The U.S. system is a hybrid between a territorial and a worldwide system. It is a worldwide system when it comes to taxation of income of U.S. citizens and resident businesses, and it is a territorial system when it comes to taxation of U.S.-earned income of foreign persons and businesses. To avoid double taxation of foreign income, U.S. citizens and resident corporations can claim foreign income tax credits to offset their U.S. tax obligations. The Tax Cuts and Jobs Act effectively exempted some of these profits but retained taxation on some categories of foreign profits and imposed a new minimum tax on another.
To effectively collect tax imposed on the U.S.-source income of foreign persons and businesses, we have various withholding regimes that require payors and transferees to collect and transmit the withholding tax to the U.S. Treasury.
The goal of these withholding regimes is to ensure the collection of tax at the source, since most foreign persons and businesses may not even be aware of their tax obligation in the U.S. It is much easier for foreign entities and persons to avoid taxation in the U.S., where they don’t have residency or a permanent address, and much harder for the U.S. Treasury to pursue and enforce the taxation of these entities once the cash changes hands.
As the part of this tax withholding regime, the payors and transferees, mostly the U.S.-based businesses, have been made responsible for collection of information about the foreign recipients, determining the required withholding percentages and amounts, withholding tax and submitting it to the U.S. Treasury and as providing the IRS and the foreign businesses with the tax information. In this way, the withholding regime makes it more efficient and enforceable for the IRS to collect tax and information about the foreign entities that conduct business in the U.S.
How do I determine how much to withhold from foreign entities and persons?
Start by asking your foreign partners to fill out the Forms W-8 series to confirm their foreign status and determine possible exemptions from the withholding requirements. The type of the income determines the tax withholding rate and compliance process that often is further regulated by Internal Revenue Code (IRC) sections and tax treaties. Generally, foreign investors are not subject to U.S tax on U.S.-source capital gains, unless they are connected with a U.S. trade or business, or realized by an individual who meets certain requirements.
The U.S.-sourced income of foreign persons and businesses usually falls into one of the following categories:
- Fixed or Determinable Annual or Periodic Income (FDAP) – interest and dividend income, royalties, rent, etc.
- Disposition of U.S. Real Estate Property Interest (USRPI) and distributions from the partnerships and corporations.
- Effectively Connected Income (ECI) – U.S.-sourced trade of business income of the foreign person or business.
FDAP income is subject to Nonresident Alien (NRA) Withholding under the IRC Sections 1441-1443 and generally subject to 30% withholding. A reduced rate, including exemption from tax, may apply by virtue of an IRC section or provision of a tax treaty between the foreign person’s country of residence and the U.S. The withholding is required at the time that the payment is made (i.e., when the beneficial owner of the payment realizes the income). There does not need to be a transfer of cash or other property. FDAP income and withholdings are reportable on Forms 1042. Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, provides information about NRA reporting and withholding responsibilities.
Disposition of U.S. real estate property interest (USRPI) by foreign persons or entities is subject to withholding of tax under IRC Section 1445 and requires the transferee to withhold tax from the seller at 15% of the amount realized on the disposition, which is normally the purchase price. Foreign Investment in Real Property Tax Act (FIRPTA) is a tax law that imposes U.S. income tax on foreign persons selling real estate in the U.S.
The buyers (transferees) of the U.S. real estate property from the foreign persons or entities are required to withhold this tax, file Form 8288 with the IRS within 20 days of the sale and transmit the tax along with the form. It is important for the transferee to know and comply with FIRPTA to avoid penalties. Available exemptions and certification forms may lower the withholding amount or eliminate the withholding requirement. The dispositions of interest in partnerships, trusts or estates by foreign persons and entities is also subject to this withholding.
Effectively connected income (ECI) is any income earned by foreign persons or entities that are engaged in a trade or business in the U.S. Individuals are engaged in a U.S. trade or business if they provide services in the U.S. or invest in the pass-through entities that generate ECI. The ECI of the foreign persons is subject to the tax withholding at the highest individual income rate, currently 37%, or at the highest corporate tax rate, currently 21%, for the foreign entities. In some instances, even if no cash has been distributed to the foreign partners or beneficiaries during the current fiscal year, the withholding and reporting of ECI may be required. The instructions for Form 8804 (Annual Return for Partnership Withholding Tax), Form 8805 (Foreign Partner’s Information Statement of Section 1446 Withholding Tax), and Form 8813 (Partnership Withholding Voucher) provide guidance to filers on how to pay and report Section 1446 withholdings based on ECI allocable to foreign partners.
The foreign persons and entities can claim back any overpaid withholding tax by filing a tax return the following year to report U.S.-sourced income and withholdings. The individual persons must file IRS Form 1040NR (or 1040NR-EZ) and business entities will have to file Form 1120-F to report all U.S.-sourced income. Business entities and individuals doing business with foreign persons or entities in the U.S. should be aware of and comply with the various withholding and reporting requirements to avoid penalties.
It is obvious that the international compliance and withholding programs are high on the IRS’s priority list: the IRS Large Business and International division has about 59 compliance campaigns employed to improve return selection, identify issues representing a risk of non-compliance and make the greatest use of limited resources. Below are the last five campaigns added in 2018:
- Individual Foreign Tax Credit Phase II – Practice Area: Withholding and International Individual Compliance
- Offshore Service Providers – Practice Area: Withholding and International Individual Compliance
- FATCA Filing Accuracy – Practice Area: Withholding and International Individual Compliance
- 1120-F Delinquent Returns Campaign – Practice Area: Cross-Border Activities
- Work Opportunity Tax Credit – Practice Area: Enterprise Activities
Contact us for help determining the withholding requirements on the payments to your foreign partners and other tax compliance issues related international business transactions.