Editor: Mindy Tyson Weber, CPA, M.Tax.
With more U.S. taxpayers engaging in cross-border transactions, the amount and frequency of cross-border payments to non-U.S. persons and entities by U.S. taxpayers have increased. As a result, U.S. tax advisers to globally active U.S. taxpayers need to be aware of the underlying U.S. withholding tax and information reporting rules relating to outbound payments. This item provides an overview of the types of income subject to U.S. withholding tax and related U.S. information reporting requirements.
U.S. Tax on Investment and Business Income of Foreign Persons
The gross basis withholding tax and net tax on business income: While it taxes citizens and residents on worldwide income, the United States asserts a more limited tax jurisdiction over nonresident alien individuals and foreign corporations (collectively referred to as “foreign persons”). Under Secs. 871(a) and 881(a), foreign persons are subject to U.S. gross basis withholding tax on U.S.-source fixed, determinable, annual, or periodic income (FDAP). In addition, foreign persons engaged in a U.S. trade or business are taxed on net income arising from that business (effectively connected income, or ECI) under Secs. 871(b)(1) and 882(a). FDAP income is generally subject to a 30% gross basis tax, while ECI (minus allowable deductions) is subject to tax at graduated rates with a maximum rate of 35% for corporations and, after 2012, 39.6% for individuals.
The gross basis tax on FDAP income is generally collected at source by the U.S. payer, who has primary liability for these taxes as the withholding agent. Furthermore, the IRS has limited ability to collect the tax from foreign persons. Thus, in most cases, the IRS will attempt to collect the gross basis tax on FDAP income from the U.S. payer, particularly since U.S. payers are subject to the jurisdiction of U.S. courts. Failure to collect and report the appropriate amount of tax on FDAP income may expose a U.S. withholding agent to substantial penalties and interest (further described below). However, U.S. withholding agents generally do not need to withhold on ECI payments, except where a U.S. partnership makes an ECI payment to a foreign partner.
FATCA: Under the Foreign Account Taxpayer Compliance Act of 2010 (FATCA) (passed as part of the Hiring Incentives to Restore Employment Act of 2010, P.L. 111-147), payments made to certain foreign persons may be subject to a 30% gross basis withholding tax. This tax applies to payments of FDAP income and to gross proceeds from the sale of securities that generate U.S.-source interest and dividend income. However, any tax withheld for purposes of the gross basis withholding tax on FDAP income may be used as a credit against amounts due under FATCA rules. Withholding agents are required to report amounts paid and withheld under the same rules that apply to the tax imposed on FDAP income under Sec. 881.
Income tax treaties: The tax imposed on FDAP income or ECI may be reduced, or even eliminated, under the provisions of a relevant income tax treaty, provided the foreign taxpayer submits appropriate documentation to the U.S. withholding agent. In most cases, timely submission of proper documentation allows the withholding agent to apply favorable treaty provisions at source, in which case the foreign payees will not be required to file a refund claim with the IRS.
However, a foreign payee must certify entitlement to treaty benefits under penalties of perjury by filing Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding , or Form 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 , as applicable, and/or provide other requisite documentation (e.g., documentation evidencing beneficial ownership, etc.) to claim treaty benefits at source. In lieu of proper documentation present at the time of payment, a withholding agent generally must withhold at the full statutory rates or risk liability for taxes, penalties, and interest.
FDAP vs. ECI
Including a wide variety of income, FDAP income is defined under Sec. 871(a)(1)(A) as “interest, . . . dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, or emoluments.” The associated regulations are more expansive and generally state that FDAP income includes virtually all gross income, with certain exceptions. For example, gains from the sale or exchange of property are not FDAP income. In addition, income that would otherwise be FDAP income is not subject to the 30% gross basis withholding tax if it is derived from the conduct of a U.S. trade or business. In that event, the income is subject to tax as ECI taxable at graduated rates after the deduction of relevant expenses.
Generally speaking, income arising from the business activities of or the assets used in a U.S. trade or business is ECI. However, sometimes it is not so easy to identify ECI. For example, gains from the sale of U.S. real property are ECI. Even gains from the sale of shares in a U.S. corporation may be ECI if the U.S. corporation’s assets primarily consist of U.S. real property. As a further complication, gains from the sale of U.S. real property are generally subject to withholding even though the gains are taxable as ECI and are not FDAP income.
Identifying deductions associated with a U.S. trade or business can also be challenging. For example, while a foreign person may generally deduct expenses that factually relate to ECI, complex rules govern the calculation of the amount of a taxpayer’s interest expense that may be deducted from ECI. With no requirement to withhold on payments of ECI, U.S. withholding agents generally do not focus on these rules, with the exception of U.S. withholding agents that are U.S. partnerships.
U.S. Tax and Information Return Obligations of U.S. Withholding Agents and Foreign Payees
Form 1042: U.S. withholding agents must generally file tax and information returns with the IRS to report FDAP income paid to foreign payees along with any tax withheld on Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. Withholding agents must file Form 1042 by March 15, though the filing deadline can be extended to Sept. 15 by submitting Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns, by March 15 (this does not extend the time to pay). Withholding agents pay the tax withheld either with Form 1042 or with Form 7004 (i.e., if extended) or deposit the tax via the Electronic Federal Tax Payment System (EFTPS).
The tax withheld must be deposited within three business days after the end of a “quarter-monthly period” if the total amount of undeposited taxes is $2,000 or more. The quarter-monthly periods end on the seventh, 15th, 22nd, and last days of the month. If at the end of any month the total amount of undeposited taxes is at least $200 but less than $2,000, the taxes must be deposited within 15 days after the end of the month. The withholding agent and the foreign payee are primarily liable for any failure to withhold tax due on amounts paid to a foreign payee. If the withholding agent fails to withhold and the foreign payee fails to satisfy its U.S. tax liability, they are both liable not only for the tax, but also for interest and any applicable penalties.
