Is your business making payments to foreign persons, including non-resident alien individuals or foreign entities? If so, depending on the character and source of the payment, a U.S. payor may have a withholding obligation and related reporting requirements.
This Q&A is intended to summarize on a high-level, the guidelines of how certain payments made to foreign recipients are generally sourced and characterized, whether they are subject to U.S. withholding tax, who holds the withholding responsibility related to those payments, and what U.S. tax filing obligations may arise.
Question: Does a Payment Require withholding?
Answer: U.S. sourced, fixed, determinable, annual or periodical (“FDAP”) income payments received by a foreign person or foreign corporation are generally subject to a withholding tax of 30 percent (absent any tax treaty reduction).
Examples of FDAP income include interest, dividends, rents, royalties, compensation for services, etc. Once it is determined that the payment being made constitutes FDAP income, a sourcing analysis is warranted to identify whether such income should be sourced within the U.S. or outside the U.S. Sourcing will determine, in general, whether the FDAP income is subject to U.S. withholding tax.
There are specific sourcing rules in the Internal Revenue Code (“IRC”) for several payment streams which may look, for example, at the residence of the payor, place of performance, etc. However, there are payment streams which constitute FDAP income but are not listed under the sourcing rules set forth in the IRC or its underlying regulations.
When a payment stream constituting FDAP income does not contain a sourcing rule, case law has long established that taxpayers should source by analogy to items of income which do have a sourcing rule in place under the IRC.
Question: When is a domestic payor treated as a withholding agent and what are their responsibilities?
Answer: Although U.S. sourced FDAP income received by a foreign individual or foreign entity triggers U.S. federal income tax to the foreign recipient entity/individual as to such income, the domestic payor is generally responsible for withholding, and failure to do so may cause the domestic payor to be liable for the federal income tax on income realized by a foreign recipient.
A withholding agent is defined as “any person, U.S. or foreign, that has control, receipt, custody, disposal, or payment of U.S. source FDAP income subject to withholding.” The withholding agent may be an individual, corporation, partnership, trust, association, or any other entity. Hence, there can be more than one withholding agent with regards to one applicable payment, so if you or your U.S. business have some type of control or custody over the payment being made to the foreign individuals/ entities, you or your business may be deemed a withholding agent subject to withholding obligations.
As stated above, the withholding agents are primarily liable if they failed to withhold the taxes on such U.S. sourced FDAP payments.
Question: What forms need to be collected and filed?
Answer: As a withholding agent, you are required to collect W-8 forms from the foreign individuals or foreign companies (i.e., W-8BEN for individuals and W-8BEN-E for corporations) receiving the applicable payment. Failure to have these forms before making a withholdable payment may result in additional withholding tax exposure.
For example, if a U.S. payor remitted an interest payment (free of withholding) to a Canadian recipient, who otherwise qualified for a zero percent withholding rate under the US-Canada Treaty, but the U.S. payor made the interest payment before receiving a completed W-8 form from the Canadian recipient, then the U.S. payor may be exposed to a 30 percent withholding tax liability on the gross interest amount paid to the Canadian recipient.
In addition to collecting W-8 forms from the foreign recipients, the withholding agent that makes payments which constitute U.S. source FDAP income must also file with the IRS an annual withholding tax return (i.e., Form 1042) to report tax withheld on the applicable income stream received by the foreign recipient.
Form 1042 must be filed with the IRS by March 15th of the year following the calendar year in which the withholdable payment was made, although a six-month extension can be requested similar to other income tax returns. Failure to timely file Form 1042 could result in harsh penalties starting at 5 percent of the unpaid tax for each month or part of a month of which the return is late, up to a maximum of 25 percent of the unpaid tax.
It is important to assess whether the type of payment you or your U.S. business is making to foreign individuals/ entities may be subject to withholding tax and the relevant rate in case a tax treaty reduces or exempts the withholding amount. An experienced attorney can help navigate the complexities of the forms required to be collected from the foreign payees and filed with the Service.
Oscar Carrillo is a Senior Associate at Zerbe, Miller, Fingeret, Frank & Jadav LLP. His practice focuses on providing tax efficient strategies to high-net worth individual clients while also representing and advocating for clients under IRS examinations and appeals. His practice includes inbound and outbound tax planning, cross-border transactions, corporate taxation, U.S. international tax compliance, federal tax controversy, penalty abatement, and corporate governance.
