United States taxpayers need to be aware of compliance rules regarding certain types of payments made to foreign persons (individuals and business entities). In fact, the IRS has an entire practice unit known as the Foreign Payments Practice, which focuses on the administration and enforcement of these cross-border payments. The primary objective is to ensure that the appropriate amount of tax is collected from foreign persons doing business in the United States. These rules require U.S. taxpayers to act as “withholding agents” on these payments, or at a minimum, make them responsible for annual information reporting to the IRS.
What Types of Foreign Payments are Subject to U.S. Withholding Tax?
Generally, a payment subject to withholding is a payment of U.S. source fixed or determinable annual or periodical (FDAP) income. Fun acronym, what does that mean? There are numerous types of FDAP payments, but the most commonly encountered are interest, dividends, royalties, and payments for services.
How Much is the Foreign Withholding Tax?
It depends of course. Generally, 30% is the default withholding tax rate for FDAP payments to foreign persons. However, the U.S. has tax treaties with many countries that allow for reduced withholding rates depending on the type of FDAP income. In some cases, the withholding rate is 0%. The rates vary based on specific country-by-country treaties and the type of recipient. For example, royalty payments to a foreign person in Canada are subject to a 10% withholding rate while royalty payments to a foreign person in Japan are subject to a 0% rate.
How do We Document the Reduced Treaty Rates?
Good question. The IRS recently released regulations related to documentation requirements for U.S. withholding agents. These regulations augment and help define existing documentation requirements within the Form W-8 series. These forms are completed by the foreign person receiving the payment and document the type of taxpayer, country location, and respective treaty citations with applicable withholding rates.
Whether or not any withholding is required, U.S. withholding agents making FDAP payments are required to file Form 1042, 1042-S and 1042-T with the IRS annually by March 15th. When withholding tax is required, tax should be remitted to the IRS generally within a few days of payment to the foreign person. Failure to remit withholding tax or failure to file required Form 1042s could result in significant interest and penalties imposed on the U.S. withholding agent.
This is a quick snapshot of tax withholding considerations for foreign persons. There are numerous types of potential payments and tax treaties to consider in addition to the annual Form 1042 burden and Form W-8 documentation. If you have any questions regarding payments to foreign persons or need assistance in reporting, please contact us.
Article written by:
Tyler Gabalski, CPA
Senior, Tax & Business Advisory Services
Bart Hickey, CPA
Senior Manager, Tax & Business Advisory Services