regulations also exempt payments to passthrough entities that are owned 80 percent or more by one or more persons each of which is an Indian tribal government or a person described in section 3402(t)(2)(E).

Commenters requested guidance on how to identify exempt payees. Exempt payees include: (1) government entities required to withhold under section 3402(t), foreign governments, tax-exempt organizations, and Indian tribal governments; (2) passthrough entities that are 80 percent or more owned by those types of entities; and (3) nonresident alien individuals and foreign corporations that receive certain types of payments (and partnerships that receive certain types of payments and that are 80 percent or more owned by nonresident alien individuals and foreign corporations). The Treasury Department and the IRS expect to issue additional guidance on how a payee can claim an exemption. The guidance is expected to provide that if the government entity receives a payee statement indicating under penalties of perjury that the payee qualifies for an exemption from section 3402(t) withholding and identifying the particular exemption, the entity will be able to rely on that statement unless it knew or had reason to know that the payee did not actually qualify for the exception. The guidance is also expected to provide that a government entity need not obtain a payee statement if the name of the payee reasonably indicates or the payor knows the payee to be a government entity (including an Indian tribal government) or foreign government. However, it is not anticipated that this “eyeball” test would apply to tax-exempt organizations, foreign corporations, nonresident alien individuals, or passthrough entities.

Section 3402(t)(2)(C) excepts payments of interest from section 3402(t) withholding. Two commenters requested that a definition of interest be provided, and other commenters inquired whether certain specific types of payments are payments of interest for purposes of this exception.

The Code and the regulations do not provide a general definition of interest. Rather, a definition of interest has arisen through case law. Generally, under long-standing case law, interest is compensation paid for the use or forbearance of money. See, for example, Old Colony R.R. Co. v. Commissioner, 284 U.S. 552 (1932), 1932-1 C.B. 274; Deputy v. DuPont, 308 U.S. 488 (1940), 1940-1 C.B. 118; see also Thompson v. Commissioner, 73 T.C. 878, 887 (1980) (interest is the charge per unit of time for the use of borrowed money); Dickman v. Commissioner, 465 U.S. 330, 337 (1984), 1984-1 C.B. 197 (interest is the equivalent of rent for the use of funds). The general standard, as developed through the case law, may be applied to particular facts and circumstances. Thus, the final regulations do not provide a definition of interest. However, the Treasury Department and the IRS continue to study whether any particular guidance with respect to the application of section 3402(t) to interest payments may assist taxpayers in complying with the section 3402(t) withholding and reporting requirements, and accordingly continue to reserve that section. See §31.3402(t)-4(c).

Section 3402(t)(2)(D) excepts payments for real property from section 3402(t) withholding. Consistent with the proposed regulations, the final regulations provide that the term payments for real property includes payments for the purchase and the leasing of real property, but does not include payments for the construction of buildings or other public works projects, such as bridges or roads.

Commenters requested that payments for construction be treated as payments for real property. One commenter interpreted 40 USC 3131-3134 (the “Miller Act”) as already protecting the Federal Government for taxes owed by the contractor. The commenter stated that the Miller Act mandates that the contractor provide a performance bond to protect the Government, and a separate payment and performance bond to protect all persons supplying labor and material in carrying out the work provided for in the contract. According to the commenter, the protection afforded by these bonds includes taxes due under the Code. See 40 USC 3131(c)(1).

The tax protection afforded by these bonds relates to employment taxes deducted from wages, not to income taxes which the contractor may owe. Therefore, these performance bonds do not protect against a contractor’s failure to pay its correct income tax liability, and the Miller Act does not provide the Federal Government protection for the contracting entity’s income tax liability.

Another commenter suggested that treating payments for construction as payments for real property would be consistent with other tax provisions, including section 460(e)(4) and §1.460-3(a) (defining the term construction contract for purposes of determining whether an exception from the required use of the percentage of completion method in determining taxable income applies), and §1.263A-8 (defining the term real property to include land, buildings, and inherently permanent structures, and the structural components of both buildings and inherently permanent structures for purposes of the requirement to capitalize interest under section 263A). Another commenter cited other Code sections and regulations, including: (1) section 469 (relating to passive activity losses and credits and providing that a “real property trade or business” includes “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business”); (2) section 856 (defining “interests in real property” to include “fee ownership and co-ownership of land or improvements thereon, leaseholds of land or improvements thereon, options to acquire land or improvements thereon, and options to acquire leaseholds of land or improvements thereon”); and (3) §1.1031(a)-1(b) (relating to like-kind exchanges and providing that the fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class).

The final regulations do not adopt these suggestions. None of these authorities provides as a general rule that payments for construction are payments for real property. Moreover, the Code and regulations sections cited serve different purposes. The relevant distinction here is between payment for a completed building (a payment for real property), and payment for the services and materials used to construct a building (not a payment for real property). There is no evidence that Congress intended to exempt payments for construction. Additionally, an exemption for construction would substantially reduce the scope of payments subject to section 3402(t) withholding.

