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. Examples of withholding agents include corporations distributing dividends, debtors paying interest, tenants paying rents, and licensees paying royalties. A withholding agent who fails to withhold and pay the withholding tax to the Internal Revenue Service (“IRS”) is liable for the tax. The IRS can also assess delinquency penalties on any withholding taxes that are not timely paid.
A withholding agent must deposit any taxes using the Electronic Federal Tax Payment System (“EFTPS”). The withholding agent also must file an annual information return, Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons.
The Form 1042 is the form used to report tax withheld on foreign persons. The Form 1042 must be filed with the IRS by March 15th of the year following the calendar year in which payment was made. This article takes a deep dive into the preparation of the Form 1042.
Section 1- Record of Federal Tax Liability.
The Form 1042 begins with Section 1, entitled “Record of Federal Tax Liability.” Section 1 contains questions asked on Lines 1 through 60.
Lines 1 through 60.
For Lines 1 through 60 you (for purposes of this article, the term “you” refers to the U.S. payer of income or withholding agent to a foreign person) must show the federal tax liability for payments made during the applicable quarter-monthly period. You should report the tax liability for each period, rather than the amount of tax actually deposited with the IRS. The tax liability must be reflected in lines 1 through 60 regardless whether the liability is under chapter 3 or chapter 4 and regardless if the liability was actually paid to the IRS. 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.
Line 61.
For Line 61, you should enter the number of Forms 1042-S filed on paper and electronically.
Lines 62a through 62c.
For Lines 62a through 62c, you should enter the amounts reported on all Forms 1042-S for the calendar year and for all Forms 1000, Owner Certificate.
Line 62a.
For Line 62a, you should enter the amount on Line 62a should equal the sum of all amounts shown on Box 2 of Form 1042-S that are payments of U.S. source Fixed, Determinable, Annual, Periodic (“FDAP”) income less the sum of all amounts that are U.S. source substitute payments reported on Line 62b. Most of the forms of U.S.-source income received by foreign persons that are 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) (for nonresident aliens) and 881(a) (for foreign corporations) impose a 30-percent tax on “interest, dividends, rents, salaries, wages, fixed or determinable annual or periodic gains, profits, and income. This enumeration is referred to as “FDAP income.”
Line 62b.
For Line 62b(1), you should list the equal the sum of all amounts shown in Box 2 of Form 1042-S that are U.S. source substitute dividend payments; and the amount shown on line 62b(2) should equal all amounts shown in Box 2 of Form 1042-S that are U.S. source substitute payments other than substitute dividend payments. The payment in lieu of dividends or “substitute dividends” occurs in connection with the short sale of stocks.
Line 62c.
For Line 62c, you should enter the amount equal to the sum of all amounts of U.S. source FDAP income shown in Box 2 of Form 1042-S and all amounts shown as gross interest on Forms 1000.
Line 62d.
For Line 62d, you should enter gross amounts of U.S. source FDAP income reported on Forms 1000 and Forms 1042-S if different from the total gross amounts actually reported on Forms 1000 and Forms 1042-S.
Total Tax Reported as Withheld or Paid
The “Total Reported as Withholding or Paid” category of the Form 1042 asks you to report the total amounts of withholding taxes paid to the IRS.
Line 63a.
For Line 63a, you should enter the amounts actually withheld be applicable adjustments on Lines 63(1) and 63c(2)
Line 63c(1).
The amounts reported on Line 63c(1) should be amounts you repaid to the beneficial owner or payee in the year following the calendar year of overwithholding pursuant to either the reimbursement or set-off procedures (and should be reported as a reduction in tax liability on Line 59). The total of the amounts reported on Line 63c(1) should equal the sum of all amounts reported in Box 9 of the corresponding Forms 1042-S.
Line 63c(2).
The amounts reported on Line 63c(2) should be amounts you withheld in the year following the calendar year of underwithholding from future payments made to a beneficial owner or from other property or additional contributions of a beneficial owner that you hold in custody or otherwise control.
Line 63d.
The amount reported on Line 63d should be the amount paid by the withholding agent from its own funds rather than through withholding from the payment to the recipient. The amount on Line 63d should equal the sum of all amounts reported in Box 11 of all Forms 1042-S sent to receipts.
Computation of Tax Due or Overpayment
The “Computation of Tax Due or Overpayment” category of the Form 1042 asks you to report the total amounts of tax due or overpayments.
Line 64a.
For LIne 64a, you should report any adjustments to total net tax liability. For example, you should report any adjustment to liability when: 1) a distributing corporation made a reasonable estimate of accumulated and current earnings and profits under Treasury Regulation Section 1.1441-3(c)(2)(ii)(A) or 1.1474-6(c)(2)(ii) and 2) a distributing corporation or intermediary paid over any underwithheld tax.
Lines 64b and 64c.
For Lines 64b and 64c, you should enter the sum of the amounts reported on the Record of Federal Tax Liability (that is, the sum of lines 5, 10, 15, 20, 25, 30, 35, 40, 50, 50, and 60) that are attributable to liability under chapter 3 (on Line 64b) and chapter 4 (on Line 64c). The amounts shown on Lines 64b and 64c should not include any amounts shown on Lines 64a and 64d.
Line 64d.
For Line 64d, you should report the amounts reported on the Record of Federal Tax Liability that are attributable to liability for specified federal procurement under Section 5000C.
