In the normal course of your trade or business, you may make payments to persons from outside the United States. If the payments you are making constitute U.S. source income, the payee may be liable for U.S. income tax, and you as the payer may be responsible for withholding U.S. income tax.
When you make payments to a foreign person, a foreign pass-through entity or intermediary, or to a U.S. person acting as agent for a foreign person, you may be responsible for withholding U.S. income taxes on those payments.
Foreign persons, for tax purposes, include nonresident alien individuals, foreign partnerships, foreign corporations, foreign trusts, foreign estates, foreign governments, and international organizations. They are generally subject to U.S. income tax on their U.S. source income. If you pay U.S. source income to a foreign person, you generally have to withhold tax at the rate of 30%. This withholding tax is required under sections 1441, 1442, and 1443 of the Internal Revenue Code, and is referred to as “NRA withholding”, referring to nonresident aliens. Lower withholding rates, or exemptions from withholding, may apply in certain cases, particularly when there is a tax treaty between the United States and the foreign person’s country of residence.
If you are the payer of the corresponding income, you are considered the withholding agent. In general, according to the Internal Revenue Service (IRS) definition, a withholding agent is “a U.S. or foreign person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding”. You, as an individual, can be considered a withholding agent, or your business, set up as a partnership or corporation, could be a withholding agent. Any other type of legal entity, including foreign intermediaries, foreign partnerships, or U.S. branches of foreign banks or insurance companies could also be withholding agents.
You may be considered a withholding agent even if you are not specifically required to withhold tax from a payment, or even if another person has withheld tax. More than one person or entity may be considered a withholding agent for the same income, even though the tax only has to be withheld once. For example, a flow-through entity may know, or have reason to know that the full amount of tax was not withheld by the person who paid the income. The flow-through entity, as a withholding agent, is then responsible for withholding the tax.
The importance of being considered a withholding agent is that you are personally liable for the tax that must be withheld. And your liability is independent of the tax liability of the foreign person who received the income. If you do not withhold the tax, and the foreign person does not meet its U.S. tax liability, both of you are liable for the tax, plus any penalties and interest that may apply. Even if the foreign person subsequently pays the tax, you could be liable for the penalties and interest for your failure to withhold.
U.S. Agent of a Foreign Person
If you pay income to a U.S. person who is acting as an agent for a foreign person, as defined above, and you have knowledge of this, you are also responsible for withholding tax on the payment, as if the payment were being made directly to the foreign person. There is an exception if the payment is being made to a financial institution and you have no reason to believe that the institution will not fulfill its obligation to withhold the tax.
How Much To Withhold
You should withhold 30% of the gross amount of the income payment that is subject to tax, without taking into account any deductions. If the source of the income or the amount subject to tax cannot be definitively determined at the time of payment, you should withhold an amount sufficient to ensure that the 30% requirement is satisfied, once the source and taxable amount of income are determined. But you should not withhold more than 30% of the total amount paid. For example, if you are not sure that the entire amount will be U.S. source income at the time you make the payment, you should withhold 30%. Then, if it is determined that part of the income is not U.S. source, the 30% you withheld will be more than sufficient to cover the obligation. And, if you make more than one payment and you withhold 30% on each payment, and it is subsequently determined that not all the payments you made are U.S. source taxable income, you will have withheld more than enough tax.
When To Withhold
You are required to withhold tax at the time you make payment of the income that is subject to tax withholding. Payment is considered to have been made to a person if it is made to a third party for the person’s benefit, for example in payment of the person’s debt, or if it is made to the person’s agent. So, there does not necessarily have to be an actual transfer of cash or property to the foreign person for a withholding obligation to exist.
If you are a U.S. partnership, you must withhold tax from distributions that include amounts that are subject to withholding. But, if you have a foreign partner whose share of income subject to withholding is not actually distributed, you must still pay the 30% tax on the date you provide or send the foreign partner a Schedule K-1 (Form 1065) or on the due date for filing that schedule, whichever is earlier. A similar obligation exists for a U.S. trust. If the trust distributes its net income, it must withhold tax on a foreign beneficiary’s income. And, if a distribution is not made, the tax must be withheld on the foreign beneficiary’s allocable share.