The proposed regulations provided that the exemption for payments for real property extends to payments for the leasing of real property. A commenter asked whether payments for construction in leased buildings are treated as payments for real property if the government entity pays the person providing the property or services directly for facility improvements rather than the lessor. Commenters also asked whether payments to the lessor for services or property (such as for utilities or insurance) or for services under the lease agreement (such as for utilities provided at the lessor’s expense) are considered payments for the lease. In addition, commenters asked whether payments to third parties required by the lease agreement (such as payments for utilities and insurance) are considered payments for the lease.

The final regulations distinguish between payments to the lessor as part of the lease and payments to a third party. Payments to the lessor that are required under the lease agreement, such as payments for utilities or insurance, are payments for leasing, and are not subject to section 3402(t) withholding. In contrast, payments to third parties for services or property are subject to section 3402(t) withholding, even if required by the lease. Thus, under the final regulations, the lease terms generally govern whether payments for leasehold improvements and for services or property in connection with a lease are subject to section 3402(t) withholding. However, because of the potential to avoid the application of withholding to payments for construction by temporarily leasing before purchasing, rather than simply purchasing, the property on which the construction will occur, payments for construction are subject to section 3402(t) withholding even if required by a lease and paid to the lessor.

Section 3402(t)(2)(A) excepts from section 3402(t) withholding amounts that are subject to withholding under another provision of chapter 3 or chapter 24 (other than section 3406). Commenters asked whether unpaid compensation paid to beneficiaries or the estates of deceased employees is subject to section 3402(t) withholding. Although such amounts generally are not subject to wage withholding under section 3402(a) (see Rev. Rul. 86-109, 1986-2 C.B. 196), the final regulations provide that these payments are excepted from section 3402(t) withholding under section 3402(t)(2)(I) as payments to an employee.

Section 3402(t)(2)(F) excepts payments made pursuant to a classified or confidential contract described in section 6050M(e)(3). Commenters asked whether this exception applies to other government operations not specifically covered by section 6050M(e)(3), recommending that the exception apply to any contract whose subject matter contains any scope of work subject to the National Industrial Security Program Operating Manual (NISPOM). Because of the express statutory language describing the confidential contracts to which the exception applies, the final regulations do not extend the exception beyond contracts described in section 6050M(e)(3).

Section 3402(t)(2)(H) excepts from section 3402(t) withholding any payment in connection with a public assistance or public welfare program for which eligibility is determined by a needs or income test. Consistent with the proposed regulations, the final regulations adopt a broad definition of in connection with to include payments made to third parties under a public assistance or public welfare program for the benefit of the recipient of benefits under the program. Consistent with the legislative history, a program for which eligibility is determined under a needs or income test does not include a program under which eligibility is based on age only (for example, Medicare). For purposes of this exception, a program providing disaster relief to victims of a natural or other disaster is considered to be a program for which eligibility is determined under a needs test.

Many commenters asked that the regulations address specific benefits under various plans. Questions about specific plans can be resolved by applying the statute and these final regulations, and special rules are not needed. However, the Treasury Department and the IRS may issue other guidance in the future, as necessary to address arrangements to which it is particularly difficult to determine the application of the statute and these final regulations.

Commenters asked how section 3402(t) applies when a government office or portion of a government office is used to administer a public welfare program. Commenters asked whether payments for expenses of that office (utilities, property insurance, maintenance) that are attributable to administering the public welfare program qualify as payments made in connection with a public welfare program under section 3402(t)(2)(H). The final regulations provide that government entities may determine the portion of any payment that is attributable to expenses to administer the public welfare program using any reasonable allocation method (including, for example, using prospective budget allocations). To ease administration, the final regulations also provide that, if a government entity makes a reasonable, good faith determination that only an insignificant portion of the government office’s payments are attributable to administering a public welfare program (or to functions other than administering a public welfare program), that insignificant portion may be disregarded.

Section 3402(t)(2)(I) excepts payments to a government employee for the employee’s services as an employee. Consistent with the proposed regulations, the final regulations interpret this exception broadly to exclude any form of compensation that is paid to the employee or on the employee’s behalf. For example, the final regulations exclude employer and employee contributions to employee benefit and deferred compensation plans, employer-provided fringe benefits, and employer payments for insurance under the Federal Employees Health Benefits Program.

