International tax law is a complex and ever-evolving area of law that governs the taxation of income earned by individuals and businesses across different countries.
As globalization continues to increase, cross-border transactions become more prevalent, and more individuals and businesses work across borders, understanding international tax law has become increasingly important.
One key area of international tax law that many individuals and businesses encounter is U.S. tax withholding. The rules surrounding U.S. tax withholding are intended to ensure that non-resident aliens pay their fair share of taxes on U.S. source income. However, these rules can be difficult to navigate and mistakes can be costly.
U.S. Tax Withholding
Whether a U.S. person is required to withhold tax depends on the “source” of the income.
U.S. persons generally must withhold tax on U.S.-source income that is paid to non-U.S. persons. U.S.-source income includes “fixed or determinable payment of annual or periodic income” or FDAP income. FDAP income consists of interest, dividends, rents, salaries, wages, premiums, annuities, compensation, remunerations, emoluments, and other gains and income that have their origins in the U.S.
The tax withholding rate for U.S.-source FDAP income is generally 30 percent unless there is a different rate provided by law or a U.S. Tax Treaty with the country where the payee resides.
Several types of income are specifically excepted from the tax withholding requirement. For example, non-U.S. source income (such as payments for services performed in foreign countries) and certain other specifically enumerated U.S.-source income (such as portfolio and other interest payments).
U.S. Tax Reporting
The payor may have the payee complete a Form W-9 or Form 8233 to determine how to report the payment to the IRS. The payee may then obtain more specific forms from the payee, including Forms W-8ECI (for income that is “effectively connected” with a U.S. trade or business) or W-BEN (for income that is not “effectively connected” with a U.S. trade or business), or some other form.
In general, if a U.S. payer makes a payment that is reportable under the law to a foreign entity or individual, the payer must provide information about the payment to the IRS on Form 1042-S. The payee may need to file Form 1042, 1042-S, and 1042-T to report the payments to the IRS and/or the payee. These forms may need to be filed even if the payor is not required to withhold tax.
Form 1042-S is used for reporting payments made to nonresident aliens (NRAs), foreign corporations (FCs), partnerships (FPRs), trusts (FTRs), estates (FREs), and other non-U.S. entities or individuals who are subject to withholding on certain types of income from sources within the United States. The form includes information about the recipient’s name, address, taxpayer identification number (TIN) or date of birth if no TIN has been obtained, type of income paid, amount paid, and any taxes withheld.
Also, when a payee claims a benefit of a tax law or treaty to reduce the rate or withholding amount, the payor may be required to complete Form 8833. This form is used to make a Treaty-Based Return Disclosure.
This is a very basic overview of these rules. The actual rules are much more involved, as is the process of applying the withholding and reporting rules to specific factual situations. Taxpayers may find Publication 515 helpful in assessing their U.S. tax withholding and reporting requirements. Given the complexity of these rules, taxpayers are well advised to have their tax attorney determine the taxpayer’s correct tax withholding and reporting obligations.
Backup withholding is a mechanism used by the IRS to ensure that taxes are collected on reportable payments made to foreign entities or individuals who fail to provide the necessary documentation.
The backup withholding rate is currently 24% for payments made after December 31st, 2020 but before January 1, 2026. The rate was previously set at 28%. Backup withholding applies when a payee fails to provide their correct TIN or provides an incorrect TIN on Form W-9 or Form W-8BEN-E. If backup withholding applies, then the payer must withhold 24% of any reportable payment made to the payee until the correct TIN is provided. The withheld amount must be remitted to the IRS.
If a payer fails to withhold backup withholding when required, they may be subject to penalties and interest on any underpayments. The reporting model for backup withholding involves the payer withholding a portion of the payment and remitting it to the IRS. The payer must also provide Form 1099-MISC or Form 1042-S to the payee and file a copy with the IRS.
Form 1099-MISC is used for reporting payments made to U.S. persons who are not employees, such as independent contractors or service providers. It includes information about the recipient’s name, address, TIN, type of income paid, the amount paid, and any taxes withheld.
Treaty Exceptions to Withholding for Nonresidents
As explained above, nonresident aliens who earn income in the United States are typically subject to mandatory withholding on that income. However, there are exceptions to this rule, which can be found in tax treaties between the United States and other countries.
These treaties provide a framework for determining how income earned by foreigners should be taxed, and they often include provisions that exempt certain types of income from mandatory withholding.
To claim a tax treaty benefit, nonresident aliens must provide a valid taxpayer identification number and complete Form W-8BEN, which certifies their eligibility for treaty benefits. This form is used to document the individual’s status as a nonresident alien and to identify any applicable tax treaty articles that may reduce or eliminate the amount of withholding required.
One common exception to mandatory withholding for nonresident aliens is found in tax treaty article 12, which deals with royalties. Under this provision, nonresident aliens may be eligible for a lesser tax treaty rate on royalties earned in the United States. This can significantly reduce the taxable portion of income subject to withholding for foreign persons.
Another exception is found in tax treaty article 10, which deals with dividends. Like royalty income, dividends paid to nonresident aliens may also be eligible for a lesser tax treaty rate under certain circumstances. To qualify for this benefit, the individual must meet specific requirements outlined in the applicable tax treaty.
In addition to these two examples, there are many other situations where nonresident aliens may be exempt from mandatory withholding under U.S. law. For example, some types of scholarship or fellowship payments made to foreign nationals may not be subject to withholding if certain conditions are met.
International tax law and U.S. tax withholding can be complex and involve multiple rules, forms, and reporting requirements. It is essential to understand the rules to ensure compliance and avoid costly missteps. Taxpayers must take into account various factors, such as the source of income, type of income, tax treaty provisions, and backup withholding requirements, among others. Nonresident aliens may be eligible for treaty benefits that can reduce their tax liability, making it crucial to understand these provisions and comply with the relevant documentation requirements.