In addition, foreign payees must file returns with the IRS to report U.S. ECI or FDAP income (Form 1120F, U.S. Income Tax Return of a Foreign Corporation , for foreign corporations, and Form 1040NR, U.S. Nonresident Alien Income Tax Return , for noncorporate foreign persons) unless (1) the payees had no U.S. ECI at any point during the tax year, and (2) the payees’ tax liability was fully satisfied by withholding at source.
Form 1042-S: In addition to Form 1042, a withholding agent must file Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, with the IRS for every foreign payee with respect to which it paid FDAP income. On each Form 1042-S, the withholding agent must indicate the amount of each category of income paid to the foreign payee (e.g., dividends, interest, etc.) and the amount of tax withheld. A separate Form 1042-S must be filed for each payee and each type of income. Note that if the withholding agent did not withhold tax on FDAP income because it was exempt from withholding tax under a relevant income tax treaty, the withholding agent still must file Form 1042-S. A copy of Form 1042-S should be sent to the foreign payee and attached to any U.S. income tax return that the payee files.
Penalties for late filing of Forms 1042 or 1042-S or late payment of tax: A penalty of up to $100 per form (up to a total maximum of $1.5 million, or $500,000 for a small business) may be imposed for each failure to file with the IRS a correct and complete Form 1042-S when due (including extensions) unless the withholding agent can show the failure was due to reasonable cause and not willful neglect. An additional penalty of up to $100 per form (with a total maximum penalty of $1.5 million) may be imposed for failure to timely provide a correct Form 1042-S to a foreign payee unless the failure is due to reasonable cause and not willful neglect. Furthermore, the failure to file electronically if required may result in a penalty of $50 per return.
Failure to file Form 1042 can result in a penalty equal to 5% of the unpaid tax for each month or part of a month the return is late, up to a maximum of 25% of the unpaid tax. In addition, a penalty equal to 0.5% of the unpaid tax for each month or part of a month the tax is unpaid, not to exceed 25%, is due if the withholding agent fails to timely pay the withheld tax.
Penalties and interest accrue on withholding taxes not paid by the due date of Form 1042, even if the IRS grants an extension of time to file. In addition, for a failure to deposit tax when due, penalties apply equal to 2% of the amount due for deposits made one to five days late, 5% of the amount due for deposits six to 15 days late, and 10% of the amount due for deposits 16 or more days late. Interest accrues from the due date to the date of payment on failure to file or pay penalties and is calculated at the rate determined under Sec. 6621.
Clearly, the potential penalties for failure to timely file or pay withholding taxes provide an enormous incentive to taxpayers to ensure they have robust internal controls to identify and monitor all instances of potential noncompliance.
As set forth above, under Secs. 871 and 881 and under FATCA, U.S. withholding agents are required to withhold 30% of FDAP income paid to foreign payees, subject to reduction under a relevant treaty. However, a withholding agent generally must have a valid Form W-8BEN on file before it grants a foreign payee a treaty benefit at source. Withholding agents that make payments to multiple foreign payees should closely monitor the status of Forms W-8BEN received, because the forms may expire at various times. For example, a Form W8-BEN without a valid taxpayer identification number (TIN) will expire after three years, and a change in circumstances that makes a previously submitted Form W8-BEN incorrect will invalidate it. Without a valid Form W-8BEN, a withholding agent will be liable for any failure to withhold the full amount of any tax due.
Withholding Tax on Foreign Partners of U.S. Partnerships
Under Sec. 1446, a U.S. partnership conducting a trade or business in the United States is required to withhold a tax equal to 39.6% of a foreign partner’s distributive share of the partnership’s U.S. ECI.
Forms 8804, 8805, and 8813: Form 8804, Annual Return for Partnership Withholding Tax (Section 1446) , Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax , and Form 8813, Partnership Withholding Tax Payment Voucher (Section 1446) , are completed by U.S. partnerships with foreign partners, to pay and report Sec. 1446 withholding tax based on effectively connected taxable income (ECTI) allocable to the foreign partners.
ECTI is the partnership’s gross income that is treated as effectively connected with the conduct of a U.S. trade or business, less deductions allocable to the income. Every partnership that has U.S. ECI allocable to a foreign partner must file a Form 8804, regardless of whether it had effectively connected taxable income allocable to a foreign partner. In other words, Form 8804 must be filed even if the partnership has an overall loss.
The partnership must also file a Form 8805 for each partner on whose behalf it paid Sec. 1446 tax, regardless of whether the partnership made any distributions during its tax year, and a Form 8813, which is a payment voucher used to send the IRS the amount the partnership withheld under Sec. 1446. Foreign partners must attach Form 8805 to their U.S. income tax returns to claim a credit for their shares of the Sec. 1446 tax withheld by the partnership. A partnership may determine a partner’s foreign or nonforeign status by relying on a W-8 form (e.g., Form W-8BEN), Form W-9, Request for Taxpayer Identification Number and Certification , or other documentation.
Forms 8804 and 8805 must be filed by the 15th day of the fourth month following the end of the partnership’s tax year. The filing deadline may be extended via Form 7004. Form 8813 must be filed on or before the 15th day of the fourth, sixth, ninth, and 12th months of the partnership’s tax year.
With the expansion of international business and cross-border transactions and payments, more taxpayers will need to become familiar with the complex U.S. tax withholding and information reporting rules that apply to payments to foreign payees. Failure to do so will expose U.S. withholding agents to substantial penalties and interest along with liability for any underlying tax.
Mindy Tyson Weber is a director, Washington National Tax in Atlanta for McGladrey LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 404-373-9605 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with McGladrey LLP.