The final regulations further provide that, consistent with the proposed regulations, the section 3402(t)(2)(l) exception applies to payments to employees under an accountable plan for the employee’s business travel expenses, and to payments made by the employee to providers of the employee’s travel, meals, and lodging when the employee is traveling on government business and is reimbursed under the accountable plan. Payments to an employee made under a reimbursement or other expense allowance arrangement that do not exceed the substantiated expenses are treated as paid under an accountable plan and are not wages if the arrangement meets the requirements of section 62(c) and the expenses are substantiated within a reasonable period of time. See §31.3401(a)-4(a). In contrast, payments to an employee under a nonaccountable plan are includible in wages subject to income tax withholding under section 3402(a), and thus are excepted from section 3402(t) withholding by section 3402(t)(2)(A).

Commenters requested that payments by a government entity to third party providers (and not to an employee) for employee travel and lodging also be excepted from section 3402(t) withholding, arguing that these payments are another way to pay for employee business travel expenses and should be excepted in the same manner as payments made under accountable plans. Commenters argued that applying withholding in this instance will complicate the travel arrangement process, reduce the use of more efficient central billing accounts, and create unjustified discrepancies in travel expense reimbursements based on the employer method of payment.

The section 3402(t)(2)(I) exception by its terms applies only to payments to employees (or their successors in interest). If the government entity pays a provider directly for employee travel expenses, there is no payment from the government entity to the employee to invoke this exception. Payments to the provider by the government entity are payments for property and services, and therefore subject to section 3402(t) withholding unless another exception applies. The exception for employee fringe benefits does not apply where a payment is made directly to the provider because, while related to the provision of a fringe benefit to the employee, the payment itself is not a fringe benefit and is made to a third party rather than to the employee. However, payments made by payment card are excepted pending future guidance. See Notice 2010-91.

The proposed regulations did not provide an explicit exception for grant payments. Commenters requested that all grant payments be excluded from section 3402(t) withholding because they are “non-exchange” transactions in which the government entity is not making a payment for property or services for the direct benefit or use of the government entity. According to commenters, grant payments are distinguishable from payments in a transaction with a vendor in which a government entity is directly purchasing property or services for its own benefit or use.

Commenters also recommended that section 3402(t) withholding not apply to the use of grant funds by grant recipients that are complying with the grant eligibility and award process. One commenter cited the example of a city or county fire department that receives a grant from a government entity specifically for the purchase of an emergency response vehicle. If the purchase of an emergency response vehicle by the local fire department were subject to section 3402(t) withholding, the commenter maintained the withholding would divert federal grant money from the authorized acquisition use into the three percent withholding process.

In cases where the grant recipient is another government entity or a tax-exempt organization, the grant payment will be excepted from section 3402(t) withholding under section 3402(t)(2)(E). In addition, grant payments may qualify as payments made in connection with a public assistance or public welfare program for which eligibility is determined by a needs or income test, and thus be excepted from withholding under section 3402(t)(2)(H). Thus, it seems likely that many grant payments will qualify for these statutory exceptions.

In light of the administrative difficulty and potential frustration to the intended use of the grant proceeds that may arise, the final regulations explicitly except all grants from section 3402(t) withholding. For this purpose, the final regulations define a grant as a transfer of funds by a government entity to a recipient (which may be a state government, local government, or other recipient) pursuant to an agreement reflecting a relationship between the government entity and the recipient when (1) the principal purpose of the relationship is to transfer a thing of value to the recipient to carry out a public purpose of support or stimulation authorized by law instead of acquiring (by purchase, lease, or barter) property or services for the direct benefit or use of the government entity; and (2) substantial involvement is not expected between the government entity and the recipient when carrying out the activity contemplated in the agreement.

The exception from section 3402(t) withholding for grants does not apply to the distribution of grant proceeds by a government entity. Commenters’ suggestions that grant proceeds be permanently excepted from withholding if the grant recipient is using the proceeds for the purposes specified in the grant is not supported by the statute and would be difficult to administer. Tracing would be required to determine which government entity purchases had been made with grant proceeds. Tracing would be particularly difficult if the grant agreement does not identify specific uses for the proceeds (for example, to purchase items necessary to improve emergency response time, which may include an additional emergency response vehicle) or if only a portion of a payment consists of grant proceeds. Accordingly, the final regulations do not adopt this suggestion.

Commenters requested guidance on whether the payment subject to withholding includes the amount of any sales tax, excise tax, or value-added tax. Sales taxes are generally paid by the purchaser, collected by the vendor, and remitted to the state. The sales tax amount generally is not included in the vendor’s gross income.

By comparison, information reporting under section 6041 and related backup withholding under section 3406 apply only to payments that are includible in the payee’s income. Therefore, if the payee is liable for sales tax and the payor includes the amount of sales tax in the total payment to the payee, the payor includes the amount of sales tax on Form 1099-MISC, “Miscellaneous Income,” as part of the reportable payment. In contrast, if (as is generally the case) the payor is liable for any sales tax and the payee merely collects sales tax from the payor, the payor does not include sales tax in the total amount reported on Form 1099-MISC.

