Withholding of Tax
In most cases, a foreign person is subject to U.S. tax on its U.S. source income. Most types of U.S. source income received by a foreign person are subject to U.S. tax of 30%. A reduced rate, including exemption, may apply if there is a tax treaty between the foreign person’s country of residence and the United States. The tax is generally withheld (NRA withholding) from the payment made to the foreign person.
The term “NRA withholding” is used in this publication descriptively to refer to withholding required under sections 1441, 1442, and 1443 of the Internal Revenue Code. In most cases, NRA withholding describes the withholding regime that requires withholding on a payment of U.S. source income. Payments to foreign persons, including nonresident alien individuals, foreign entities, and governments, may be subject to NRA withholding.
A withholding agent (defined next) is the person responsible for withholding on payments made to a foreign person. However, a withholding agent that can reliably associate the payment with documentation (discussed later) from a U.S. person is not required to withhold. In addition, a withholding agent may apply a reduced rate of withholding (including an exemption from withholding) if it can reliably associate the payment with documentation from a beneficial owner that is a foreign person entitled to a reduced rate of withholding.
You are a withholding agent if you are a U.S. or foreign person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding. A withholding agent may be an individual, corporation, partnership, trust, association, nominee (under section 1446 of the Code), or any other entity, including any foreign intermediary, foreign partnership, or U.S. branch of certain foreign banks and insurance companies. You may be a withholding agent even if there is no requirement to withhold from a payment or even if another person has withheld the required amount from the payment.
Although several persons may be withholding agents for a single payment, the full tax is required to be withheld only once. In most cases, the U.S. person who pays an amount subject to NRA withholding is the person responsible for withholding. However, other persons may be required to withhold. For example, a payment made by a flow-through entity or nonqualified intermediary that knows, or has reason to know, that the full amount of NRA withholding was not done by the person from which it receives a payment is required to do the appropriate withholding since it also falls within the definition of a withholding agent. In addition, withholding must be done by any qualified intermediary, withholding foreign partnership, or withholding foreign trust in accordance with the terms of its withholding agreement, discussed later.
Liability for tax. As a withholding agent, you are personally liable for any tax required to be withheld. This liability is independent of the tax liability of the foreign person to whom the payment is made. If you fail to withhold and the foreign payee fails to satisfy its U.S. tax liability, then both you and the foreign person are liable for tax, as well as interest and any applicable penalties.
The applicable tax will be collected only once. If the foreign person satisfies its U.S. tax liability, you are not liable for the tax but remain liable for any interest and penalties for failure to withhold.
Determination of amount to withhold. You must withhold on the gross amount subject to NRA withholding. You cannot reduce the gross amount by any deductions.
If the determination of the source of the income or the amount subject to tax depends on facts that are not known at the time of payment, you must withhold an amount sufficient to ensure that at least 30% of the amount subsequently determined to be subject to withholding is withheld. In no case, however, should you withhold more than 30% of the total amount paid. Or, you may make a reasonable estimate of the amount from U.S. sources and put a corresponding part of the amount due in escrow until the amount from U.S. sources can be determined, at which time withholding becomes due.
When to withhold. Withholding is required at the time you make a payment of an amount subject to withholding. A payment is made to a person if that person realizes income, whether or not there is an actual transfer of cash or other property. A payment is considered made to a person if it is paid for that person’s benefit. For example, a payment made to a creditor of a person in satisfaction of that person’s debt to the creditor is considered made to the person. A payment also is considered made to a person if it is made to that person’s agent.
A U.S. partnership should withhold when any distributions that include amounts subject to withholding are made. However, if a foreign partner’s distributive share of income subject to withholding is not actually distributed, the U.S. partnership must withhold on the foreign partner’s distributive share of the income on the earlier of the date that a Schedule K-1 (Form 1065) is provided or mailed to the partner or the due date for furnishing that schedule. If the distributable amount consists of effectively connected income.
A U.S. trust is required to withhold on the amount includible in the gross income of a foreign beneficiary to the extent the trust’s distributable net income consists of an amount subject to withholding. To the extent a U.S. trust is required to distribute an amount subject to withholding but does not actually distribute the amount, it must withhold on the foreign beneficiary’s allocable share at the time the income is required to be reported on Form 1042-S.
