Making service payments to a foreign person is one of the common types of cross-border transactions. A U.S. taxpayer needs to be aware of the applicability of withholding tax and related reporting requirements to ensure they comply and avoid unintended consequences. A U.S. payor must collect withholding tax and remit it to the IRS in the case it is applicable. If the tax is not properly withheld, the U.S. payor (withholding agent) will be liable for the cost of non-compliance, including withholding tax, interest, and penalty.
Source of Income
In general, the U.S. government has the right to tax a foreign person’s U.S. income. Foreign persons not engaged in a trade or business are subject to U.S. tax on the gross amount of certain categories of U.S. source income, commonly referred to as fixed, determinable, annual, or periodical (FDAP) income. Common types of FDAP income include dividends, rent, interest, royalties, loan guarantee fees, and certain payments for personal services.
U.S. withholding requirements for payments made to a foreign person are specific to income earned from a U.S. source. The source is the place where the personal service is performed rather than where a contract is executed, the place of payment, or where the person resides. When a U.S. company employs a non-resident alien professional who works in both his/her home country and the U.S., only the workdays performed in the U.S. are allocated as U.S. source income. If you make a management fee payment to a foreign-related party and none of the services are performed in the U.S., the management service fee is not considered as U.S. source income and, therefore, is not subject to the withholding tax requirement.
Withholding Tax Rate and Tax Treaties
The withholding tax rate is generally 30% on FDAP income; however, many tax treaties exist with other nations that can reduce the tax rate. To facilitate commerce and encourage cooperation between countries, the U.S. has entered into tax treaty agreements with many countries which provide mutually beneficial tax treatment for U.S. workers working abroad and those foreign individuals who work in the United States.
Tax treaties often provide reduced tax withholding rates based on the type of income (compensation, dividends, interest, royalties, etc.) and can exempt income from being taxable until a certain amount of time in the U.S. occurs or a compensation dollar threshold is met.
Form 8233 must be completed by the foreign person who is claiming tax treaty exemption on personal services performed in the U.S. The U.S. payor must obtain this form from the foreign payee and complete the section certifying its acceptance of the form. A completed copy is required to be forwarded to the IRS within five days of the acceptance of the form.
Filing Requirements
Federal reporting obligations exist regardless of whether any dollar amount has been withheld. The U.S. payor must provide annual information returns (1042 and 1042-S) to the IRS and each payee by March 15 of the year following any payments made. The annual summary of 1042-S transmittal forms, 1042-T, is required if filing paper forms but not required if filing electronically.
Traditional income tax filing extensions do not apply to Form 1042-S. Instead, file Form 8809 to receive an automatic 30-day extension for the IRS filing and fax a letter to the IRS if you require an extension for providing Form 1042-S to the payees.
A U.S. payor is personally liable for collection and remittance of tax on payments made to a foreign person for personal services performed in the U.S., and does not receive Form 8233 from the foreign payee. Withholding tax on payments made to a foreign person can be complicated. The U.S. payor should thoroughly review and understand the tax requirements necessary to maintain compliance and ensure all tax obligations are met.
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