The IRS has invested in data-integrity tools and is scrutinizing errors on informational reporting forms such as the Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. Thus, with improved technology, the IRS is more likely to detect missed, incorrect, or late filings. This article highlights important questions payers of U.S-sourced fixed, determinable, annual, or periodical income should consider before making payments of such items to foreign persons to make sure withholding agents are withholding timely, remitting withheld taxes, and reporting properly on Form 1042-S to reduce the risk of penalties and IRS examination.
- What is fixed, determinable, annual, or periodical (FDAP) income?
- FDAP income includes items such as interest, dividends, royalties, rent, salaries, wages, premiums, annuities, compensation, renumeration, emoluments, and other fixed or determinable annual or periodical gains, profits, and income. The U.S. taxes foreign persons including foreign individuals, corporations, trusts, etc., on their U.S.-sourced FDAP income. U.S.-sourced FDAP income is generally subject to a 30% withholding tax on a gross basis unless exempt by statute or reduced by treaty. The withholding tax is not only the enforcement mechanism, but also the substantive tax. When U.S.-sourced FDAP is paid to a foreign person, it must be reported on Forms 1042 and 1042-S (in addition to being subjected to the applicable withholding rules).
- Is the income from U.S. or foreign sources?
- After determining if the payment is FDAP income, it is necessary to determine whether the item of income is from U.S. or foreign sources as the withholding and reporting obligations generally only apply to U.S.-sourced FDAP income. There are sourcing rules for different types of FDAP income. For example, compensation for services is sourced based on the place where services are performed. Items such as interest and dividends depend on where the payer resides and if they are a U.S. or foreign entity. Royalties are generally sourced to the place where the underlying intellectual property has been exploited.
- Is there a valid certificate of status of beneficial owner for U.S. tax withholding and reporting on file? Were there any tax treaty benefits claimed or was a claim made that the income is effectively connected with the conduct of a U.S. trade of business?
- It is important to confirm the non-U.S. status of the payee and eligibility for treaty benefits. Form W-8BEN should be obtained from the foreign person (or Form W-8BEN-E if the beneficial owner is a foreign entity). These forms are certificates of status of the beneficial owner of an item of income and should be kept on record, and will be requested in an IRS audit. Treaty eligibility, which is often a complex question, can be asserted on the forms. Fortunately, withholding agents can generally rely upon valid, properly executed Forms W-8BEN/W-8BEN-E in determining whether a foreign person is eligible for treaty benefits. In some cases, the W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, can turn off withholding because the payee is engaged in a U.S. trade or business. In particular, it should be noted that a W-8ECI does not turn off withholding on payments of compensation to individuals for services performed in the United States.
- Are there penalties for noncompliance or incorrect withholding and reporting?
- Yes, it is becoming increasingly important to understand how and what to withhold on payments of U.S.-sourced FDAP to foreign persons. Withholding agents may become personally liable for the taxes required to be withheld if the withholding forms are incorrect or were not filed in a timely manner. Failure to file, failure to file timely, or filing incomplete or incorrect forms can result in interest, penalties, and audits for both the withholding agent and the recipient, especially if the payee does not satisfy their U.S. tax liability. Failure to timely remit withheld taxes to the Treasury can also result in penalties and interest.
- Important due dates
- Depending upon the amount of undeposited withholding taxes, withholding agents are required to use the Electronic Federal Tax Payments System (EFTPS) to deposit the tax withheld. Withholding taxes are generally due with respect to amounts paid and not on an accrual basis. In general, taxes must be remitted to the IRS within 3 business days after the end of the quarter-monthly period ending on the seventh, 15th, 22nd, and the last days of the month, for payments over $2,000, at the end of a month for payments between $200 and $2,000, or at the end of a calendar year for any payment of less than $200.
- The reporting of Form 1042/1042-S is due March 15 of the following calendar year.
We recommend that each payment be carefully examined under the withholding regulations to determine if withholding and related information reporting are applicable. The rules governing the withholding of income tax with respect to payments to non-U.S. persons are complex and carry significant penalties. Please reach out to our specialized international tax team for assistance. Submit the Contact Us form below if you have questions.