Are you making payments to foreign persons, whether or not the person is a related party? Are you maintaining the proper documentation for U.S. withholding and reporting purposes?
Generally, a U.S. person (this includes individuals and businesses) making payments for certain income items to a foreign person is required to withhold U.S. tax on such payments and report this income and withholding to the IRS. U.S. persons need to determine their compliance with the rules by implementing procedures to track and analyze payments to foreign persons. Note that U.S. withholding requirements are now a Tier I issue for the IRS. Although IRS examination of a Tier I issue is not required by an examiner, a taxpayer should anticipate this issue to be raised under audit. For a more detailed discussion of the Tier I withholding tax issue, see this Insight dated March 10, 2010.
A payment is subject to non-resident withholding if it is from sources within the U.S. and it is either fixed or determinable annual or periodical income (“FDAP”), or a gain from the disposition of timber, coal and iron ore, or from the sale of certain intangible property. Examples of these types of payments include, but are not limited to, interest, dividends, rents, royalties and the performance of services in the U.S.
The general U.S. income tax withholding rate for payments to foreign persons is 30%. This rate may be reduced, to zero in some cases, pursuant to an income tax treaty or a Code section that exempts the payment from tax.
For each foreign payee, the U.S. payor must obtain Form W-8 to certify the payee’s foreign status. There are two different forms to obtain this certification. The U.S. payor MUST obtain one of these forms in order to support a tax withholding rate less than 30%. In many situations, the payor is asked by the payee to determine which form is applicable. The payee will need to obtain a U.S. taxpayer identification number (TIN) in order to comply with the withholding regulations.
- Form W-8BEN is used to certify that the payee is a foreign person and to claim a treaty benefit for a reduced or zero tax rate.
- Form W-8ECI is used to certify that the foreign person has effectively connected income with a U.S. trade or business and is filing a U.S. income tax return to report and compute U.S. tax liability. The payor is not required to withhold U.S. income tax from payments to persons with ECI if this form is received.
If the payor has reason to believe the payee is a foreign person and has provided a false W-8, the payor should withhold tax at the 30% rate. Likewise, if neither form is obtained, the payor should withhold at the 30% rate.
Payments and withholding taxes are reported on U.S. Form 1042 and Form 1042-S. Amounts need to be reported on Form 1042 series even if no amount is withheld from the payment due to the treaty-based position.
For assistance with compliance with payments to foreign persons and other related issues, please contact Cynthia Hoffman.
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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.