A different reporting rule applies to reportable payment card transactions under section 6050W. Section 1.6050W-1(a)(6) provides that the gross amount reportable on Form 1099-K, “Merchant Card and Third Party Network Payments,” is the total dollar amount of aggregate reportable payment transactions for each participating payee without regard to any adjustments for credit, cash equivalents, discount amounts, fees, refunded amount or any other amounts. Thus, the gross amount reported on Form 1099-K includes the amount of sales tax, excise tax, or value-added tax paid as part of a payment transaction.

Similar to reporting under section 6050W, but in contrast to reporting under section 6041, section 3402(t) withholding does not depend on whether an amount is includible in gross income. The entire amount paid for property or services is subject to withholding regardless of whether the vendor realizes a profit on transactions covered by the payments. Accordingly, the final regulations provide that the amount subject to withholding and reporting includes any sales, excise or value-added tax. However, the final regulations also permit government entities to exclude the amount of any sales, value-added, or excise tax, for purposes of section 3402(t) withholding, provided the exclusion is applied consistently to all payments to a given payee during the calendar year. This rule is similar to the rules permitting payors to exclude the amount of the wager from gambling winnings for reporting and withholding purposes under §31.3406(g)-2(d)(2) or to exclude commissions and option premiums in determining gross proceeds from securities sales for reporting purposes under §1.6045-1(d)(5).

Commenters requested guidance on whether loan guarantees provided by government entities and payments on loan guarantees are subject to section 3402(t) withholding. The final regulations provide that the loan guarantee itself (meaning a guarantee provided by a government entity on a loan by a lender) is not a payment subject to section 3402(t). The underlying amounts are still loans and guaranteeing a loan or making a loan that is expected to be repaid through the payment of principal and interest is not a payment for property or services.

Payments of principal and interest by the government entity as guarantor of the loan so that the borrower can continue performing services under the contract are also not subject to withholding under section 3402(t). The government entity is making these payments as guarantor of the loan, and the payments are being made to the lender, not to a third party contractor that is performing services or transferring property. Thus, the final regulations provide that government entity payments of principal and interest on a loan pursuant to a loan guarantee are not subject to section 3402(t) withholding.

Under some circumstances, borrowers use the funds from guaranteed loans to fund a specific project. As part of a loan guarantee, the government has the right to assume the operation of the underlying project if the borrower ceases making payments on the loan. If the government entity (through a right of subrogation) assumes the operation of the underlying project, the government entity as the operator of the project makes payments to the contractors providing services and property for the project. In that case, payments by the government entity to third party contractors are payments for property or services. Although the government exercised its right of subrogation pursuant to the loan guarantee or the underlying loan, and not as a party to the underlying contract between the borrower and the third party contractors, the government is stepping into the borrower’s shoes and making payments for property or services directly to the third party contractors. Accordingly, the final regulations provide that section 3402(t) withholding applies in that case.

Commenters requested clarification that a government entity’s repayments of principal on a loan are not subject to section 3402(t) withholding. Generally, repayments of principal on a loan will not be subject to section 3402(t) withholding because they are not payments for property or services. However, if a government entity issues a debt obligation to a person providing services as part of the purchase price, the debt’s fair market value is subject to section 3402(t) withholding when the obligation becomes effective, unless an exception applies. If a government entity issues a debt obligation to a person providing property as part of the purchase price, the debt’s issue price as determined under section 1273 or 1274, as applicable, is subject to section 3402(t) withholding unless an exception applies (for example, the exception for payments for real property will apply to a debt obligation issued as part of a government entity’s purchase of real property). For administrative convenience, the regulations allow the government entity and the person providing property to agree to use the stated principal amount of the debt obligation in lieu of the issue price as the amount of the payment attributable to the debt obligation that is subject to section 3402(t) withholding. Thus, for example under these rules, if a government entity pays a person in 2013 for the performance of services with $50,000 cash and a 5-year note valued at $50,000, then the note’s fair market value would be subject to section 3402(t) withholding in 2013 along with the cash payment, but the repayment of the principal after the note matured in 2018 would not be subject to section 3402(t) withholding. If a government entity uses a third party debt obligation (a debt obligation issued by another government entity or by an entity other than a government entity) to pay for property or services, the fair market value of the debt obligation is subject to section 3402(t) withholding, unless an exception applies.

The final regulations also except payments to purchase stock, bonds, and other negotiable instruments primarily for investment purposes. Although these payments are for intangible property, withholding on purchases in stock and bond markets is not practicable given the functioning of the investment markets in which buyers and sellers are paired on a virtually anonymous basis. However, a government entity’s payment of investment advisory fees to investment advisors (including a payment from the government entity’s account) is a payment for services subject to section 3402(t) withholding. In contrast, investment advisory fees paid, for example, by a mutual fund in which a government entity owns shares are not subject to section 3402(t) withholding, since these payments are not made by the government entity.

