Navigating Withholding Tax on International Payments

This article offers a thorough overview of the U.S. withholding tax regime related to international payments. It discusses identifying payment types, determining payee status, applying relevant withholding rules, treaty relief, documentation and reporting requirements, and practical steps for compliance. The goal is to assist withholding agents and U.S. payors in fulfilling their obligations and minimizing the risk of penalties.

Identifying the Type and Source of Payment

Withholding tax obligations mainly arise from U.S. source fixed or determinable annual or periodical (FDAP) income paid to foreign persons. FDAP income includes interest, dividends, rents, royalties, compensation, and certain gains. Specific rules determine the source of income: for example, interest is sourced by the residence of the payer, dividends by the type of corporation, and services by where they are performed.

Determining the Status of the Payee

The withholding regime differentiates between U.S. persons and foreign persons. Withholding under Chapter 3 (IRC §§ 1441–1443) applies only to payments to foreign persons, including nonresident aliens and foreign entities. The payee’s status must be verified through proper documentation, usually via Form W-8 (for foreign persons) or Form W-9 (for U.S. persons). Without documentation, presumption rules apply, which may lead to the maximum withholding rate being applied.

Application of Withholding Regimes

A. Chapter 3 Withholding (IRC §§ 1441–1443) The default rule is a 30% withholding on U.S. source FDAP income paid to foreign persons, unless a lower treaty rate applies. Certain types of income, such as portfolio interest and bank deposit interest, may be exempt.

B. Chapter 4 Withholding (FATCA, IRC §§ 1471–1474) FATCA imposes a 30% withholding on U.S. source FDAP income paid to certain foreign financial institutions (FFIs) and non-financial foreign entities (NFFEs) that do not comply with FATCA requirements. If Chapter 4 withholding applies, Chapter 3 withholding is not required on the same payment.

C. Other Withholding Regimes

• FIRPTA (IRC § 1445): Withholding on dispositions of U.S. real property interests by foreign persons, generally at 15%.

• Partnership Withholding (IRC § 1446): Withholding on effectively connected income allocable to foreign partners.

• Section 1446(f): Withholding on transfers of partnership interests by foreign persons.

Treaty Relief

The U.S. maintains income tax treaties with many countries, which may reduce or eliminate withholding on certain types of income. To claim treaty benefits, the payee must provide a valid Form W-8BEN (individual) or W-8BEN-E (entity), including a U.S. or foreign TIN and a claim of residency in a treaty country. Many treaties include Limitation on Benefits (LOB) provisions that must be satisfied for treaty relief to apply.

Backup Withholding

Backup withholding generally applies only to U.S. persons who fail to provide a TIN or are notified by the IRS of underreporting. It does not apply to non-resident aliens if proper documentation is provided.

Special Considerations

• Payments to intermediaries or flow-through entities require the withholding agent to obtain documentation for the beneficial owners.

• Payments to disregarded entities are treated as made to the owner for withholding purposes.

• Special rules apply for payments to foreign partnerships and trusts, often requiring a look-through to the partners or beneficiaries.

Documentation and Reporting

Withholding agents must obtain and review the appropriate documentation (Forms W-8 or W-9) to determine the payee’s status and eligibility for reduced withholding. Payments subject to Chapter 3 or 4 withholding must be reported on Form 1042-S, and the withheld tax remitted via Form 1042. Payments to U.S. persons are reported on Form 1099, with backup withholding applied if required.

Deposit and Remittance of Withheld Taxes

All taxes withheld must be deposited electronically using the Electronic Federal Tax Payment System (EFTPS). Deposits must be made according to the IRS deposit schedule to avoid penalties.

Penalties for Noncompliance

Withholding agents are liable for any under withheld tax, plus interest and penalties. If the foreign person pays the tax, the agent is relieved of the tax liability but remains liable for penalties and interest.

Country-Specific Withholding Rates

Under U.S. domestic law, the default withholding rate is 30% on U.S. source FDAP income to foreign persons, unless reduced by treaty. Treaty rates vary by country and type of income. For example, the U.S.-Canada treaty provides for 0% withholding on interest and 15% on dividends.

Conclusion

Withholding tax on international payments is a complex area requiring careful attention to the type of payment, payee status, and documentation, applicable U.S. tax law, and relevant tax treaties. Noncompliance can result in significant liability for withholding agents. It is essential to consult the latest IRS guidance, relevant treaties, and seek professional advice for complex or high-value transactions.

How Trowbridge Can Help

At Trowbridge Professional Corporation, our team of tax experts specializes in optimizing tax strategies and helping clients navigate changing tax policies. If you're interested in learning more about how we can assist you in optimizing your tax planning strategies, we invite you to schedule a call with us today.