As many of my readers may know, there is a 30% withholding tax imposed on certain payments to foreign persons (whether individuals or entities) by US-payors. The 30% rate may be reduced or eliminated if a relevant treaty can apply.
Withholding is required only for particular types of income provided the income has not been derived from conducting an active trade or business in the US. In other words, the income on which withholding tax is imposed is of a more passive nature. Different rules apply when the income is derived from the active conduct of a US trade or business.
In addition, in order for withholding duties to arise, the income must be derived from what is called “US sources”. This in itself is a very complicated topic and will be examined below. When the US tax law speaks of “sourcing” of income, it is referring to the origin of the income as being earned in the United States or in a foreign country. If treated as earned in the United States, withholding issues arise. The sourcing rules depend on the type of income being paid. In other words, different sourcing rules apply for different categories of income.
Why Should I Care?
If you are a foreign investor into the United States, you should and will care! If you don’t understand the withholding rules, you will be in for a rude awakening when you see that a 30% tax has been taken from proceeds paid with regard to your US investment. If you are a “withholding agent” (a US-payor of amounts to a foreign person), you should and will also care! If you fail to withhold or do not withhold properly, you may be held personally responsible to pay the tax.
Withholding issues are directly linked to the Form W-8BEN and Form W-8BEN-E which will be covered in detail in blog posts coming soon.
Types of Income Subject to Withholding & Sourcing Rules
The types of income subject to withholding include (but are not limited to) dividends, interest, rental income, royalties, alimony, grants and prizes, compensation for personal services and other items of so-called “fixed determinable annual periodical income”.
Sourcing rules are contained largely in particular sections of the US Internal Revenue Code (IRC). The relevant sections are IRC Sections 861-863 and Section 865. The statutory rules cover interest, dividends, compensation for services, rents and royalties, gains from sales of property and social security benefits. See for example, IRC 861 which provides rules as to when specific classes of income (e.g., interest income, dividend income, rental and royalty income) are sourced “within” the US.
Section 861 will provide guidance for example, if you are sourcing dividend income. The rules generally provide that dividend income is determined by the payor’s country of incorporation. Dividends from US domestic corporations are generally “US source” income. Dividends paid from foreign corporations are generally treated as “foreign source”. However, to illustrate the complexity of the rules, even a dividend from a foreign corporation may be classified as having a “U.S. source”! This is so if at least 50 percent of the corporation’s gross income for the preceding three years was income that was treated as “effectively connected” with its conduct of a US trade or business.
Wages and any other compensation for services performed within the United States are generally considered to be from US sources; payments for services performed outside the United States will be non-US source. The place where the personal services are performed generally determines the “source” of the personal service income, regardless of where the contract was made, or the place of payment, or the residence of the payer. Thus, for example, a nonresident alien individual living in Poland who creates dress designs in Poland for a US company client, will earn non-US source income when paid by the US company for the services carried out in Poland.
Complexity is the Order of the Day
The complexity of the sourcing rules can become somewhat daunting and professional tax advice should be undertaken. For example, mortgage interest paid by a US individual to a foreign bank on real property even if located abroad may be subject to withholding tax (if the link is not working, please see the archived version of the post here).
A settlement payment (e.g., an amount paid to avoid a lawsuit) paid by a US payor to a foreign person may also be subject to withholding tax. The nature of the item for which the settlement payment is substituted will control the “characterization” of the payment. See, U.S. v. Gilmore, 372 U.S. 39 (1963). Similarly, the source of the item for which a settlement payment is substituted will control the “source” of the payment. See Rev. Rul. 83-177, 1983-2 C.B. 112 and see IRS Private Letter Ruling PLR 200620016.
Hopefully my blog post today, serves as a head’s up!
The IRS has a professional International Practice Unit for sourcing of income, here. See also IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities and Publication 519, US Tax Guide for Aliens for more information.
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