Technology and the relative ease of travel make the world seem a little bit smaller every day. This means more and more taxpayers are finding themselves transacting with foreign companies and individuals. As an example, let’s say one of your best friends from college was from another country – I’m going to go with Iceland because it is a beautiful country that I would love to visit again and have enjoyed daydreaming about while procrastinating writing this article. Your Icelandic friend provides marketing consulting services, and you’ve contracted with her to provide marketing for your start-up company. She is not a U.S. resident, and she’s going to be providing all her consulting services from the comfort of her own home in Iceland…or perhaps, while sitting in a hot spring – thanks technology! So, does the IRS care that you’re paying her for this?
For many U.S. taxpayers, the reporting requirements when engaging in foreign transactions can be murky at best. Worst-case scenario (and, unfortunately, a very common scenario), taxpayers are entirely unaware of the reporting requirements. If thinking about this is already giving you a headache, but you’re worried it might be applicable to your business, you should contact a Blue & Co. advisor now, and we’ll help you figure it out. But, if you’re the type of person who likes to understand what you need to do to stay on the good side of the IRS, let’s get into it!
Reportable Payments and Withholding
In general, to ensure that tax is paid on U.S.-source income, a flat 30% withholding tax is imposed on the U.S.-source gross income of foreign persons. (Don’t worry, we’re going to get to how you determine what U.S.-source income is in a minute.) Foreign persons subject to this withholding include nonresident alien individuals and foreign corporations, partnerships, trusts, and estates. To ensure payment of the tax, withholding requirements are imposed on the withholding agent, who is the person (or entity) having control, receipt, custody, disposal, or payment of any of the specified items of income subject to withholding. In our example, you would be the withholding agent and your Icelandic friend would be the foreign person; therefore, you would bear the responsibility for reporting to the IRS.
The 30% withholding tax applies to various types of U.S.-source income. A simple way to think about U.S.-source income for this purpose is “outbound” business payments to foreign persons. Some examples of reportable U.S.-source income are interest (except certain portfolio interest), bank account and accrued original issue discount (OID); dividends; rentals; royalties; alimony; social security benefits; compensation for independent personal services; and any other fixed or determinable annual or periodical (FDAP) income.
Lower withholding rates apply to other types of income (such as scholarship or fellowship grants, distributions to foreign partners and gross investment income of foreign private foundations). Additional exceptions from withholding are also provided in the Internal Revenue Code (“IRC”). And, U.S. tax treaties may reduce the rate of withholding.
Foreign persons are subject to an information-reporting requirement stemming from the nonresident withholding provisions of Chapter 3 of the IRC; this is often referred to as part of the “Chapter 3 Withholding” regime. However, there is another information-reporting regime tied to the Foreign Account Tax Compliance Act (FATCA) and the withholding provisions under Chapter 4 of the IRC. This is often referred to as the “Chapter 4 Withholding” regime. Generally, if the FATCA regime under Chapter 4 applies to a payment, then withholding under the Chapter 3 rules are not required.
Income Tax Treaties
The U.S. has signed tax treaties with dozens of countries and these treaties affect the withholding rates on payments to foreign persons. Individual treaties will provide reduced withholding rates and exceptions from withholding for different types of transactions. So, for every foreign person you’re making payments to, you’re going to have to determine if a reduced treaty rate applies for each type of payment made. (Of course, we’d be more than happy to help you with that!)
Now, let’s get back to that marketing service agreement you have with your Icelandic friend – you will not be required to withhold on this payment because it is not U.S.-source income (since the services are performed in Iceland). But, if your friend also invested in your start-up company and you paid her a dividend, then instead of the general 30% withholding, you would be required to withhold at a rate of 15% per the U.S. – Iceland Income Tax Treaty.
If a reduced withholding rate applies, the withholding agent must obtain documentation in order to apply the reduced rate of withholding. The series of Forms W-8 is used to provide this documentation; there are different forms depending on the type of foreign person. These forms are similar in concept to the Form W-9 provided by U.S. persons.
The withholding agent should receive the applicable signed Form W-8 before paying any foreign person, and it will generally remain valid for a period starting on the date the form is signed and ending on the last day of the third succeeding calendar year, unless a change in circumstance makes any information on the form incorrect.
Source Rules for Reportable Payments
Reporting and withholding usually apply to U.S.-source income, and determining the source of the income depends on the type of transaction. General sourcing rules for some common transactions are:
|Type of income:||Source of income is determined by:|
|Salaries, wages, and other compensation||Where the services are performed|
|Business income: Personal services||Where the services are performed|
Sale of inventory – purchased
|Where the inventory is sold|
Sale of inventory – produced
|Where the inventory is produced|
|Dividends||Whether the corporation is U.S. or foreign (exceptions apply)|
|Interest||The residence of the payer|
|Rents||Where the property is located|
|Royalties – patents, copyrights, etc.||Where the property is used|
|Royalties – natural resources||Where the property is located|
Distributions attributable to contributions
|Where the services were performed that earned the pension|
Investment earnings on contributions
|The location of the pension trust|
|Sale of real property||The location of the property|
|Sale of personal property||The seller’s tax home (exceptions apply)|
|Scholarships and fellowship grants||Generally, the residence of payer|
|Guarantee of indebtedness||The residence of the debtor or whether the payment is effectively connected with a U.S. trade or business|
A withholding agent must file Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, annually to report income paid to a foreign person during the tax year that is subject to withholding (unless an exception applies). This form must be filed even if no amount is withheld because a treaty exception applies to the payment.
A separate Form 1042-S is filed with the IRS by the withholding agent for each recipient, as well as for each type of income paid to the same recipient. A copy of this form is also given to the recipient. The withholding agent also must file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, to report and pay the taxes withheld from the payments of income. Both forms must be filed by March 15 of the year following the calendar year the income was paid, regardless of the taxpayer’s fiscal year (extensions are available if necessary). The amount of tax required to be withheld will determine when the withholding must be deposited. There are penalties for failing to properly withhold and/or file Form 1042 and 1042-S. These penalties are imposed on the payor, not the payee.
As you can probably tell, transacting with foreign persons can result in a number of additional reporting requirements, and the reporting and withholding requirements in this article are just the tip of the iceberg. To make matters worse, failure to properly report can result in significant penalties. However, help is just a click or phone call away! Blue & Co is here to help – contact us today!