The final regulations generally adopt the same basic rules as the proposed regulations on applying section 3402(t) where either the payor or the payee is a partnership or S corporation (a passthrough entity). Payments from a passthrough entity generally are not subject to section 3402(t) withholding unless 80 percent or more of the passthrough entity is owned in the aggregate by government entities required to withhold under section 3402(t)(1). Similarly, payments to a passthrough entity generally are subject to section 3402(t) withholding unless 80 percent or more of the passthrough entity is owned in the aggregate by persons described in section 3402(t)(2)(E) (government entities required to withhold under section 3402(t)(1), tax-exempt entities, and foreign governments) and Indian tribal governments. Expanding on the exceptions in the proposed regulations, the final regulations additionally provide that certain payments to a partnership that is 80 percent or more owned by foreign corporations or nonresident alien individuals are not subject to section 3402(t) withholding. This exception does not apply to S corporations because nonresident alien individuals and foreign corporations are not permissible shareholders of an S corporation under section 1361(b)(1). The regulations also provide that, as a general rule, whether a passthrough entity is subject to section 3402(t) is determined on the first day of the passthrough entity’s taxable year. However, any manipulation of the ownership percentage with intent to avoid application of section 3402(t) will be recharacterized as appropriate to reflect the actual ownership percentage. Because the government entity is responsible for withholding and may not have sufficient information regarding the payee’s ownership structure, the final regulations provide that this rule applies only if the government entity knew or should have known that the payee’s ownership percentage had been manipulated with intent to avoid application of section 3402(t).

Commenters requested that payments to all passthrough entities be excepted from section 3402(t) withholding. The final regulations do not adopt this suggestion. A passthrough entity exemption would create opportunities for payees to circumvent section 3402(t) by using passthrough entities to receive government payments.

The final regulations adopt the same reporting and payment rules for section 3402(t) withholding purposes as the proposed regulations. Final regulations under section 6011 provide that the payor required to withhold under section 3402(t) must file Form 945, “Annual Return of Withheld Federal Income Tax,” reporting the amounts withheld. Final regulations under section 6302 provide that the amounts withheld under section 3402(t) must be deposited and reported in the same manner as other nonpayroll withheld amounts, such as withholding on gambling winnings and pensions. Pursuant to existing regulations, these amounts are treated as if they were employment taxes for purposes of the deposit rules, but are subject to special rules for determining the payor’s deposit schedule. See §31.6302-4. Additionally, final regulations under section 6051 provide that payors required to withhold amounts under section 3402(t) must file information returns and furnish payee statements on Form 1099-MISC, “Miscellaneous Income” (or any successor form), reporting such payments and tax withheld. Because this reporting is pursuant to regulations under section 6051, the exceptions provided in the regulations under section 6041 relating to Form 1099 do not apply.

Commenters requested that the regulations permit fiscal year taxpayers to credit amounts withheld against their income tax liability for the fiscal year in which the tax is withheld. The final regulations do not adopt this suggestion because it is inconsistent with the statute. Section 31 governs the taxable year against which a taxpayer may credit income tax. Section 31(a)(1) provides that “[t]he amount withheld as tax under chapter 24 shall be allowed to the recipient of the income as a credit against the tax imposed by this subtitle.” Chapter 24 includes section 3402(t), and section 31(a)(1) is in subtitle A, income taxes. Thus, by its terms, section 31(a)(1) applies to persons who have had income tax withheld from a payment pursuant to section 3402(t). Section 31(a)(2) provides the general rule on the timing of the allowance of the credit allowed under section 31(a)(1): “The amount so withheld during any calendar year shall be allowed as a credit for the taxable year beginning in such calendar year. If more than one taxable year begins in a calendar year, such amount shall be allowed as a credit for the last taxable year so beginning.” Thus, absent a special rule, section 31(a)(2) generally applies for purposes of withholdings required under chapter 24, which includes section 3402(t).

Section 31(c) provides a special rule solely for backup withholding. Under section 31(c), any credit allowed by section 31(a) for backup withholding under section 3406 must be allowed for the taxable year of the recipient of the income in which the income is received. Section 31(c) is limited by its terms to section 3406 withholding only, and thus does not apply to section 3402(t) withholding.

Practical considerations also support the section 31(a)(2) crediting rule. Taxpayers generally will have received Forms 1099-MISC reporting the withholding prior to filing income tax returns crediting the income tax withheld, promoting accuracy in return filing.

Commenters requested that taxpayers be permitted to credit the income tax withheld against the estimated tax liability for the specific tax quarter in which the income tax is withheld. However, the Code specifically provides that crediting for estimated tax purposes occurs in the taxable year in which the tax withheld may be taken as a credit against income tax liability. See sections 6654(g)(1) and 6655(g)(1)(B). Thus, the final regulations do not adopt this comment.

