On April 25, 2017, we posted the first part of a blog series entitled “Tax Withholding When Business Activities Involve International Entities and Individuals”. In this blog, we would like to expand on the issue of withholding taxes on payments made to foreign payees.
Anyone who makes certain types of payments to a foreign entity or foreign individual is considered by the IRS to be a Withholding Agent and is responsible for ensuring taxes are collected and remitted to the IRS. Failure to do so can result in the Withholding Agent being liable for the under-withheld taxes, and any related penalties and interest. Note that a foreign individual is an individual who is not a resident under U.S. tax law and is neither a citizen nor a permanent resident (i.e. a green card holder).
Types of payments on which taxes need to be withheld are those that are U.S.-sourced and not effectively connected with a US trade or business. Payment types include interest, dividends, capital gains, rent, sales commissions, and compensation for personal services (this list is not exhaustive). Payments to certain foreign financial institutions are also subject to withholding. The default rate used for tax withholding is 30%, but this rate may be reduced depending on the tax treaty. Even if there is no required withholding, there may be required reporting.
If the amount of tax withheld from a payment exceeds the foreign recipient’s actual U.S. tax liability, the foreign person (entity or individual) can file a U.S. tax return to request a refund. This may happen if withholding was at the 30% default rate, but a treaty provision allows for a reduced rate or the income is subject instead to graduated tax rates.
If you are making a payment to a foreign individual or entity that could be subject to withholding or reporting, a form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Withholding and Reporting (Individuals), or form W-8BEN-E, Certificate of Foreign Status of Beneficial Owner for United States Withholding and Reporting (Entities) should be obtained from the foreign recipient. This form is used by the recipient to confirm their status as a foreign recipient and if applicable, claim reduced withholding pursuant to a tax treaty.
Another form in the W-8 series is the W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States. This is used by the foreign recipient to certify that the payment is income connected with the conduct of a U.S. trade or business (Effectively Connected Income – ECI) and, with certain exceptions, not subject to withholding. However, ECI is still subject to U.S. taxation and the recipient must file a U.S. tax return to report the income and expenses of the U.S. trade or business.
The rules are complex and the above is only a brief overview. More information is available in IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities and the instructions to the W-8 series forms.
The following are a few hypothetical examples of U.S. taxes being withheld on payments to foreign recipients. The stories are based on actual situations, but the names and exact details have been changed.
NRA Withholding – “The Nephew’s Surprise”
Li Wei is a resident of Taiwan with no ties to the U.S. His uncle was a longtime U.S. resident and recently passed away, leaving his retirement accounts, totaling $500,000, to Li Wei. The custodian of the retirement accounts sent Li Wei the balance in the accounts but only after withholding U.S. taxes at the mandatory rate of 30%. The distribution was reported to Li Wei on Form 1042-S the following year. Li Wei was surprised to owe $150,000 in U.S. taxes on these funds and contacted a U.S. accounting firm to ask whether this was correct.
The accounting firm assessed Li Wei’s situation and recommended gathering additional information from the retirement account custodian. They were able to separate the funds Li Wei received between pre-tax contributions, after-tax contributions, and investment growth. Reporting the contributions separately resulted in Li Wei receiving a significant portion of the $150,000 in taxes refunded, since his uncle’s pre-tax contributions were nontaxable, and the after-tax contributions were taxed at ordinary graduated income tax rates rather than the flat rate of 30%.
NRA Withholding – “The Foreign Student”
Sarah is a citizen of a foreign country who came to the U.S. for graduate studies. She works in a lab on campus as part of her program. She has scholarships to cover her tuition and receives a stipend from the university to help with other expenses, such as rent and food.
As a student in the U.S., Sarah will be considered a non-resident alien for up to five calendar years, even though she is physically present in the U.S. As a result, the university will need to withhold taxes on her wages and stipend under special withholding rules. However, Sarah may be exempt from U.S. taxes on all or a portion of this income depending upon the treaty between her country and the U.S. In order to take advantage of any treaty benefits and request that the university withhold no or reduced taxes, Sarah will need to complete and provide to the university either form W-8BEN or form 8233, Exemption from Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual. Which form she must provide to the university will depend on which income (wages and/or stipend) is eligible for treaty benefits.
For her annual tax filing, Sarah will need to file Form 1040NR, U.S. Nonresident Alien Income Tax Return, to report any U.S. sourced taxable income and Form 8843, Statement for Exempt Individuals and Individuals with a Medical Condition, to claim exemption from days of substantial presence in the U.S.
NRA Withholding – “The Loan From a Foreign Affiliate”
CloudArbre, Inc. is a U.S. subsidiary of a foreign parent. To expand operations in the U.S., CloudArbre needs some additional funding and enters into a loan agreement with its parent.
When the note payments begin, CloudArbre is required to withhold 30% of the interest portion of each payment and remit the withheld taxes to the IRS. The payments and taxes withheld are reported annually to the foreign parent using Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. CloudArbre will also need to file form 1042, Annual Withholding Tax Return for U.S Source Income of Foreign Persons. Information reported on both forms includes the recipient’s name and address, amount subject to withholding, amount withheld, the withholding agent’s name, address, and identification number.
If CloudArbre fails to withhold, they will be liable to pay the tax and any associated penalties and interest. If they do not file the required series 1042 forms, they will be subject to penalties and interest for failure to file.
Sciarabba Walker & Co., LLP can help individuals and businesses comply with the complex U.S. withholding rules on payments to foreign recipients. Contact at firstname.lastname@example.org for assistance.