Payments you make that are subject to NRA withholding tax are reported on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. An annual tax return must be filed on Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons.
You may also be responsible for backup withholding on payments that are reported on Form 1099. Normally, payments reportable on 1099 forms would be subject to backup withholding if the payee does not provide you with a taxpayer identification number, for example. But you may also be responsible for backup withholding tax at a rate of 28% if you make payments to a foreign intermediary or a flow-through entity that collects income for a U.S. person subject to 1099 reporting. Backup withholding for the year is reported on Form 945, Annual Return of Withheld Federal Income Tax.
If the foreign entity provides you with one of the forms from the W-8 series, which are used to certify reduced withholding tax rates or exemption form U.S. income tax withholding for foreign persons, you do not have to withhold tax, or issue a Form 1099. The forms used to exempt the foreign persons include Forms W-8BEN, W-8ECI, and W-8EXP.
Who Is Subject to NRA Withholding?
NRA withholding applies to foreign persons and not to U.S. persons. You normally determine whether a payee is a foreign person or a U.S. person by the documentation that is provided to you as the payer. Normally you would withhold the 30% tax unless you have valid documentation showing that the payee is a U.S. person, or a foreign person entitled to a lower withholding rate.
You can treat the payee as a U.S. person if you receive a Form W-9, since this form can only be used by U.S. persons. Foreign persons would normally provide you with a Form W-8. If you are paying a person for personal services, that person should give you a Form W-4, to have less tax withheld, or Form 8233, Exemption from Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual, to be exempt from withholding.
Documentation that can identify a foreign person as the beneficial owner includes Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding. In addition to establishing the person’s foreign status, this form can be used to claim a reduced rate of withholding or an exemption from withholding based on a tax treaty. It can also be used to avoid 1099 reporting and backup withholding on income that is not subject to NRA withholding, such as proceeds from the sale of securities.
Identifying the Payee
There are some situations in which the person you are paying may not be the actual beneficial owner of that income. In these cases you will need to identify the actual payee or ultimate recipient or beneficial owner of your payment in order to determine whether that person is a foreign person subject to NRA withholding.
As mentioned above, you may have to withhold tax on payments made to a U.S. person who is receiving the payment as an agent of a foreign person. And there may be cases where you are paying an entity, but the entity should be disregarded for tax withholding purposes, because it is not a corporation and the owner and the entity are one and the same. In this case, if the owner is a foreign person, NRA withholding would apply unless the person presents documentation showing eligibility for a lower rate of withholding or exemption from withholding. If the owner is a U.S. person, NRA withholding does not apply, but you may need to report the payment on a Form 1099.
If you make a payment to what is termed a flow-through entity, the withholding tax rules to apply will depend on whether the owners or beneficiaries of the flow-through entity are foreign or U.S. persons. But if the income you are paying is effectively connected with a U.S. trade or business, the payment is treated as having been made directly to the entity, and not to the ultimate owners or beneficiaries.
Flow-through entities include foreign partnerships, foreign trusts, and fiscally transparent entities that receive income for which treaty benefits apply. A distinction is made between foreign partnerships and trusts that are withholding and those that are non-withholding. Flow-through entities include those that are non-withholding.
A flow-through entity should generally give you a Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding. This form should indicate whether it is a qualified flow-through entity and whether it is assuming responsibility for withholding. The flow-through entity may also give you the information you need to determine whether the owners or beneficiaries are U.S. or foreign persons, how much of the payment corresponds to each owner or beneficiary, and whether any of them are subject to a reduced rate of NRA withholding.
If a foreign partnership is not considered to be a withholding partnership, the partners are considered to be the payees for purposes of determining what withholding rules apply. If one of the partners is also a flow-through entity, you would need to determine who the owners or beneficiaries of that entity are, and apply the withholding rules to them.
For example, you make a payment to a non-withholding foreign partnership that has three partners: a nonresident alien individual, a foreign corporation, and a U.S. individual. The partnership gives you Form W-8IMY, and associates a Form W-8BEN with the nonresident alien individual and the foreign corporation, and a Form W-9 from the U.S. individual. You would withhold the 30% tax on the amounts corresponding to the nonresident alien and the foreign corporation, and pay and report the tax on Form 1042-S. The amount of the payment corresponding to the U.S. individual would be reported on the applicable Form 1099.
