By Anthony Diosdi
The United States often taxes the gross income received by foreign persons. In addition, the person controlling the payment of the income may need to deduct and withhold U.S. taxes before payment is made to a foreign person. The following types of foreign persons may be subject to U.S. withholding taxes:
(i) Nonresident alien individuals;
(ii) Foreign corporations;
(iii) Foreign partnerships, and
(iv) Foreign estates and trusts.
A nonresident alien is an individual who is neither a citizen nor resident of the United States. A foreign corporation is a corporation organized or created under the laws of a foreign country. Likewise, a foreign partnership is a partnership organized or created under the laws of a foreign country. An estate is foreign if its foreign-source income, other than any income effectively connected with a U.S. trade or business, is not subject to U.S. taxation. A trust is foreign if either no U.S. court is able to exercise primary supervision over the administration of the trust, or no U.S. persons have the authority to control all substantial decisions of the trust.
Any person having control, receipt, custody, disposal, or payment of an item of U.S.-source income to a foreign person could be obligated to withhold U.S. tax. Not only may a withholding agent have an obligation to withhold U.S. tax on income paid to a foreign person, a withholding agent may be required to file a Form 1042-S with the Internal Revenue Service (“IRS”). A Form 1042-S is used to report payments to the IRS by U.S. based individuals and businesses to foreign persons. If you are a U.S. based individual or business and made a payment to a foreign person, you will likely need to report the payment on a Form 1042-S to the IRS. This article discusses the Form 1042-S. The Form 1042-S is due no later than March 15th of the next tax year after the payment to a foreign person or entity. A penalty of up to $100 of up to $100 per form (up to a total maximum of $1.5 million) may be assessed by the IRS for each failure to timely file a Form 1042-S. This article takes a deep dive into the preparation of the Form 1042-S.
Box 1.
Box-1 asks the preparer of the Form 1042-S to state an “Income Code.” All filers must enter the appropriate two-digit income code in Box 1. Below are some examples of the income codes for Box 1..
1. Use code 06 for dividends.
2. Use code 09 for capital gains.
3. Use code 17 for payments for independent personal services performed by a foreign person or foreign entity.
4. Use code 29 if you are paying bank deposit interest.
5. Use code 24 (qualified investment entity (QIE) distributions of capital gains from a QIE)
Box 2.
Box 2 is entitled “Gross Income.” Box 2 is completed for each income type, enter the gross amount you (for purposes of this article, the term “you” refers to the U.S. payer of income or withholding agent to a foreign person) paid (in whole dollars) to or on behalf of the recipient during the calendar year, including withheld tax.
Box 3.
Box 3 is entitled “Chapter Indicator.” If you are reporting amounts in boxes 7 through 9, enter either a “3” or “4” to indicate whether the amounts were withheld pursuant to chapter 3 or 4. Generally, an amount subject to chapter 3 withholding is an amount from sources within the U.S. that is FDAP income. FDAP income is all income included in gross income, issue discount (“OID”), dividends, rents, royalties, and compensation. On March 18, 2010, the HIRE Act added to the Internal Revenue Code chapter 4, composed of Sections 1471 through 1474 (referred to as FATCA). Chapter 4 generally requires withholding agents to withhold 30 percent on withholdable payments made to certain FFIs (FFI is the abbreviation for foreign financial institution) and NFFEs (NFFE is the abbreviation for any non-U.S. entity that is not treated as a financial institution). Chapter 4 payments may not be reduced by tax treaty.
Boxes 3a and 4a.
Boxes 3a and 4a are entitled “Exemption Code.” The exemption codes can be found on Appendix B to the Form 1042-S. The withholding agent should enter the appropriate exemption code that applies. In certain cases, more than one exemption code will apply.
Boxes 3b and 4b
Boxes 3b and 4b are entitled “Tax Rates.” For boxes 3b and 4b, the preparer must enter the correct rate of U.S. withholding tax that applies to Box 2 (gross income) or Box 6 (net income), as appropriate.
Box 5.
Box 5 is entitled “Withholding Allowance.” This box should be completed only if the income code reported in Box 1 is 16 (scholarship or fellowship grants), 17 (compensation for independent services), 18 (compensation for dependent personal services), 19 (compensation for teaching), 20 (compensation during studying and training), or 42 (earnings as an artist or athlete-no central withholding agreement).
Box 6.
Box 6 is entitled “Net Income.” Box 6 should only be completed if an entry was made in Box 5.
Box 7a.
Box 7a is entitled “Federal Tax Withheld.” For Box 7a, the preparer should enter the total amount of U.S. federal tax actually withheld under chapter 3 or 4.
Box 7b.
Box 7b should be checked if a withholding agent withheld tax during the calendar year that was not required to be deposited with the IRS pursuant to escrow procedures discussed in the regulations.
Box 7c.
Box 7c should be checked if you are a partnership that received an amount subject to withholding and you are withholding on the amount includible in a foreign partner’s share after March 15 of the subsequent year.
Box 8.
For Box 8, if you are a withholding agent filing a Form 1042-S to report income that has already been subject to withholding by another withholding agent, enter the amount actually withheld by the other agent(s) in Box 8.
Box 9.
