Withholding on U.S. Business Income of Foreign Vendors – Part 1

FATCA, ONESOURCE, Tax Information Reporting, W-8 & W-9 Foreign Reporting, Withholding Management Posted by Paula Singer 0 Comment

Posted on February 20, 2012

Foreign vendors being paid by U.S. organizations may include foreign enterprises that are engaged in a U.S. trade or business. Income of a foreign vendor that is effectively connected with the enterprise’s U.S. trade or business is subject to U.S. income tax after allowable deductions at graduated rates. Such effectively connected income (called ECI), when paid by a withholding agent, is subject to 30 percent withholding (called NRA withholding) unless the income: 1) is not of a type that is subject to NRA withholding; or, 2) an exemption from NRA withholding is available and procedures for claiming the exemption from withholding are followed. A foreign vendor receiving ECI may be either an entity or a foreign national who is a nonresident alien for U.S. tax purposes. Resident aliens are generally taxed like U.S. citizens.

Some types of income are deemed to be effectively connected income by U.S. tax law. Examples include, as a general rule, income from personal services performed in the U.S. (exceptions are described in IRS Publication 515) and sales of U.S. real estate. When a foreign vendor is a resident of a tax treaty country, the Business Profits Article of the applicable treaty might deem the income to be business profits (these treaty deeming rules vary by treaty). Some types of income, such as rents from U.S. real property, may be treated as ECI by election. Income that is usually from investments and subject to gross basis taxation (such as interest, rents of U.S. property and royalties for the use, or right to use, intangible personal property in the U.S.) are also taxed on a net basis if they meet either the assets test or the activities test. Income meets the assets test if the income is associated with U.S. assets used in, or held for use in, the conduct of a U.S. trade or business. For example, interest earned on bank deposits in an account used for a U.S. rental property covered by an ECI election is also ECI. Income meets the activities test if the activities of the enterprise conducted in the U.S. are a material factor in the realization of the income.

The ECI of foreign vendors is subject to reporting to the beneficial owner and IRS on Form 1042-S (whether exempt from withholding or not) unless an exception applies. For example, there is an exception from NRA withholding and Form 1042-S reporting for sales of U.S. real estate by foreign persons because this ECI is subject to a different set of rules for withholding, reporting and IRS forms. Also, ECI might be exempt from tax under the provision of an available income tax treaty. ECI that is exempted from withholding is reported under Exemption Code 01 (for ECI) or 04 (for treaty-exempt income). Otherwise, the Exemption Code is 00, indicating that taxes were withheld.

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Categories: FATCA, ONESOURCE, Tax Information Reporting, W-8 & W-9 Foreign Reporting, Withholding Management

About Paula Singer

Paula N. Singer, Esq. a practice leader with Thomson Reuters and award-winning author has over 30 years of experience as a tax lawyer specializing in cross-border tax issues for individuals, businesses, trusts, and estates. In 1994, Paula co-founded Windstar Technologies, Inc., to provide an easy-to-use and understand software solution for international tax compliance and reporting. A nationally recognized international tax attorney and partner in the law firm Vacovec, Mayotte and Singer LLP, in Newton, Massachusetts, Paula’s practice has concentrated in international tax matters for individuals, businesses, trusts, and estates. She has provided individuals and organizations with tax planning as well as compliance services for individuals relocating internationally since 1978. Paula is a frequent speaker and author of over 80 published articles and is the author of numerous tax guide books. Her articles on international tax topics have appeared in AILA publications, Tax Analysts’ Tax Notes International and Tax Notes as well as their online services, West and RIA publications, and bar association publications. Paula assisted the IRS and NAFSA with the development of Form 1040NR-EZ. Her comments on proposed regulations under section 7701(b) on the substantial presence test and under section 1441 on withholding on payments to foreign persons were incorporated into the final regulations under each section. Paula was a panelist with IRS International Issues Specialist, Lowell Hancock on two IRS webcasts on TaxTalkToday.tv “US Tax Withholding Issues in the Global Business Economy” Dec 2002 and on “Understanding U.S. Income Tax Treaties”, Mar 2008 and on a series of audio seminars in 2009 sponsored by the immigration portal ILW.com. The IRS has used Paula’s tax guidebooks to train their personnel. Paula is also co-author with Prof. Cynthia Blum of Rutgers Law School of two law review articles, “A Comprehensive Policy for U.S. Residence-Based Taxation of Individuals” published in 2008 by the Vanderbilt Journal of Transnational Taxation and “A Proposal for Taking the Complexities out of U.S. Retirement Distributions to Foreign Nationals’ published in 2012 by the Florida Tax Review, the law review of the University of Florida’s graduate tax program.