Industries: International Business
By: Ashley Kiel
Any time a company makes a payment to a foreign person or foreign company, the company should consider how the U.S. government needs to be notified that this payment has been made. Generally, most payments of U.S. source income made to nonresidents are reportable in some way, even if no tax is due on the payment. Determining whether or not a payment is in fact U.S. source depends on what type of payment is ultimately being made. For example, interest is U.S source if the payer resides in the U.S, dividends are U.S. source if the underlying company paying the dividend is a U.S headquartered corporation, services are U.S. source if they’re performed in the U.S, and rents are U.S. source if the rented property is located within the U.S. These are just some examples of the most common types of income.
The types of payments noted above are known as fixed, determinable, annual, or periodic (“FDAP”) income. Income is considered “fixed” if the amount actually paid is able to be calculated in advance of payment. Income is considered “determinable” if there is a known basis for figuring the amount ultimately paid (for example, an hourly rate for an independent contractor), and finally an amount is “annual or periodic” if it is paid yearly or in regular intervals. In certain situations, FDAP income can also be treated as effectively connected income (“ECI”). This second type of income arises when a foreign person or entity engages in a U.S. trade or business. It is important to distinguish between these two types of income, as FDAP is typically reported on form 1042, while ECI is typically reported on other forms. Additionally, FDAP is taxed at a flat rate of 30% (absent a reduced rate via treaty), while deductions are allowed against ECI, and it is taxed at the graduated tax rates or lesser rate under a tax treaty. It is most common to see FDAP income treated as ECI when it is earned through an investment partnership; however, it is important to consult your tax advisor to be sure the income is being classified correctly so the correct forms are filed and the correct withholding tax is paid.
A foreign person or entity is generally subject to 30% statutory withholding tax on certain types of U.S. source income. Therefore, companies making payments to foreign persons that are U.S. source income must withhold 30% of the gross amount and submit that income tax payment to the IRS. Many tax treaties offer a lower rate of withholding, or zero withholding, on certain types of FDAP income. A claim for a benefit under a tax treaty for a nonresident individual can be made on Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding. Entities should use form W-8BEN-E to make the same certification. It is important to note that any individual or entity claiming a reduced withholding tax rate on form W-8BEN or W-8BEN-E must provide their U.S. tax ID number or their foreign ID number on these forms. If a Company does not have a tax ID number, they are required to withhold at the base rate of 30%.
The regulations governing the withholding of income tax for foreign individuals or entities can be complex. In order to comply with these laws and avoid related penalties, it is crucial to carefully examine the withholding rules to determine the source of income and what regulations or taxation exemptions may apply. We recommend consulting your tax advisor when making any payment to a foreign individual or entity to be sure that these areas are properly considered.