In the world where cross-border transactions have become more customary and use of international resources has often become a necessity, companies frequently find themselves working with foreign contractors and vendors not being always fully aware of their additional withholding/reporting obligations.
In order to avoid costly mistakes down the road, it is very important to become familiar with the rules on withholding and reporting associated with hiring a foreign contractor or dealing with a foreign vendor. Whenever dealing with foreign payees, a payor is responsible for withholding from payments of US sourced income made to them. Those payments include, but are not limited to, compensation for services, interests, dividends, rents, royalties, premiums, annuities or other fixed or determinable annual or periodical gains, profits or income (FDAP). A payment is considered to have been made whether it is made directly to the beneficial owner or to another person, such as an intermediary, agent or partnership for the benefit of the beneficial owner. In order to determine whether FDAP withholding from a foreign payee is required, the first step is to establish whether a payment constitutes income from US sources. Foreign persons are generally subject to 30% withholding on gross US sourced income. Let’s say a company hired a foreign web designer in Romania who built a website for it without ever stepping a foot on the US soil. Payments to the above web designer would not be US sourced since the services were performed outside of the United States and, hence, would not be subject to FDAP withholding. The issue becomes more complex when only some services are performed in the US while others are performed outside of the country. There are specific sourcing rules for each type of FDAP income and they should be analyzed in every case.
Once it is established that income is indeed from US sources, the next step is to obtain a Form W-8 (there are six different types of forms W-8) from your foreign payee. The more frequently used are Form W-8BEN for foreign individuals and Form W-8 BEN E for foreign entities which are used to establish payee’s foreign status and to determine if such person is the beneficial owner of the income for which the form is being furnished, and if a reduced rate of, or exemption from withholding under an income tax treaty, is applicable.
In addition, there is Form 8233 that is used specifically for claiming tax treaty exemption from withholding on compensation for independent and certain dependent personal services. Unlike Forms W-8 BEN and W-8BEN E which are kept for internal records, Form 8233 is to be furnished to the IRS within five days of acceptance.
A withholding agent or payer of the income may rely on a properly completed Form W-8BEN (E) to treat a payment associated with FDAP income as a payment to a foreign person who beneficially owns the amounts paid and, if applicable, to apply a reduced rate or an exemption from withholding at source. Without a properly filled out Form W-8BEN (E) or Form 8233 on file and without recognizing the need to withhold, a payor may end up being personally liable for withholdings which can be rather hefty amounts. Once withholdings are made, they are to be timely deposited with the IRS (please refer to Publication 515 to determine how frequently deposits are to be made). In addition, FDAP payments are to be reported on Forms 1042, 1042S and 1042T which are due by March 15 of the year following the year of payment.
Even if no withholdings are made due to the exemption claimed under a tax treaty, the above forms are still required to be filed by the due date to report total amount of payments made and exempt from tax under the treaty.
There are also potential state reporting/withholding obligations that may vary depending on particular circumstances and should not be ignored. The above rules refer only to FDAP withholdings. The rules for withholding and reporting effectively connected gross income allocable to foreign partners is beyond the scope of this article.