For small business entrepreneurs with foreign vendors, the U.S. withholding tax rules can sneak up on you if you’re not paying close enough attention. In most cases, however, following these rules is simply a matter of documentary procedure rather than mastering any tax complexities. But given that the penalties for non-compliance in the cross-border context can range from onerous to crippling, it’s important to familiarize yourself with the basic withholding tax concepts and reporting rules.
U.S. Tax on Cross-Border Payments
Let’s start with the basics. While the U.S. government taxes its citizens and tax residents on worldwide income, it taxes foreign persons, including nonresident alien individuals and foreign corporations, in a more limited manner.
First, foreign persons are generally subject to tax on
U.S.-source “FDAP” (fixed, determinable, annual, or periodic) income, which
includes passive-type items, such as interest, rent, royalties, and
dividends. This income is taxed on a
gross basis (i.e., with no offsetting deductions) at the rate of 30% by way of
withholding at source by the U.S. payer, who has primary responsibility as the
“withholding agent” to collect, deposit, and report the tax to the IRS. Failure to do so can expose the U.S. payer to
significant penalties and interest.
Withheld tax must generally be deposited with the IRS within three business days after the end of a “quarter-monthly” period (which ends on the 7th, 15th, 22nd, and last day of the month) if the total amount of undeposited taxes is $2,000 or more. If the taxes are less than $2000 but $200 or more, then they must be deposited by the 15th of the following month.
Second, foreign persons who are considered to earn income “effectively connected” with a trade or business in the U.S. (in contrast to the passive-natured FDAP income) are subject to tax at graduated rates on a net basis (i.e., reduced by available deductions). U.S. payers generally do not need to withhold tax on such effectively connected income (“ECI”).
Common Situations Involving Foreign vendors
To bring these tax concepts to life, let’s apply them in the context of real world situations. An example of a U.S.-source FDAP payment to a foreign vendor could be a license fee paid to a foreign company for the non-exclusive right to use their intellectual property, such as a computer software program. In this case, if the payment were treated as a royalty for tax purposes, the U.S. payer would generally by required to withhold 30% on the fee, unless the rate is reduced by a relevant international tax treaty.
(Perhaps less relevant here, but still notable, is that in the case of FDAP payments made to certain foreign financial intuitions, additional withholding rules under FATCA may apply. For further information on FATCA, you can visit the IRS website.)
In many cases, payments to foreign vendors are for services. An example in the context of computer software could be payments for the repair or maintenance of the software. In this case, the foreign person’s income would generally not be subject to withholding, but rather subject to net basis taxation as ECI, if the services were performed in the U.S., or potentially not subject to U.S. taxation at all, if the services were performed outside the U.S.
Documentation and Reporting
While tax documentation and reporting may seem tedious, this is the area where entrepreneurs with foreign vendors need to pay closest attention. Even though withholding may not be required for most overseas payments to vendors (e.g., because they are payments for services), the rule of thumb for entrepreneurs is that tax documentation and/or reporting is always required in some form or another.
The following documentation and reporting forms are essential in the context of overseas payments:
Form W-8: You should request your foreign vendor to provide you with a filled-out Form W-8 before making your first payment. You do not need to file the form with the IRS, but you do need to keep it on file in case the IRS requests to see it. Without the form, you’re required to assume that the vendor is a U.S. person and, as such, you are responsible for backup withholding on payments to the vendor at the rate of 28%. In the case of FDAP income where withholding is required, the form can be used to establish entitlement to a reduced withholding rate or exemption under an applicable treaty. The Form W-8 comes in a number of variations depending on the circumstances (e.g., Form W-8BEN for FDAP payments to foreign individuals, Form W-8BEN-E for FDAP payments to foreign entities, Form W-8ECI for ECI).
Forms 1042 and 1042-S: If you’ve made withholdable payments (e.g., FDAP) to a foreign vendor during the year, you generally must file the Form 1042 (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons) to report the FDAP income and amount of tax withheld. The form is due by March 15 following the end of the tax year, although an extension can be obtained. In addition, you must file Form 1042-S (Foreign Person’s U.S. Source Income Subject to Withholding) for each foreign for payee and each type of income.
Best Practice Recommendations
How can small business owners ensure that overseas payments are handled smoothly from a tax reporting perspective? Here are some business practices that we recommend in order to stay on top of your taxes:
Determine which of your vendors are foreign persons – procedures should be in place to accurately determine the tax residency of your foreign vendors.
Determine the character and source of your payments – Your tax and reporting requirements depend on the type of payment you make and whether the payment is U.S. source (generally, in the case of FDAP income) or foreign source (e.g., in the case of services).
Obtain a completed Form W-8 before any payment to a foreign vendor – If this proves difficult and you receive push back from your vendors, you should explain the tax risk to you and your vendor and insist on receiving a completed form.
Periodically spot check your Forms W-8 to ensure that they are still valid – Generally, a Form W-8BEN is valid for 3 years, unless a change in circumstances makes any information on the form incorrect. Under certain conditions, a Form W-8BEN can remain valid indefinitely.
Monitor payments to determine if a Form 1042 requirement has been triggered – Penalties for late filing the Forms 1042 and 1042-S can be enormous, not to mention the interest that accrues on top of the penalties. Internal controls are essential to ensure compliance with your tax reporting obligations.
Integrating these practices into your small business can go
a long way towards ensuring tax compliance and reducing the risk of IRS
scrutiny. Like many other company
practices, what seems burdensome at first, quickly becomes business habit.
Joshua Ashman, CPA, and Ephraim Moss, Esq., are co-founders of Expat Tax Professionals. They specialize in the areas of international taxation and U.S. expatriate taxation, and have extensive experience with international compliance and U.S. expat tax returns.