Now assume that you make a payment to a non-withholding foreign partnership that has two partners: a foreign corporation and another non-withholding foreign partnership. This second partnership has two partners, both of whom are nonresident alien individuals. The first partnership gives you Form W-8IMY, associating the foreign corporation with a Form W-8BEN and associating the second partnership with its own Form W-8IMY. This second Form W-8IMY has withholding statements for its two nonresident alien partners. Since you have documentation for the withholding status of the ultimate payees, who are the foreign corporation and the two nonresident alien individuals in this case, you treat them as the payees and withhold tax from the payment to them.
A foreign trust could be a simple trust or a grantor trust. A simple trust is required to distribute all its income annually. In this case, the payees are the beneficiaries of the trust. In a grantor trust, the payees are the owners of the trust. If you are making a payment to a foreign trust, you would apply basically the same criteria as you would for a foreign partnership in determining who the beneficial owners are, what withholding tax rules apply, and how the payment should be reported. The trust should give you a Form W-8IMY or other documentation associating the withholding requirements with the payees.
Fiscally Transparent Entity
A foreign entity may be treated as fiscally transparent if a reduced rate of withholding is being claimed under an income tax treaty. The persons that hold an interest in the foreign entity determine whether the entity is fiscally transparent based on each item of income. The interest holders make this determination based on the laws of the jurisdiction in which they are organized or incorporated, or where they are considered residents.
An entity is considered fiscally transparent if the interest holders are required to separately take into account their share of the entity’s income on a current basis, whether or not the income has been distributed. Also, the character and source of the income must be determined as if the income had been realized by the interest holders directly from the source.
You as the payer of the income should be able to determine whether the entity you are paying is fiscally transparent based on the Form W-8IMY it gives you. If the entity is fiscally transparent, then for purposes of withholding tax, the payees are the interest holders of the entity.
An intermediary is a broker, custodian, nominee, or any other person that acts as an agent in receiving income for another person. Generally, when you make payments to an intermediary, for tax withholding purposes you are making payments to the account holders or customers and not to the intermediary itself. You would apply the rules for NRA withholding and 1099 reporting as if the payments were made directly to the final account holders or customers.
A foreign intermediary is considered either a qualified intermediary or a nonqualified intermediary for U.S. income tax withholding purposes. This determination can be made based on the information provided in the intermediary’s Form W-8IMY. Also, based on this same form and its associated information and documentation, you should be able to determine whether the account holders or customers are foreign or U.S. persons, and if they are foreign, whether they qualify for reduced withholding or an exemption from withholding.
If you make a payment to a nonqualified intermediary, the payments are treated as having been made to the account holders or customers, for U.S. withholding tax purposes, and you will have to withhold and report the tax. You would report the amounts paid to any foreign account holders or customers on Form 1042-S and the amounts paid to U.S. account holders or customers on the appropriate Form 1099.
A qualified intermediary is one that has entered into an agreement with the IRS to act as the primary withholding agent and that is entitled to use simplified withholding and reporting procedures. Foreign financial institutions and foreign branches of U.S. financial institutions are the intermediaries that can generally qualify for this status. If you make a payment to one of these qualified intermediaries that has assumed primary responsibility for NRA and backup withholding and 1099 reporting, you do not need to withhold or report tax on the payment. The intermediary’s Form W-8IMY should indicate whether it has assumed primary responsibility.
When you make a payment of U.S. source income to a person or entity that you know is considered a foreign person for tax purposes, you are normally required to withhold U.S. income tax at a rate of 30% and report it on Form 1042-S. You may also need to withhold this tax when you pay a U.S. person acting as an agent of a foreign person. And, you may need to identify the actual beneficial owner when you make payment to a flow-through entity or a foreign intermediary.
You can check the withholding tax status of a foreign person by reviewing the applicable Form W-8 and the corresponding withholding statements and documentation. The fact that you may be held personally liable for the tax and any associated penalties and interest if the tax obligation is not met, makes it important to be clear about who you are paying and how the associated U.S. income tax obligation is being met.