Line 64e.
For Line 64e, you should report the amount equal to the sum of Lines 64a through 64d.
Line 65.
For Line 65, you should enter the total tax deposits you made for the reporting year.
Line 66.
For Line 66, you should enter any overpayment reported on the previous year’s Form 1042 that you are applying as a credit for this year’s Form 1042.
Line 67.
You are permitted to take a credit for amounts withheld by other withholding agents that relate to the total net tax liability reported on Lines 64b and 64c. On Line 67, you may claim a credit on Line 67.
Line 70a and 70b.
For Line 70a, you should enter any overpayment attributable to payments subject to withholding under chapter 3 and 4. For Line 70b, you should enter any overpayment attributable to payments subject to the excise tax on specified federal procurement payments. Internal Revenue Code Section 5000C(a) imposes a tax equal to 2 percent of the amount of a specified federal procurement payment to any foreign persons. Federal procurement generally refers to contracts with the federal government.
Line 71.
You may claim an overpayment (the sum of Lines 70a and 70b) as a refund or a credit.
Section 2. Reconciliation
Section 2 entitled “Reconciliation” is used by the withholding agent to reconcile the amounts of U.S. source FDAP income reportable under chapter 4 and paid by the withholding agent during the calendar year with total amount of U.S. source FDAP income reported on all Forms 1042-S filed by the withholding agent.
Line 1.
For Line 1, you should enter the amounts of U.S. source FDAP income required to be withheld under chapter 4, including amounts withheld upon but for which no deposit has been made under an escrow procedure.
Line 2.
For Line 2, you should enter amounts of U.S. source FDAP income not required to be withheld under chapter 4 on Lines 2a through 2b according to the exception to withholding that applied to each payment reportable on Form 1042-S.
Line 2a.
For Line 2a, you should enter amounts of U.S. FDAP income that are withholdable payments, but for which the withholding agent has obtained documentation that establishes a chapter 4 status that does not require withholding under chapter 4. For example PFFI. A PFFI is an FFI that has agreed to satisfy the obligations of an FFI agreement under chapter 4 with respect to all of its branches of the FFI, other than a branch that is reporting Model 1 FFI or a U.S. branch.
Line 2b.
For Line 2b you should enter the amounts of U.S. source FDAP income that are not withholdable payments because they are nonfinancial type payments (for example, royalties, services, rents). The amount reported on this line should generally equal the aggregate amount reported in Box 2 of all Forms 1042-S filed for the calendar year for which the exemption Code 16, Excluded nonfinancial payments were reported.
Line 2c.
For Line 2c, you should enter the amounts of U.S. source FDAP income that are not withholdable payments because they are related to grandfathered obligations. See Treas. Reg. Section 1.1471-2(b). Under Treasury Regulation Section 1.1471-2(b), solely for purposes of a foreign passthru payment, the term grandfathered obligation includes any obligation that is executed on or before the date that is six months after the date on which final regulations defining the term foreign passthru payment are filed with the Federal Register.
Line 2d.
For Line 2d, enter the amounts of U.S. source FDAP income that are not withholdable payments because they are payments of effectively connected income (ECI). Generally, when a foreign person engages in a trade or business in the United States that generates FDAP income, all income from the FDAP source is considered tobe ECI.
Line 2e.
For Line 2e, you should enter the sum of all amounts of U.S. source FDAP income required to be reported on Form 1042 but that are not required to be withheld under chapter 4.
Line 4.
For Line 4, enter the sum of all amounts shown in Box 2 of Form 1042-S that are payments of U.S. source FDAP income (including amounts reported under both chapter 3 and chapter 4). The amount on Line 4 should equal the total gross amounts of U.S. source FDAP income reported on Line 62c.
Line 5.
For Line 5, you should enter the total reported on Line 4 (total amount of U.S. FDAP income reported on all Forms 1042-S) less the total reported on Line 3 total (total U.S. source FDAP income reportable under chapter 4).
Line 6.
If the amount reported on Line 5 is other than zero, use this line to provide explanation for the variance. If additional space is needed, you should attach a sheet to Form 1042 explaining the difference noted on Line 5.
Section 3. Potential Section 871(m) Transactions
Check the box if you are a withholding agent that makes any payment under a potential Section 871(m) transaction during the year, including a notional principal contract or other derivative contract that references, in whole or in part, a U.S. stock or underlying security. A notional principal contract is a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.
Section 4. Dividend Equivalent Payments by a Qualified Derivatives Dealer
Section 4 entitled “Dividend Equivalent Payments by a Qualified Derivatives Dealer (QDD”) asks you to attach Schedule Q if payments were made by a QDD. Internal Revenue Code Section 871(m) treats payments under equity derivative contracts that reference U.S.-source dividends as if they were equivalent to U.S.-source dividends. Dividend equivalents are typically treated as U.S. source dividend income that is subject to a 30 percent withholding tax. However, Treasury Regulation 1.871-15(g) exempts qualified derivatives dealers or QDDs from tax and withholding requirements if overwithholding would occur. Treasury Regulation Section 1.871-15(g) allows the IRS to reduce tax to the extent it can be established that tax has been paid on another dividend equivalent in the chain, is not otherwise due, or is appropriate to address the role of financial intermediaries in the chain.
If you were a QDD during the reporting year, check the box for Section 4 and attach Schedule Q to the Form 1042.
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.