Many commenters requested that taxpayers be permitted to credit their section 3402(t) withholding against employment taxes on wages or other taxes. The final regulations do not adopt this suggestion. Section 3402(t)(3) directs that crediting occur under the rules in section 31(a), which provides for crediting against income tax. As noted in the preamble to the proposed regulations, if a statute permits income tax payments to be treated as employment tax payments, or vice versa, it makes specific provision for that treatment. See, for example, section 3510(b) (providing that domestic employment taxes are treated as taxes due for estimated tax purposes under section 6654); and section 31(b) (providing for the crediting against income tax of the special refund of social security tax under section 6413(c) applicable when an employee receives wages from two or more employers in excess of the social security contribution and benefit base). The Code does not provide for section 3402(t) withholding to be treated as payments of the taxpayer’s employment tax liability. In addition, payments of income tax and employment taxes occur under different processes, using different forms, and are subject to different procedures for corrections of underpayments and overpayments, as well as different audit procedures and potential penalties. Therefore, the crediting of an amount withheld for income tax against an employment tax obligation is not administratively feasible.

Amounts withheld on payments to passthrough entities are subject to the same crediting rules as payments made to other entities. Thus, a passthrough entity with a fiscal year may only claim the credit for its fiscal year beginning in the calendar year during which the amount was withheld pursuant to section 31(a)(2). The timing of when the owners of the passthrough entity take into account the credit would then be determined under the rules applicable to that type of passthrough entity (for example, section 706 for a partnership). Commenters specifically asked how the credit would be allocated by a partnership. This allocation is governed by the rules set forth in §1.704-1(b)(4)(ii), with appropriate adjustments under section 705.

Commenters requested clarification that a government entity is liable for tax that the entity was required to withhold under section 3402(t) but did not withhold, unless the entity can demonstrate that the payee has paid its income tax liability. Commenters also requested clarification of the rules applicable to corrections of overwithholding and underwithholding, and guidance on the effect of repayments, underpayments, or overpayments for services or property on the determination of section 3402(t) liability.

Section 3402(t)(3) provides that, for purposes of sections 3403 and 3404 and for purposes of so much of subtitle F (except section 7205) as relates to Chapter 24, Collection of Income Tax at Source, payments to any person for property or services that are subject to withholding are treated as if the payments were wages paid by an employer to an employee. If a government entity fails to withhold the tax imposed by section 3402(t), section 3403 applies to determine the government entity’s liability.

Section 3403 provides that the employer is liable for the payment of tax required to be deducted and withheld under Chapter 24, and is not liable to any person for the amount of that payment. Section 31.3403-1 of the Employment Tax Regulations provides that every employer required to deduct and withhold the tax under section 3402 from an employee’s wages is liable for the payment of the tax whether or not the employer collects the tax from the employee. If the employer fails to withhold all or part of the amount required to be withheld, and thereafter the employee pays the tax, section 3402(d) provides that the tax will not be collected from the employer. Thus, for purposes of section 3402(t), the government entity generally will be liable if it fails to withhold unless under section 3402(d) it can demonstrate that the contractor reported the amount subject to section 3402(t) withholding on its return and paid the income tax due (which may include payment through an amended return or settlement of an audit).

Pursuant to section 3402(t)(3), the rules for adjustments of overpayments or underpayments of income tax withholding on wages also apply to section 3402(t) withholding. See section 6413, §31.6413(a)-2(c)(1), and §31.6413(a)-1(b)(1)(i) (repayments and reimbursements to employees of overwithholding, and correction of overpayments of income tax withholding); section 6205 and §31.6205-1 (corrections of underpayments of income tax withholding). If an error is discovered before a return is filed, the payor must report on the return and pay to the IRS the correct amount of income tax withholding. Corrections of overwithholding or underwithholding of income tax before the return is filed are not adjustments, and a payor that discovers an error before a return is filed but does not report and pay the correct amount of tax to the IRS may not later correct the error through an adjustment.

For purposes of correcting overpayments of income tax withholding, a payor must repay or reimburse the overwithheld income tax to the payee in the same calendar year as the original payment in order to make an adjustment. The payor can then make that adjustment on its return at any time before the period of limitations on credit or refund under section 6511 expires for that calendar year. If the amount of the overwithheld income tax is not repaid or reimbursed to the payee in the same calendar year as the original payment, there is no overpayment to be adjusted; rather the amount withheld will be credited to the payee and subject to a potential tax refund. However, an adjustment may be made to correct an administrative error (that is, an inaccurate reporting of the amount actually withheld).

For purposes of correcting underpayments of income tax withholding, an adjustment can generally only be made in the same calendar year as the original payment. An exception to this general rule applies to corrections for administrative errors (that is, an inaccurate reporting of the amount actually withheld).