Withholding and Reporting Obligations
You are required to report payments subject to NRA withholding on Form 1042-S and to file a tax return on Form 1042. An exception from reporting may apply to individuals who are not required to withhold from a payment and who do not make the payment in the course of their trade or business.
Form 1099 reporting and backup withholding. You also may be responsible as a payer for reporting on Form 1099 payments made to a U.S. person. You must withhold 28% (backup withholding rate) from a reportable payment made to a U.S. person that is subject to Form 1099 reporting if any of the following apply.
- The U.S. person has not provided its taxpayer identification number (TIN) in the manner required.
- The IRS notifies you that the TIN furnished by the payee is incorrect.
- There has been a notified payee underreporting.
- There has been a payee certification failure.
In most cases, a TIN must be provided by a U.S. non-exempt recipient on Form W-9, Request for Taxpayer Identification Number and Certification. A payer files a tax return on Form 945, Annual Return of Withheld Federal Income Tax, for backup withholding.
You may be required to file Form 1099 and, if appropriate, backup withhold, even if you do not make the payments directly to that U.S. person. For example, you are required to report income paid to a foreign intermediary or flow-through entity that collects for a U.S. person subject to Form 1099 reporting.
Foreign persons who provide Form W-8BEN, Form W-8ECI, or Form W-8EXP (or applicable documentary evidence) are exempt from backup withholding and Form 1099 reporting.
Wages paid to employees. If you are the employer of a nonresident alien, you generally must withhold taxes at graduated rates.
Effectively connected income by partnerships. A withholding agent that is a partnership (whether U.S. or foreign) is also responsible for withholding on its income effectively connected with a U.S. trade or business that is allocable to foreign partners.
U.S. real property interest. A withholding agent also may be responsible for withholding if a foreign person transfers a U.S. real property interest to the agent, or if it is a corporation, partnership, trust, or estate that distributes a U.S. real property interest to a shareholder, partner, or beneficiary that is a foreign person.
Persons Subject to NRA Withholding
NRA withholding applies only to payments made to a payee that is a foreign person. It does not apply to payments made to U.S. persons.
Usually, you determine the payee’s status as a U.S. or foreign person based on the documentation that person provides.. However, if you have received no documentation or you cannot reliably associate all or a part of a payment with documentation, then you must apply certain presumption rules, discussed later.
Identifying the Payee
In most cases, the payee is the person to whom you make the payment, regardless of whether that person is the beneficial owner of the income. However, there are situations in which the payee is a person other than the one to whom you actually make a payment.
U.S. agent of foreign person. If you make a payment to a U.S. person and you have actual knowledge that the U.S. person is receiving the payment as an agent of a foreign person, you must treat the payment as made to the foreign person. However, if the U.S. person is a financial institution, you may treat the institution as the payee provided you have no reason to believe that the institution will not comply with its own obligation to withhold.
If the payment is not subject to NRA withholding (for example, gross proceeds from the sales of securities), you must treat the payment as made to a U.S. person and not as a payment to a foreign person. You may be required to report the payment on Form 1099 and, if applicable, backup withhold.
Disregarded entities. A business entity that is not a corporation and that has a single owner may be disregarded as an entity separate from its owner (a disregarded entity) for federal tax purposes. The payee of a payment made to a disregarded entity is the owner of the entity.
If the owner of the entity is a foreign person, you must apply NRA withholding unless you can treat the foreign owner as a beneficial owner entitled to a reduced rate of withholding.
If the owner is a U.S. person, you do not apply NRA withholding. However, you may be required to report the payment on Form 1099 and, if applicable, backup withhold. You may assume that a foreign entity is not a disregarded entity unless you can reliably associate the payment with documentation provided by the owner or you have actual knowledge or reason to know that the foreign entity is a disregarded entity.
The payees of payments (other than income effectively connected with a U.S. trade or business) made to a foreign flow-through entity are the owners or beneficiaries of the flow-through entity. This rule applies for purposes of NRA withholding and for Form 1099 reporting and backup withholding. Income that is, or is deemed to be, effectively connected with the conduct of a U.S. trade or business of a flow-through entity is treated as paid to the entity.
All of the following are flow-through entities.
