Complying with domestic U.S. tax law can be tough; when foreign taxpayers are brought into the mix, the complexity can become overwhelming. In today’s global society, U.S. taxpayers (both businesses and individuals) are engaging in transactions with nonresident aliens more than ever. In part one of this two-part blog, we’ll take a high-level look at the circumstances where a U.S. taxpayer can encounter a withholding and/or reporting requirement as it relates to payments to nonresident aliens.
To begin, a nonresident alien (“NRA”) is a foreign person who is not a U.S. citizen or U.S. resident (with the former being relatively straightforward, and the latter typically focusing on whether an individual has a green card or, if none, their amount of time spent in the U.S.). For a more in-depth look at who is subject to this tax, see our International Taxation for Individuals blog series.
Withholding on effectively connected income.
Special U.S. tax rules are applicable to nonresident aliens; income of NRAs can be bifurcated into (1) effectively connected income (“ECI”) and (2) fixed or determinable annual or periodic income (“FDAP”). Under statutory rules, ECI looks to whether a nonresident alien is “engaged in a United States trade of business”; providing personal services within the U.S. statutorily meets this standard. The “United States trade or business” requirement is modified under income tax treaties, with applicable standards focusing generally on whether a “fixed place of business” is available in the United States (for independent services) and the number of days spent in the U.S. (for dependent personal services – i.e., services on behalf of an employer). ECI is taxable to recipients in a similar fashion to how U.S. taxpayers are taxed – on a net basis at graduated rates, with credits/deductions available.
Importantly, withholding requirements can exist even in the context of effectively connected income!
Two primary examples are for wages and for a foreign partner’s distributive share of effectively connected income. Nonresident alien employees performing services in the U.S. are subject to wage withholding requirements in the same fashion as U.S. taxpayers (irrespective of whether the wages are paid by a foreign or domestic employer). As to foreign partners, a nonresident alien individual partner is considered to be engaged in any United States trade or business in which the partnership is engaged. To this end, a foreign partner’s distributive share of partnership net income effectively connected with a partnership’s U.S. trade or business is taxed under general Code provisions, and the partnership must withhold tax at the maximum applicable rate for the income.
Withholding on FDAP income.
FDAP income is taxed in a drastically different fashion. Statutorily, a mandatory 30% withholding rate is applied on a foreign person’s U.S. sourced FDAP income, subject to income tax treaty modifications (which often reduce withholding rates below 30%). Whether an income item is sourced to the U.S. is inherently fact-specific; however, the desire with FDAP is to make most income subject to tax once it is determined to be U.S. sourced. FDAP functions as a bit of a “catch-all” for U.S. sourced income, which is neither ECI nor capital gains.
FDAP is taxed on a gross basis – credits and deductions are not available to offset income. Critically, tax on FDAP income is collected through withholding by income payors; typically, the last United States taxpayer with control over the income item of a foreign taxpayer must meet any withholding requirements. A withholding agent generally is personally liable for any amount required to be withheld (and can be liable for interest and penalties as well).
Withholding must occur on payments made to a foreign person unless the withholding agent can reliably associate the payment with documentation establishing the payee as either a U.S. taxpayer or a foreign taxpayer entitled to a reduced or zero rate of withholding. A nonresident alien will identify their foreign status by completing and remitting Form W-8. Form W-8BEN is completed by foreign individuals to certify their foreign status (and, if applicable, claim treaty benefits, as discussed below); Form W-8BEN-E is completed by foreign entities. If a foreign recipient is not subject to withholding because income is ECI, Form W-8ECI is supplied. It is important to note that a “foreign person” for these purposes includes a nonresident alien individual, foreign corporation, foreign partnership, foreign trust and a foreign estate.
The most common way a foreign person with non-ECI U.S.-sourced income will reduce (or eliminate) their required withholding rate is through an income tax treaty - if their country of residence has one with the U.S. (over sixty exist) and they are eligible for its benefits. As noted, a foreign person will typically invoke treaty benefits – and the associated reduction/elimination in withholding requirements - on Form W-8BEN. If the treaty claim is valid, withholding should be applied at the applicable tax rate.
As stated, nonresident alien withholding and reporting requirements exist only for U.S.-sourced income. Typically, the source of the payment (either U.S. or foreign) is determined where the services are performed (for wages and nonemployee compensation), residence (for interest), company is formed (for dividends), location of property (for rent), etc. Sourcing is always a crucial determination in the withholding context.
If the above has taught you anything, it’s that dealing with foreign withholding can be challenging. Often, withholding requires consideration of multiple factors before a determination can be made. This area should never be taken lightly given the significant exposure for withholding agents. Fortunately, The Tax Warriors® at Drucker & Scaccetti are available to assist and advise on these challenging matters. Call on us for all your international tax needs. We are always prepared to help.