U.S. Withholding Tax on Payments to Foreign Persons

In the ever-expanding globalization of the economy, it is more common than ever for a U.S. person to make payments to foreign persons. Depending on the type of payment made, and whether it is U.S. sourced, there may be U.S. withholding tax imposed on the payment unless an exemption applies. 

The reason for withholding U.S. tax at the source is that the IRS does not want to allocate the time, energy, and expense (e.g., the IRS agents travelling around the world) to collect U.S. tax from payees. Thus, the obligation to withhold and remit the U.S. tax to the IRS remains with the U.S. payor unless the foreign payee files and pays the U.S. tax.

This column focuses on some of the withholding tax provisions that apply to more salient and common business payment situations that may arise when a U.S. person makes a fixed and determinable annual and periodic (FDAP) income payment to a foreign person.¹ 

Determine if the Payee Is Foreign

Determining if the payee is foreign is generally made through a system of internal reporting, typically by the payor requesting a completed IRS Form W-9 (which would indicate the payee is a U.S. person with a U.S. tax identification number) or by obtaining a completed IRS Form W-8, which would indicate the payee is foreign.² If, for example, a foreign payee provides a Form W-8ECI, they are indicating that they will be reporting the income on their U.S. tax return. It will include their U.S. tax ID number on the form for IRS reporting purposes, so no U.S. withholding would be required. The payee may also complete the treaty section of IRS Form W-8 indicating that they qualify for a reduced treaty rate of withholding (or just provide proof that they are foreign for purposes of service-fee payments). U.S. payors can rely on these forms unless they have reason to believe that the payee is not accurately representing who and what they are on these documents.³ The forms are retained by the payor and are not sent to the IRS, but they must be provided to the IRS as support for U.S. withholding or reduced withholding if the IRS audits the payor.⁴ 

Character and Sourcing – Key Determinations

 
Generally, U.S. withholding applies to payments that are U.S. sourced. There are different sourcing rules depending upon the type of FDAP payment made: 

• Services – Where the service is provided⁵
• Interest – Residence of the borrower
• Royalties – Where the intangible property is exploited
• Rents – Where the property is located
• Sale of property – Residence of the seller 

Compliance Considerations

In addition to obtaining completed W-9s or W-8s from the payment recipient to internally document who the payee is and what their status and residency is, there are also U.S. tax withholding and payment reporting provisions. Generally, the U.S. withholding tax rate is 30% on the gross payment, but this may be reduced or eliminated pursuant to an income tax treaty that the United States may have with the recipient’s home nation.⁶ When the tax is required to be remitted to the IRS depends upon the size of the payment. The larger the payment, the sooner the tax must be deposited with the IRS. Annually by March 15, the U.S. payor must file an IRS Form 1042 and 1042S reporting the amounts paid and U.S. taxes withheld and remitted to the IRS, and must provide a copy to the foreign recipient. If the 1042 and 1042S is properly completed, that obviates the need for the foreign recipient to file a U.S. tax return. 

Practical Considerations

When there is a failure to withhold U.S. tax on payments to foreign recipients it is often because the payments are to related parties or related entities coupled with a failure to request W-9s or W-8s. This may arise in relation to payments of intercompany interest, royalties, or service fees. Complications can also arise in determining how the payment should be characterized under U.S. income tax principles, because different types of payments have different sourcing rules. What characterizes the payment is what it is in substance, not what the payment is called in the contract. For example, determining what constitutes a service fee (sourced where the service is provided) and what constitutes a royalty payment (sourced where the intellectual property is exploited) can be tricky and tends to hinge on who retains the right to the property produced. 

It can also be a challenge to clean up past failures. Trying to get U.S. withholding tax back from a foreign recipient can be next to impossible, which can result in additional cost to the U.S. payor plus a gross-up on the additional U.S. tax payment. However, if there are ongoing payments with the foreign recipient, provided the contract governing the transaction permits, there may be an opportunity to true up on subsequent payments.

It may be well worth the time and effort to review all payments to ensure that proper documentation is in place and that proper U.S. tax is being administered, including ensuring that forms W-9 and W-8 are obtained from all payees. 

The IRS announced a voluntary disclosure program to try to get more taxpayers to comply with U.S. withholding and reporting associated with foreign payments by not penalizing taxpayers that enter the program. Technically, the program expired in early 2021. The IRS, however, has continued to informally accept and receive taxpayers into the voluntary disclosure program, but, as of January 2022, it has not formally announced extension of the program. Visiting the IRS website can provide additional information about this voluntary disclosure program.  

¹ There may be other U.S. withholding situations not discussed in this column: for example, when a foreign person sells a U.S. real estate interest or a partnership interest that has a U.S. trade or business operated directly or indirectly by the partnership. Further, U.S. withholding can also apply to payments made to foreign financial institutions (the Foreign Account Tax Compliance Act or “FATCA”), which is also not discussed herein.  
² Foreign individuals typically complete Form W-8BEN and foreign entities complete Form W-8BEN-E. Other W-8 series forms may apply in other situations. 
³ For example, if the payor knows the forms or information provided on these forms is incorrect – perhaps because the contract governing the payments indicates otherwise – then the forms cannot be relied upon. Other available information can also call into question the accuracy of the forms. In essence, the payor is under some duty of care to make sure the forms are completed by the payee correctly. 
⁴ The FATCA section of W-8 forms also should be completed by the payee. The FATCA section can appear quite daunting. However, unless payments are being made to a foreign financial institution of some type (a bank, mutual fund, investment fund, insurance company, etc.), an exception from withholding is typical in most business payment situations to an active or passive nonfinancial foreign entity. The FATCA withholding and reporting provisions are beyond the scope of this article. 
⁵ Payment of deferred compensation is sourced where the compensation was earned. Further, the rules and potential treaty provisions related to pension payments can be complex and are outside the scope of this article. 
6 In certain situations, the U.S. tax code exempts certain payments from U.S. tax, such as interest on portfolio debt. Discussing these exemptions is outside the scope of this article.