- A foreign partnership (other than a withholding foreign partnership).
- A foreign simple or foreign grantor trust (other than a withholding foreign trust).
- A fiscally transparent entity receiving income for which treaty benefits are claimed. See Fiscally transparent entity , later.
In most cases, you treat a payee as a flow-through entity if it provides you with a Form W-8IMY (see Documentation , later) on which it claims such status. You also may be required to treat the entity as a flow-through entity under the presumption rules, discussed later.
You must determine whether the owners or beneficiaries of a flow-through entity are U.S. or foreign persons, how much of the payment relates to each owner or beneficiary, and, if the owner or beneficiary is foreign, whether a reduced rate of NRA withholding applies. You make these determinations based on the documentation and other information (contained in a withholding statement) that is associated with the flow-through entity’s Form W-8IMY. If you do not have all of the information that is required to reliably associate a payment with a specific payee, you must apply the presumption rules. See Documentation and Presumption Rules , later.
Withholding foreign partnerships and withholding foreign trusts are not flow-through entities.
Foreign partnerships. A foreign partnership is any partnership that is not organized under the laws of any state of the United States or the District of Columbia or any partnership that is treated as foreign under the income tax regulations. If a foreign partnership is not a withholding foreign partnership, the payees of income are the partners of the partnership, provided the partners are not themselves a flow-through entity or a foreign intermediary. However, the payee is the partnership itself if the partnership is claiming treaty benefits on the basis that it is not fiscally transparent and that it meets all the other requirements for claiming treaty benefits. If a partner is a foreign flow-through entity or a foreign intermediary, you apply the payee determination rules to that partner to determine the payees.
A nonwithholding foreign partnership has three partners: a nonresident alien individual; a foreign corporation; and a U.S. citizen. You make a payment of U.S. source interest to the partnership. It gives you a Form W-8IMY with which it associates Form W-8BEN from the nonresident alien; Form W-8BEN from the foreign corporation; and Form W-9 from the U.S. citizen. The partnership also gives you a complete withholding statement that enables you to associate a part of the interest payment to each partner.
You must treat all three partners as the payees of the interest payment as if the payment were made directly to them. Report the payment to the nonresident alien and the foreign corporation on Forms 1042-S. Report the payment to the U.S. citizen on Form 1099-INT.
A nonwithholding foreign partnership has two partners: a foreign corporation and a nonwithholding foreign partnership. The second partnership has two partners, both nonresident alien individuals. You make a payment of U.S. source interest to the first partnership. It gives you a valid Form W-8IMY with which it associates a Form W-8BEN from the foreign corporation and a Form W-8IMY from the second partnership. In addition, Forms W-8BEN from the partners are associated with the Form W-8IMY from the second partnership. The Forms W-8IMY from the partnerships have complete withholding statements associated with them. Because you can reliably associate a part of the interest payment with the Form W-8BEN provided by the foreign corporation and the Forms W-8BEN provided by the nonresident alien individual partners as a result of the withholding statements, you must treat them as the payees of the interest.
Foreign simple and grantor trust. A trust is foreign unless it meets both of the following tests.
- A court within the United States is able to exercise primary supervision over the administration of the trust.
- One or more U.S. persons have the authority to control all substantial decisions of the trust.
In most cases, a foreign simple trust is a foreign trust that is required to distribute all of its income annually. A foreign grantor trust is a foreign trust that is treated as a grantor trust under sections 671 through 679 of the Code.
The payees of a payment made to a foreign simple trust are the beneficiaries of the trust. The payees of a payment made to a foreign grantor trust are the owners of the trust. However, the payee is the foreign simple or grantor trust itself if the trust is claiming treaty benefits on the basis that it is not fiscally transparent and that it meets all the other requirements for claiming treaty benefits. If the beneficiaries or owners are themselves flow-through entities or foreign intermediaries, you apply the payee determination rules to that beneficiary or owner to determine the payees.
A foreign simple trust has three beneficiaries: two nonresident alien individuals and a U.S. citizen. You make a payment of interest to the foreign trust. It gives you a Form W-8IMY with which it associates Forms W-8BEN from the nonresident aliens and a Form W-9 from the U.S. citizen. The trust also gives you a complete withholding statement that enables you to associate a part of the interest payment with the forms provided by each beneficiary. You must treat all three beneficiaries as the payees of the interest payment as if the payment were made directly to them. Report the payment to the nonresident aliens on Forms 1042-S. Report the payment to the U.S. citizen on Form 1099-INT.