Pursuant to section 3402(t)(3), the rules for claims for refund of income tax withholding on wages also apply to section 3402(t) withholding. See section 6414 and §31.6414-1. Section 6414 permits refunds of income tax withholding only to the extent the amount of the overpayment was not actually deducted and withheld from the payee.

Amounts withheld under section 3402(t) are reported on an annual Form 945. Accordingly, any corrections of overwithholding or underwithholding during the calendar year are not adjustments; the government entity must report and pay to the IRS the correct amount of tax on Form 945. For example, if a government entity pays an amount subject to section 3402(t) withholding in error to a contractor and the contractor repays the net amount to the government entity within the same calendar year, the government entity should not report the amount and the related withholding on the annual Form 945 (that is, the government entity should report and pay the correct amount of tax on Form 945). Because the correction is made before the return is filed, the correction does not constitute an adjustment. The government entity may reduce its deposit of other withholding reportable on Form 945 for that calendar year to account for the deposit of section 3402(t) withholding on the amount repaid by the contractor. If the contractor repays the government entity an amount in a later calendar year, no adjustment can be made because an adjustment is permitted only in the case of an administrative error (an inaccurate reporting of the amount actually withheld) discovered after the filing of the Form 945. The contractor already received a credit for the amount withheld under the general rules for crediting income tax withholding.

Similarly, the government entity can collect underwithholding only during the same calendar year as the payment (except corrections made in the case of administrative errors). If the underpayment is discovered in a later calendar year, the government entity is liable under section 3403 for any amount that should have been withheld, unless under section 3402(d) it can demonstrate that the contractor reported the amount subject to section 3402(t) withholding on its return and paid the income tax due (which may include payment through an amended return or settlement of an audit). The contractor is liable for any income tax due on any payment subject to withholding regardless of whether the government entity actually withholds any amount from the payment.

The final regulations provide that the $10,000 payment threshold applies to the actual payment made by the government entity, even if the amount of the actual payment is incorrect. For example, if an excessive payment is subject to section 3402(t) withholding, the subsequent repayment of all or a portion of the initial payment does not affect whether the $10,000 threshold was met with respect to the initial payment. Any correction of income tax withholding applies only to the withholding on the amount repaid and not to the remaining portion of the original payment, even if that remaining portion is less than $10,000. Similarly, if the payment was less than $10,000 due to an insufficient payment to the payee, the $10,000 threshold applies separately to the initial payment and the subsequent payment (to make up for the insufficient payment) unless the anti-abuse rule applies (that is, unless the payment was divided into two or more payments primarily to avoid the $10,000 payment threshold).

Numerous commenters indicated that an extended period of time following the issuance of final regulations would be necessary for government entities to adopt the systems and processes necessary to comply with the §3402(t) withholding and related reporting requirements. Noting the necessity to formulate government acquisition rules that are consistent with the final regulations, as well as the infrastructure needed to apply those rules, some commenters stated that government entities would need at least 18 months from the issuance of final regulations under section 3402(t) to be able to comply.

In response to these practical considerations, the final regulations provide that the withholding and reporting requirements under these regulations apply to payments made after December 31, 2012, subject to an existing contract exception. Thus, under the regulations, payments made under written binding contracts in effect on December 31, 2012, are not subject to section 3402(t) withholding, while payments made after December 31, 2012, under contracts entered into after December 31, 2012, are subject to section 3402(t) withholding unless otherwise excepted. In addition, if an existing contract is materially modified after December 31, 2012, the contract ceases to be an existing contract and payments under the contract become subject to section 3402(t) withholding. With respect to payments before January 1, 2013, government entities are not required to apply section 3402(t) withholding and the related reporting, and accordingly will not be subject to any liability, penalties or interest for failure to do so.

Commenters requested that the material modification rule be removed because of the difficulty in determining whether it applies. Commenters anticipated disputes between parties about what constitutes a material modification and questioned how such disputes would be resolved. Certain commenters also requested that a mere contract renewal not be considered a material modification. Some commenters suggested that, in lieu of a material modification rule, withholding should apply to all contracts after a certain effective date, including those that have not been materially modified.

In response to these comments, at the same time that these final regulations are being issued, the IRS and the Treasury Department are proposing regulations to provide that the exception for payments made under existing contracts will not apply to payments made on or after January 1, 2014. See REG-151687-10. Thus, under these proposed regulations, payments on or after January 1, 2014, under all contracts (existing and new) would be subject to withholding under section 3402(t) unless an exception applies.

The final regulations retain the material modification rule but provide that a mere contract renewal will generally not be considered a material modification. For this purpose, a modification is not a material modification unless it materially affects either the payment terms of the contract or the services or property to be provided under the contract. Thus, for example, a change order (meaning a change in the specifications of a contract that the government entity is authorized to make under the contract without the contractor’s consent) generally would not be a material modification unless the change materially affected the price or other payment terms, or the services or property to be provided. The final regulations also provide that modifying a contract to conform to changes in the applicable law is not a material modification.

