What the IRS Watches for When Your Payments Go Across the Border
In this fast-paced era dominated by ever-evolving technology, even a small business can find itself engaged in transactions with vendors or contractors based in a foreign country. These payments may include compensation for services, consideration for goods, etc. If you have a business partner based in a foreign country, the payments may include interest on a loan, or dividends paid from US profits. In any case, you expect to make such payments and move on, right? Not so if the payments go outside of the country. Here’s why:
US Tax Withholding
When you make certain payments to a payee based outside of the US, the IRS generally requires you to withhold 30% of the gross payment amount so that you can remit that 30% to the IRS. (The 30% rate can often be reduced to a lower rate under the tax treaty with the country where the payee resides – but it’s not automatic. More on this later.) The natural question is “On what payment do I have to collect the US tax when the payment goes to a foreign business or person?” Here are some of the typical payments subject to the withholding:
- Fees for personal services
- Some types of gain
The payment must represent income that is sourced to the US in order to be subject to the withholding. Then, how do you know if it is US source or foreign source? Each item of income has its own sourcing rule:
|If you have:||Then the source of that income is determined by:|
|Pay for personal services||Where the services are performed|
|Dividends||The type of corporation (US or foreign)|
|Interest||The residence of the payer|
|Rents||Where the property is located|
|Royalties – Patents, copyrights, etc.||Where the property is used|
Is there any reporting requirement?
Outbound business payments are typically reported on IRS Form 1042-S, which must be furnished to the payee. (Think of a Form 1099, which is used for similar purposes for some domestic payments.) IRS Form 1042 must also be filed with 1042-S to report aggregate amounts reported on each Form 1042-S. You need to file the form even if no US tax is withheld. The reporting requirement arises with the actual payment, not the accrual, of the amount.
Basis for withholding at a reduced rate or no withholding
As mentioned earlier, the US tax withholding must be equal to 30% of the gross payment amount unless a reduced rate under a US tax treaty applies or the entire amount of withholding should be eliminated for a particular reason. The following are typical situations where the statutory 30% withholding is waived:
IRS Form W-8BEN
If a payee is located in a country with which the US has income tax treaty, odds are you can reduce the rate. IRS Publication 515 comes in handy, as it provides a table listing applicable rates for different types of payments made to residents in many treaty partner countries. When your payee certifies that he/she is a resident of certain treaty partner country, you can apply the reduced rate to come up with the net amount to be paid to the payee. This certification is typically made on IRS Form W-8BEN. The form does not need to be filed with the IRS but it must be retained in your files as support for the treaty withholding rate.
IRS Form W-8ECI
If your payee is an entity (such as a corporation or partnership) doing business in the US, and the payment is income that is connected with their conduct of such US business, they may wish to have the withholding waived because they are filing a US tax return to report all of their income in connection with their US business. Their wish can be granted if they certify that the payment is connected with their US business and therefore not subject to US tax withholding. This certification is typically made on IRS Form W-8ECI. Again, the form does not need to be filed with the IRS. If the payee is an individual, the US tax must still be withheld.
Penalties for incompliance
Here is a summary of penalties for non-filing of each form identified below:
|Forms||Type of penalty||Amount of penalty|
|1042||Late filing||5% of unpaid tax up to 25%.|
|1042-S||Late filing||$30 per form within 30 days from due date,$60 per form after 30 days and before Aug 1,$100 per form after Aug 1.|
In addition to late filing penalties, companies can also be assessed penalties for late payment of withheld taxes.
Other potential consequences
Surprisingly, noncompliance with Form 1042 reporting could potentially cause problems for a non-US payee, too. Form 1042 reporting may be most relevant in a situation where a non-US investor sets up a US subsidiary in order to expand the existing non-US business into the US, and the US subsidiary makes routine payments to the non-US investing entity. The general trend in the US concerning withholding tax rates is gradually moving towards a zero percent rate, especially for interest and dividend payments between the US and our treaty partner countries. Because of this trend towards zero rates, you might think that the noncompliance will not have any significant financial implications: when there is no withholding required the late filing penalty is $0. However, unless the payment amount is properly reported on Form 1042-S by the payer, the payee must file a US federal income tax return and disclose their position that they are entitled to a reduced treaty rate (including zero percent rate). Otherwise, the IRS could demand the statutory 30% tax on the payment and even a $10,000 penalty for payee’s failure to disclose the treaty-based position. Given the alternatives, filing the 1042 is likely the simpler route!
Because of these and many other complex rules, international business operations call for special care. Give us a call any time to talk about it!
Author: Masataka Yamaguchi, CPA, International Tax Manager