By Anthony Diosdi
In today’s global environment, many U.S. businesses hire foreign contractors for a variety of reasons. The very act of a U.S. business of paying a foreign contractor may result in withholding and compliance requirements. This article discusses a U.S. businesses potential obligation to withhold U.S. taxes to a foreign contractor.
Introduction to the FDAP Rules
United States source income that is effectively connected with a U.S. trade or business will be taxable to foreign persons at the usual individual or corporate rates. Appropriate deductions and credits apply in the determination of U.S. federal tax liabilities. On the other hand, United States source income received by foreign persons that is not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount of the income received.
Internal Revenue Code Sections 871(a) (applies to nonresident individuals) and Internal Revenue Code Section 881(a) (applies to foreign corporations) imposes a flat-tax on U.S. source “interest, dividends, rents, salaries, and other fixed or determinable annual or periodic gains, profits, and income.” The 30 percent withholding on the aforementioned income is often referred to as “FDAP.” The collection of this withholding tax is affected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person. See IRC Sections 1441 and 1442. In certain cases, tax treaties provide for a reduction or elimination of withholding taxes on specified items of United States- source FDAP income that is not attributable to a permanent establishment in the United States.
Withholding in the Context of Services by a Foreign Contractor
Payment of money to a foreign contractor could be classified as FDAP income and thus subjecting the U.S. payor of income to withholding. If the foreign contractor performed services on behalf of a U.S. individual or business in the United States, the U.S. person or business will likely need to withhold 30 percent (or in certain cases the applicable treaty rate). If a nonresident alien is an employee working within the United States, normal wage withholding provisions will apply to the compensation income. Otherwise, the 30-percent withholding requirements provided for under Internal Revenue Code Section 1441 continues to apply (with exception of the provisions of Revenue Ruling 70-543) for items of compensation received by a nonresident alien for working in the United States as an independent contractor. This withholding requirement will apply even though the income is effectively connected with a U.S. trade or business of providing personal services.
The analysis is different in cases where the foreign independent contractor performs services outside the United States. If the performance of services by a foreign independent contractor is performed outside the United States, there is typically no withholding requirement placed on the U.S. payor. Just because the performance of services is conducted outside the United States, one should not assume that there is no withholding obligation. For example, let’s assume that a Delaware based LLC pays a Singapean technology company to perform technology services. Let’s also assume that the Singaporean company performed all services outside the United States. One would think that since the Singaporean technology company performed all services outside the United States, the Delaware LLC has no obligation to withhold. As indicated above, this is not necessarily the case.
The rapid evolution of electronic commerce and the Internet has generated many difficult conceptual issues. If the Singaporean technology company regularly and continuously undertakes to effect a substantial quantity of sales to customers in the United States through Internet advertising and sales on a website that is maintained by an independent Internet service provider in the United States. This arrangement could support a conclusion that the Delaware based LLC has an obligation to withhold. In such a case, the Delaware based LLC may be required to withhold 30 percent of the payments made to the Singaporean technology company.
Information Return Requirements
If the Delaware LLC is required withhold, the Delaware LLC would need to deposit any money withheld with a Federal Reserve Bank or an authorized financial institution using a federal tax deposit coupon or through electronic funds transfer. See Treas. Reg. Section 1.6302-2. The Delaware LLC would also be required to file an annual informational return, Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. The Form 1042 is due by March 15th of the year following the end of the calendar year in which the tax was required to be withheld. The Delaware LLC would also need to file a Form 1042-S with the Internal Revenue Code or “IRS.”
Conclusion
This article was designed to provide the reader with an introduction to the rules regarding the withholding provisions that apply to foreign contractors. Anyone considering hiring a foreign individual or business should consult with an international tax attorney.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.