Fiscally transparent entity. If a reduced rate of withholding under an income tax treaty is claimed, a flow-through entity includes any entity in which the interest holder must treat the entity as fiscally transparent. The determination of whether an entity is fiscally transparent is made on an item of income basis (that is, the determination is made separately for interest, dividends, royalties, etc.). The interest holder in an entity makes the determination by applying the laws of the jurisdiction where the interest holder is organized, incorporated, or otherwise considered a resident. An entity is considered to be fiscally transparent for the income to the extent the laws of that jurisdiction require the interest holder to separately take into account on a current basis the interest holder’s share of the income, whether or not distributed to the interest holder, and the character and source of the income to the interest holder are determined as if the income was realized directly from the source that paid it to the entity. Subject to the standards of knowledge rules discussed later, you generally make the determination that an entity is fiscally transparent based on a Form W-8IMY provided by the entity.
The payees of a payment made to a fiscally transparent entity are the interest holders of the entity.
Entity A is a business organization organized under the laws of country X that has an income tax treaty in force with the United States. A has two interest holders, B and C. B is a corporation organized under the laws of country Y. C is a corporation organized under the laws of country Z. Both countries Y and Z have an income tax treaty in force with the United States.
A receives royalty income from U.S. sources that is not effectively connected with the conduct of a trade or business in the United States. For U.S. income tax purposes, A is treated as a partnership. Country X treats A as a partnership and requires the interest holders in A to separately take into account on a current basis their respective shares of the income paid to A even if the income is not distributed. The laws of country X provide that the character and source of the income to A’s interest holders are determined as if the income was realized directly from the source that paid it to A. Accordingly, A is fiscally transparent in its jurisdiction, country X.
B and C are not fiscally transparent under the laws of their respective countries of incorporation. Country Y requires B to separately take into account on a current basis B’s share of the income paid to A, and the character and source of the income to B is determined as if the income was realized directly from the source that paid it to A. Accordingly, A is fiscally transparent for that income under the laws of country Y, and B is treated as deriving its share of the U.S. source royalty income for purposes of the U.S.-Y income tax treaty. Country Z, on the other hand, treats A as a corporation and does not require C to take into account its share of A’s income on a current basis whether or not distributed. Therefore, A is not treated as fiscally transparent under the laws of country Z. Accordingly, C is not treated as deriving its share of the U.S. source royalty income for purposes of the U.S.-Z income tax treaty.
A payee is subject to NRA withholding only if it is a foreign person. A foreign person includes a nonresident alien individual, foreign corporation, foreign partnership, foreign trust, foreign estate, and any other person that is not a U.S. person. It also includes a foreign branch of a U.S. financial institution if the foreign branch is a qualified intermediary. In most cases, the U.S. branch of a foreign corporation or partnership is treated as a foreign person.
Nonresident alien. A nonresident alien is an individual who is not a U.S. citizen or a resident alien. A resident of a foreign country under the residence article of an income tax treaty is a nonresident alien individual for purposes of withholding.
Married to U.S. citizen or resident alien. Nonresident alien individuals married to U.S. citizens or resident aliens may choose to be treated as resident aliens for certain income tax purposes. However, these individuals are still subject to the NRA withholding rules that apply to nonresident aliens for all income except wages. Wages paid to these individuals are subject to graduated withholding.
Resident alien. A resident alien is an individual who is not a citizen or national of the United States and who meets either the green card test or the substantial presence test for the calendar year.
- Green card test. An alien is a resident alien if the individual was a lawful permanent resident of the United States at any time during the calendar year. This is known as the green card test because these aliens hold immigrant visas (also known as green cards).
- Substantial presence test. An alien is considered a resident alien if the individual meets the substantial presence test for the calendar year. Under this test, the individual must be physically present in the United States on at least:
- 31 days during the current calendar year, and
- 183 days during the current year and the 2 preceding years, counting all the days of physical presence in the current year, but only 1/3 the number of days of presence in the first preceding year, and only 1/6 the number of days in the second preceding year.