Several commenters requested guidance on the application of section 3402(t) withholding to payments under Medicare provider agreements. Under the final regulations, Medicare provider agreements in effect as of December 31, 2012, are existing contracts for purposes of the existing contract exception unless materially modified after December 31, 2012. Additionally, renewals of Medicare provider agreements will not be treated as material modifications to the extent the agreement is modified to conform to federal law. As with other existing contracts, the proposed regulations issued with these final regulations would provide that payments made by government entities on or after January 1, 2014, under both existing and new Medicare provider agreements will be subject to section 3402(t) withholding.

Consistent with the proposed regulations, the final regulations provide a transition rule for payments for property and services made before January 1, 2014. Under this rule, a government entity will not be liable for interest and penalties for failure to withhold on payments for property or services made before January 1, 2014, if the entity made a good faith effort to comply with section 3402(t). However, this rule does not relieve the entity from liability for the amount of tax required to be withheld under section 3402(t).

These regulations apply to payments made after December 31, 2012. In addition, the regulations will not apply to payments under a contract existing on December 31, 2012, unless the contract is materially modified after December 31, 2012.

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation, and because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Paragraph 1. The authority citation for part 31 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Sections 31.3402(t)-0, 31.3402(t)-1, 31.3402(t)-2, 31.3402(t)-3, 31.3402(t)-4, 31.3402(t)-5, 31.3402(t)-6, and 31.3402(t)-7 are added to read as follows:

This document contains proposed amendments to 26 CFR Part 31 under section 3402(t) of the Internal Revenue Code (Code). Section 3402(t) of the Code was added by section 511 of the Tax Increase Prevention and Reconciliation Act of 2005, Public Law 109-222 (TIPRA), 120 Stat. 345, which was enacted into law on May 17, 2006. Section 3402(t)(1) provides that the Government of the United States, every State, every political subdivision thereof, and every instrumentality of the foregoing (including multi-State agencies) making any payment to any person providing any property or services (including any payment made in connection with a government voucher or certificate program which functions as a payment for property or services) shall deduct and withhold from such payment a tax in an amount equal to 3 percent of such payment. Section 3402(t)(2) provides exceptions to withholding under section 3402(t).

Section 1511 of the American Recovery and Reinvestment Act of 2009 (Public Law 111-5), 123 Stat. 115, 355, amended the effective date of section 3402(t) withholding. As amended, the statute provides that section 3402(t) applies to payments made after December 31, 2011.

Notice 2010-91, 2010-52 I.R.B. 915, provided interim guidance on the application of section 3402(t) to payments by debit cards, credit cards, stored value cards, and other payment cards.

Proposed regulations under sections 3402(t), 3406, 6011, 6051, 6071, and 6302 of the Code were published in the Federal Register on December 5, 2008 (REG-158747-06, 2009-4 I.R.B. 362 [73 FR 74082]) (the “2008 proposed regulations”). The 2008 proposed regulations proposed applying the withholding obligations to payments beginning on January 1, 2011, but proposed excluding payments made under contracts existing on January 1, 2011, unless those contracts were materially modified. The final regulations provide an additional one-year extension beyond the amended effective date of the statute. Thus, under the final regulations, the withholding obligation applies to payments made after December 31, 2012, and the exclusion applies to contracts existing on December 31, 2012, that are not materially modified on or after December 31, 2012. These final regulations under sections 3402(t), 3406, 6011, 6051, 6071, and 6302 of the Code (REG-158747-06, Treasury Decision 9524) are being published in the Federal Register concurrently with these proposed regulations.

Several commenters on the 2008 proposed regulations expressed concern that the requirement to differentiate between payments subject to withholding and payments not subject to withholding based on whether the payment was made under a contract existing on December 31, 2011, and whether that contract had been materially modified, would be burdensome to apply. In response to these concerns, these proposed regulations would provide that the exclusion for payments under existing contracts that had not been materially modified would terminate with payments after December 31, 2013. Thus, these proposed regulations would subject payments under all contracts to section 3402(t) withholding after December 31, 2013, unless another exception applied. This rule would avoid the administrative burden of distinguishing between payments made under existing contracts and all other payments while allowing time to address concerns about applying the withholding requirements to existing contracts.

These regulations are proposed to apply to payments made after December 31, 2011.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation, and because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are timely submitted to the IRS. All comments will be available at www.regulations.gov or for public inspection and copying upon request. A public hearing will be scheduled if requested in writing by any person that timely submits written or electronic comments. If a public hearing is scheduled, notice of the date, time, and place for the hearing will be published in the Federal Register.

Paragraph 1. The authority citation for part 31 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 31.3402(t)-1 is amended by revising paragraph (d)(2) to read as follows: