Volume 24 Issue 6 -- November/December 2012
It is
becoming increasingly common for even small US companies to retain as
independent contractors individuals located in other countries. It is
easy for them to provide Internet or web-related design and programming
services, for example, without regard to where they are physically
located. What are the implications for the US companies that hire them?
The tax
code imposes a broad set of withholding rules on foreign payments of
certain US-source income, including non-employee compensation for
services. Generally, the tax regulations require that a withholding
agent that makes a payment of U.S.-source income to a foreign person
obtain documentation that identifies the beneficial owner as a foreign
person entitled to a reduced rate of withholding. Otherwise, the
withholding agent must withhold 30% of the payment as U.S. tax.
Broadly
speaking, US source income earned by non-US persons (i.e., persons who
are not citizens or residents of the US) is taxed in one of two ways.
Income connected with a US trade or business is taxed in the US on a
net basis at graduated rates and requires the filing of a tax return by
the owner of the business.
Technically,
income connected with a US trade or business is not subject to
withholding (but it can be subject to other reporting, e.g., Form 1099).
Most US
source income not connected with a US trade or business is taxed on a
gross basis at 30% (or an applicable lower treaty rate) and is paid
through withholding. If the US payor fails to withhold the required tax
amounts, then the US payor is liable for the tax.
Income
that is exempt from US tax either because it is deemed not to have a US
source or because of an applicable tax treaty is not subject to
withholding.
Theoretically
income earned by a non-US person for services provided entirely outside
the US is not US source income under the Internal Revenue Code. In
addition, many tax treaties provide for reduced or no tax on certain
compensation income if specific requirements are met. The regulations
exclude from withholding payments for compensation that is exempt from
tax either under the Code or under a tax treaty.
Many tax
treaties exempt from US tax income that a non-US person earns from
independent (i.e., non-employee) services performed entirely outside of
the US unless the individual is present in the US for certain periods
of time in the year or has a fixed base or permanent establishment in
the US. Treaties, however, vary in the way they address this issue so
it is necessary to consider the specific wording of each applicable
treaty.
In many
cases, however, applying these principles can be difficult. Because the
US payor of the income is liable for any tax not withheld, the US
person bears the risk of failing to withhold when required.
First,
treaty rules determining what income is subject to US tax vary somewhat
from country to country. Second, a US payor of income to a foreign
person may not know all of the facts concerning whether the non-US
person is subject to US tax. For example, the foreign person may be
engaged in US activities unknown to the US payor. For these reasons, it
can be difficult for the US person to know whether the income is truly
exempt or subject to a reduced rate of withholding.
Fortunately,
there is a relatively straightforward way for the US payor to avoid the
risks. The simplest way is to withhold 30% of the payment unless the
payee provides the necessary documentation, which in this case is
usually IRS Form 8233. Although the foreign person will likely
complain, using Form 8233 to establish a treaty exemption or rate
reduction is the only way the US payor can protect itself. If the payee
supplies the Form 8233 then the US person can avoid withholding or
withhold at the applicable treaty rate.
If the
foreign person is unwilling to provide Form 8233, then the only prudent
thing is to withhold at the 30% rate to protect the payor from possible
liability for failing to properly withhold. In the event that this
withholding would overpay the tax due from the foreign person, the
foreign person would have to file a US return to obtain a refund.
A US tax
ID number will usually be required to complete Form 8233. This is
likely to be a point of contention with the foreign person. Payments
subject to foreign withholding are reported on Form 1042-S and Form
1042 (even if no amount was withheld).
If you have
questions about withholding on foreign payments or similar issues,
please contact the Tax & Business Professionals.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.
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