In most cases, the days the alien is in the United States as a teacher, student, or trainee on an “F,” “J,” “M,” or “Q” visa are not counted. This exception is for a limited period of time.
For more information on resident and nonresident status, the tests for residence, and the exceptions to them, see Publication 519.
Note. If your employee is late in notifying you that his or her status changed from nonresident alien to resident alien, you may have to make an adjustment to Form 941 if that employee was exempt from withholding of social security and Medicare taxes as a nonresident alien. For more information on making adjustments, see chapter 13 of Publication 15 (Circular E).
Resident of a U.S. possession. A bona fide resident of Puerto Rico, the U.S. Virgin Islands, Guam, the Commonwealth of the Northern Mariana Islands (CNMI), or American Samoa who is not a U.S. citizen or a U.S. national is treated as a nonresident alien for the withholding rules explained here. A bona fide resident of a possession is someone who:
- Meets the presence test,
- Does not have a tax home outside the possession, and
- Does not have a closer connection to the United States or to a foreign country than to the possession.
For more information, see Publication 570, Tax Guide for Individuals With Income From U.S. Possessions.
Foreign corporations. A foreign corporation is one that does not fit the definition of a domestic corporation. A domestic corporation is one that was created or organized in the United States or under the laws of the United States, any of its states, or the District of Columbia.
Guam or Northern Mariana Islands corporations. A corporation created or organized in, or under the laws of, Guam or the CNMI is not considered a foreign corporation for the purpose of withholding tax for the tax year if:
- At all times during the tax year less than 25% in value of the corporation’s stock is owned, directly or indirectly, by foreign persons; and
- At least 20% of the corporation’s gross income is derived from sources within Guam or the CNMI for the 3-year period ending with the close of the preceding tax year of the corporation (or the period the corporation has been in existence, if less).
Note. The provisions discussed below under U.S. Virgin Islands and American Samoa corporations will apply to Guam or CNMI corporations when an implementing agreement is in effect between the United States and that possession.
U.S. Virgin Islands and American Samoa corporations. A corporation created or organized in, or under the laws of, the U.S. Virgin Islands or American Samoa is not considered a foreign corporation for the purposes of withholding tax for the tax year if:
- At all times during the tax year less than 25% in value of the corporation’s stock is owned, directly or indirectly, by foreign persons,
- At least 65% of the corporation’s gross income is effectively connected with the conduct of a trade or business in the U.S. Virgin Islands, American Samoa, Guam, the CNMI, or the United States for the 3-year period ending with the close of the tax year of the corporation (or the period the corporation or any predecessor has been in existence, if less), and
- No substantial part of the income of the corporation is used, directly or indirectly, to satisfy obligations to a person who is not a bona fide resident of the U.S. Virgin Islands, American Samoa, Guam, the CNMI, or the United States.
Foreign private foundations. A private foundation that was created or organized under the laws of a foreign country is a foreign private foundation. Gross investment income from sources within the United States paid to a qualified foreign private foundation is subject to NRA withholding at a 4% rate (unless exempted by a treaty) rather than the ordinary statutory 30% rate.
Other foreign organizations, associations, and charitable institutions. An organization may be exempt from income tax under section 501(a) of the Internal Revenue Code even if it was formed under foreign law. In most cases, you do not have to withhold tax on payments of income to these foreign tax-exempt organizations unless the IRS has determined that they are foreign private foundations.
Payments to these organizations, however, must be reported on Form 1042-S, even though no tax is withheld. You must withhold tax on the unrelated business income (as described in Publication 598, Tax on Unrelated Business Income of Exempt Organizations) of foreign tax-exempt organizations in the same way that you would withhold tax on similar income of nonexempt organizations.
U.S. branches of foreign persons. In most cases, a payment to a U.S. branch of a foreign person is a payment made to the foreign person. However, you may treat payments to U.S. branches of foreign banks and foreign insurance companies (discussed earlier) that are subject to U.S. regulatory supervision as payments made to a U.S. person, if you and the U.S. branch have agreed to do so, and if their agreement is evidenced by a withholding certificate, Form W-8IMY. For this purpose, a financial institution organized under the laws of a U.S. possession is treated as a U.S. branch.
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