By Anthony Diosdi
U.S. companies regularly hire foreign contractors to perform various tasks. U.S. companies often do not consider the potential U.S. withholding tax consequences of retaining a foreign contractor. Many forms of U.S.-source income received by foreign persons is subject to a flat tax of 30 percent on the gross amount of income received. Internal Revenue Code Sections 871(a) (for nonresident aliens) and 881(a) (for foreign corporations) impose the 30-percent tax on “interest * * * dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income.” The collection of such taxes is affected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person to withhold the tax and pay it over to the Internal Revenue Service (“IRS”). The tax collected is, therefore, often referred to as a “withholding tax.” The obligation imposed on the payor to withhold tax is intended to assure its collection. The U.S. payor of income to a foreign person is often referred to as withholding agents. A potential withholding agent will generally be responsible for determining the existence of a withholding obligation.
Withholding In Respect of Compensation Income
If a foreign person is an employee working within the U.S., normal wage withholding provisions will apply to the compensation income. Otherwise, the 30-percent FDAP withholding requirements will apply for compensation received by a foreign person that worked in the U.S. as an independent contractor. Internal Revenue Code Section 861(a)(3) provides an exception to the withholding rules for compensation income paid to nonresident aliens. Under Section 861(a)(3), withholding is not required if: 1) the services are performed while a nonresident alien is temporarily in the U.S.; 2) the individual’s presence in the U.S. during the tax year is less than 90 days; 3) the compensation amount is $3,000 or less; and 4) the services are performed as an employee or independent contractor of: (i) a nonresident alien or foreign corporation or domestic partnership in a foreign country or U.S. possession.
Compensation paid for services performed outside of the U.S. is foreign source income and not subject to withholding. Compensation for services performed within and outside the U.S. into foreign and U.S. source portions with purposes of withholding. Unless the majority of the work was performed within the U.S., in which the entire compensation paid to the nonresident alien may need to be treated as U.S. source for purposes of withholding.
Responsibilities of Withholding Agents
A withholding agent will generally be responsible for determining the existence of a withholding obligation. Withholding agents are persons having “control, receipt, custody, disposal, or payment” of an item of income received by a foreign person. A withholding agent must deposit any taxes withheld with a Federal Reserve bank or an authorized financial institution. The withholding agent must also file an annual Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons and attach a separate Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding.
Let’s go through a basic example to illustrate how a U.S. person making payments to a foreign person for services performed may potentially avoid liabilities associated with withholding. Let’s assume a U.S. law firm hires a foreign person to be a receptionist. The U.S. law firm would be classified as a withholding agent. As a withholding agent, the U.S. law firm must be able to readily determine if there is a withholding required and withhold any applicable withholding taxes. This may present difficulties for the U.S. law firm that may not have detailed information about the foreign receptionist. Suppose for example, that the foreign person performs her receptionist duties within the U.S. How does the U.S. law firm know whether the withholding obligation applies?
The regulations establish an elaborate system of documentation and certification that must be satisfied to avoid the withholding requirements. See Treas. Reg. Section 1.1441-1. A withholding agent can rely upon certain forms of documentation to justify not withholding or a reduction in withholding. One such document is a Form W-8. Although there are a number of different Forms W-8s, the most common is the Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding. A foreign person uses a Form W-8BEN to: 1) establish foreign status; 2) claim a reduced rate of withholding under an income tax treaty; or 3) claim an exemption from withholding from withholding.
Absent actual knowledge that any statements on the Form W-8BEN are inaccurate, the receipt of a valid Form W-8BEN can be relied on to avoid liability for a withholding tax to a foreign payee.
Conclusion
Any U.S. person making payment for compensation to a foreign person may be obligated to withhold U.S. tax. A U.S. person who fails to withhold may be liable for uncollected tax. Therefore, a U.S. person must carefully monitor any payments made to a foreign person to ensure that the appropriate amount of tax is being withheld. In certain cases, a U.S. payor of compensation income to a foreign payee may rely on a type of a Form W-8 to avoid withholding.
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.