NRA Withholding

by Paula N. Singer, Esq.

The IRS has begun to enforce the long-standing (but largely ignored) withholding and reporting obligations of organizations making payments to foreign entities and to foreign nationals who are nonresident aliens for federal tax purposes (collectively called “foreign persons”).

While domestic entities, U.S. citizens, and resident aliens (collectively called “U.S. persons”) are subject to income tax on their worldwide income, foreign entities and nonresident aliens are subject to tax only on their U.S.-source income. As a result, the withholding and reporting rules for payments to foreign persons are different from the rules for payments to U.S. persons.

Payers may document the U.S. or foreign status of their payees with a Form W-9 as a certificate of U.S. status or a Form W-8BEN as a certificate of foreign status. A U.S. taxpayer identification number (TIN) is required on Form W-9 to avoid 28 percent backup withholding, but no TIN is required on the Form W-8BEN used solely as a certificate of foreign status.

Thirty Percent Withholding
Under the Internal Revenue Code (the “Code”), gross U.S.-source income payments made to foreign persons are subject to 30 percent withholding (called “NRA withholding”) unless an exception applies. There is a lower 14 percent rate for certain scholarship and fellowship grants paid to or on behalf of candidates for a degree at an educational institution or by certain specified types of organizations provided the recipients are in F, J, M, or Q immigration status. NRA withholding is required even if the payment is not in the ordinary course of business, such as a resident alien making an alimony payment to a nonresident alien ex-spouse. There is no de minimis rule for amounts subject to NRA withholding. A $30 payment to a nonresident alien involved in a clinical trial would still be subject to NRA withholding.

Payers must timely deposit withheld amounts using the deposit schedule provided in IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities. Payers required to deposit wages electronically must also deposit these other withheld taxes (called “1042 deposits”) electronically. Payers who fail to withhold and timely deposit the taxes are liable for the underwithheld taxes, plus penalties and interest. 

Source of Income
The rules for sourcing income vary with the type of income paid. Pay for services is sourced where the services are performed, regardless of the location of the payer or currency of the payment. Pay for use of real or personal property (including intangibles) is sourced where the property is located or used regardless of where the beneficial owner is located.

Since foreign persons are not subject to U.S. tax on foreign-source income, it is important to document foreign-source income in contracts and invoices. A payment including unallocated U.S. and foreign-source income is subject to 30 percent withholding on the total payment. The beneficial owner of the income may allocate the income on a U.S. tax return (Form 1040NR for an individual or trust, Form 1120-F for a foreign corporation) to obtain a refund of the taxes withheld on the foreign-source portion of the payment.

Withholding Exceptions
There are two important exceptions from NRA withholding: 1) payments excluded from income under the Code and 2) employee wages subject to wage withholding.

Other exemptions from withholding are available under a Code or income tax treaty provision provided the beneficial owner of the income meets the conditions for the exemption. The beneficial owner is the one subject to tax under U.S. tax rules. The payer may allow the exemption from withholding only if the payer has a valid signed and dated withholding certificate (Form W-8BEN, W-8ECI, W-8EXP, W-9, or 8233) from the beneficial owner of the income prior to the payment being made. The form varies with the type of income, payee, and/or exemption being claimed. Withholding and reporting must be in the name of the beneficial owner of the income even if payment is made to a third party such as an agent.

Generally, for a withholding certificate to be valid for an exemption from withholding, it must include the beneficial owner’s U.S. taxpayer identification number (TIN). (A U.S. TIN is not required simply to make a payment subject to NRA withholding.) There is an exception for income on publicly traded investments and related loans. An individual beneficial owner must provide a Social Security number (SSN) or individual taxpayer identification number (ITIN). Other beneficial owners must provide an employer identification number (EIN).

Presumptions
A payer who has no information about the payee must apply IRS presumptions, which always result in tax withholding and reporting. Under the presumption rules, payees are presumed to be 1099 reportable and subject to 28 percent backup withholding on their worldwide income.

A payer who knows (or has reason to know) that the beneficial owner is a foreign person, must withhold 30 percent. For purposes of these rules, personnel making the payments are deemed to know what anyone else in the organization knows about the payee.

Form 1042-S Reporting
The payer must report gross income and taxes withheld, if any, on income subject to NRA withholding rules to the recipient and the IRS on a Form 1042-S (not 1099!) information return. There is no exemption from reporting for payments made to corporations as there is for 1099 reporting. Even if the payment was exempt from tax under a Code or tax treaty provision, Form 1042-S is required.  

If withholding was at the statutory rate, no U.S. TIN is required on Form 1042-S.   Forms 1042-S reporting a payment exempt from withholding (except for treaty-exempt income on publicly traded investments) must generally have a U.S. TIN unless an exception is provided in the form’s instructions. Otherwise, the payer will be obligated to pay the underwithheld taxes plus penalties and interest and may be subject to a $50 penalty for failure to include a TIN on the form. 

Payers filing 250 or more Forms 1042-S must submit them electronically through the IRS Filing Information Returns Electronically (FIRE) system. Payers issuing Form(s) 1042-S must also submit a Form 1042 tax return even if they did not withhold taxes from the payments. Failure to report timely and accurately can result in penalties and interest.

About The Author

Paula N. Singer, Esq. chairman of Windstar Technologies, Inc. and partner in the tax law firm, Vacovec, Mayotte & Singer, Newton, MA, has over 25 years of experience providing advice and compliance services to employers on cross-border employment matters. She is also the editor of "US Tax Compliance For Immigrants And Employers: The Lawyer's Complete Guide". To learn more, see: http://www.ilw.com/store/tax.shtm. For more information, visit www.windstar.com. For additional information, call 1-800-259-6398 or email: info@windstar.com.

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