Box 9 should be completed only if you repaid a recipient under the reimbursement or set-off procedures set forth in Treasury Regulations Section 1.1461-2(a)(2) or (3). Treasury Regulation Section 1.1461-2 permits a withholding agent to reimburse itself by reducing, by the amount of tax actually repaid to the beneficial owner or payee, the amount of any deposit of tax made by the withholding agent for any subsequent payment period occurring before the end of the calendar year following the calendar year of overwithholding. Under the set-off procedure, the withholding agent may repay the beneficial owner or payee by applying the amount overwithheld against any amount which otherwise would be required under chapter 3 of the Internal Revenue Code or its regulations thereunder to be withheld from income paid by the withholding agent to such person before the earlier of the due date (without regard to extensions) for filing the Form 1042-S for the calendar year of overwithholding or the date that the Form 1042-S is actually filed with the IRS.
Box 10.
For Box 10, you should enter the combined amounts reported in box7a (federal tax withheld), box 8 (tax withheld by other agents), and box 9 (overwithheld tax repaid to recipient pursuant to adjustment procedures).
Box 11.
For Box 11, you should enter the total amount of tax paid by you and not withheld from the payment to the recipient.
Box 12a.
For Box 12a, you must enter its Employer Identification Number or (“EIN”).
Boxes 12b and 12c.
For Boxes 12b and 12c, you must state the withholding agent’s status codes from the list of Recipient Status Codes in Appendix B. You must enter both chapter 3 and a chapter 4 withholding agent status code regardless of the type of payment being made. If you are a U.S. financial institution (“USFI”), Box 12b should indicate your chapter 4 status code as 01, except when a foreign branch of a USFI issues Form 1042-S. In such a case, the chapter 4 status code would be 50.
Box 12d.
For Box 12d, your name must be entered.
Box 12e.
For Box 12e, the GIIN provided must be disclosed. GIIN means Global Intermediary Identification Number assigned to a Participating Foreign Financial Institution (“PFFI”) or registered FFI. The GIIN is a 19-character identification number.
Box 12f.
For Box 12f, you must enter the code (from the list at IRS.gov/CountryCodes) for the country for which you are resident under that country’s tax laws. Enter “OC” (other country) only when the country of residence does not appear on the list. If you are a U.S. person, enter “US” in Box 12f.
Box 12g.
For Box 12g, you must enter your foreign tax identification number, if applicable.
Boxes 13a through 13e.
For Boxes 13a through 13e, the complete name of the foreign recipient, address, country code, and U.S. TIN should be entered.
Boxes 13f and 13g.
For Boxes 13f and 13g, the receipt status code from the list of Recipient Status Codes in Appendix B in the instructions to prepare Form 1042-S should be entered for chapter 3 and chapter 4 status codes.
Box 13i.
For Box 13i, the recipient’s foreign identification number used in the recipient’s country of residence for tax purposes.
Box 13j.
For Box 13j, if you are making a payment for which a beneficial owner that is an entity has claimed a reduction rate of withholding under an income tax treaty and provided documentation that establishes the limitation on benefits (“LOB”) article under which the beneficial owner qualifies, the applicable LOB code from Appendix B to the instruction for Form 1042-S must be entered.
Box 13K.
For Box 13K, if you are a financial institution reporting amounts paid to your direct account holder with respect to an account maintained by you, you must report the recipient’s account number in Box 13K.
Box 13I.
For Box 13I, you must enter the recipient’s date of birth.
Boxes 14a and 14b.
For Boxes 14a and 14b, you must enter the primary withholding agent’s name and EIN. If you are an intermediary or flow-through entity reporting amounts withheld by another withholding agent in box 8, you must provide the name and EIN of the withholding agent that withheld the tax.
Boxes 15.
You must check Box 15 to notify the IRS that an NQI (any intermediary that is a foreign person and that is not a QI). that used the alternative procedures of Regulations Section 1.1441-1(e)(3)(iv)(D) failed to properly comply with those procedures. The withholding regulations differentiate between a qualified intermediary (“QI”) and a nonqualified intermediary (“NQI”). A qualified intermediary has qualified and registered with the IRS to be responsible for withholding on payments to the ultimate beneficiaries at the appropriate withholding rate. See Treas. Reg. Section 1.1441-1(b)(2)(v). NQIs must provide the appropriate Forms W-9 and W-8BEN to the payor, who retains responsibility for withholding at the appropriate rate. See Treas. Reg. Section 1.1441-1(b)(2)(vii)(B).
Boxes 15a through 15i.
If you are reporting amounts subject to reporting chapter 3 or 4 purposes paid to a recipient whose withholding certificates or other documents have been submitted to you (or should have been submitted to you) with a Form W-8IMY provided by an intermediary or flow-through entity, you must include the name and address of the intermediary or flow-through entity whose Form W-8IMY the recipient’s Form W-8 or other documentation is associated.
Boxes 16a Through 16e
For boxes 16a through 16e, you should list the payer’s name, payer’s TIN, payer’s GIIN, payer’s chapter 3 status code, and payer’s chapter 4 status code.
Boxes 17a Through 17c,
For boxes 17a through 17c, you should list the any state income tax withheld, payer’s state tax number, and the name of the state which withheld income tax.
Conclusion
With the expansion of cross-border transactions, more U.S. businesses will need to become familiar with U.S. tax, withholding, and compliance rules. Failure to become familiar with these rules can result in substantial penalties.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi 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.