Payments made by U.S. citizens and resident aliens (“U.S. persons”) to non-U.S. persons are typically subject to U.S. tax withholding and result in U.S. tax reporting requirements. These requirements can be difficult to understand and a misstep can prove to be very costly.
U.S. Tax Withholding
Whether a U.S. person is required to withhold tax depends on the “source” of the income. U.S. persons generally must withhold tax on U.S.-source income that is paid to non-U.S. persons. U.S.-source income includes “fixed or determinable payment of annual or periodic income” or FDAP income. FDAP income consists of interest, dividends, rents, salaries, wages, premiums, annuities, compensation, remunerations, emoluments, and other gains and income that have their origins in the U.S.
The tax withholding rate for U.S.-source FDAP income is generally 30 percent unless there is a different rate provided by law or a U.S. Tax Treaty with the country where the payee resides.
Several types of income are specifically excepted from the tax withholding requirement. For example, non-U.S. source income (such as payments for services performed in foreign countries) and certain other specifically enumerated U.S.-source income (such as portfolio and other interest payments).
U.S. Tax Reporting
There payor may have the payee complete a Form W-9 or Form 8233 to determine how to report the payment to the IRS. The payee may then obtain more specific forms from the payee, including Forms W-8ECI (for income that is “effectively connected” with a U.S. trade or business) or W-BEN (for income that is not “effectively connected” with a U.S. trade or business), or some other form.
If appropriate, the payor can then report the payment to the U.S. government. The payee may need to file Form 1042, 1042-S, and 1042-T to report the payments to the IRS and/or the payee. These forms may need to be filed even if the payor is not required to withhold tax.
Also, when a payee claims a benefit of a tax law or treaty to reduce the rate or withholding amount, the payor may be required to complete a Form 8833. This form is used to make a Treaty-Based Return Disclosure.
This is a very basic overview of these rules. The actual rules are much more involved, as is the process of applying the withholding and reporting rules to specific factual situations. Taxpayers may find Publication 515 helpful in assessing their U.S. tax withholding and reporting requirements. Given the complexity of these rules, taxpayers are well advised to have their tax counsel determine the taxpayer’s correct tax withholding and reporting obligations.