U.S. withholding tax requirements on payments to nonresidents and foreign entities.

• Author: Weber, Mindy Tyson

With more U.S. taxpayers engaging in cross-border transactions, the amount and frequency of cross-border payments to non-U.S. persons and entities by U.S. taxpayers have increased. As a result, U.S. tax advisers to globally active U.S. taxpayers need to be aware of the underlying U.S. withholding tax and information reporting rules relating to outbound payments. This item provides an overview of the types of income subject to U.S. withholding tax and related U.S. information reporting requirements.

U.S. Tax on Investment and Business Income of Foreign Persons

The gross basis withholding tax and net tax on business income: While it taxes citizens and residents on worldwide income, the United States asserts a more limited tax jurisdiction over nonresident alien individuals and foreign corporations (collectively referred to as "foreign persons"). Under Secs. 871(a) and 881(a), foreign persons are subject to U.S. gross basis withholding tax on U.S.-source fixed, determinable, annual, or periodic income (FDAP). In addition, foreign persons engaged in a U.S. trade or business are taxed on net income arising from that business (effectively connected income, or ECI) under Secs. 871(b)(1) and 882(a). FDAP income is generally subject to a 30% gross basis tax, while ECI (minus allowable deductions) is subject to tax at graduated rates with a maximum rate of 35% for corporations and, after 2012, 39.6% for individuals.

The gross basis tax on FDAP income is generally collected at source by the U.S. payer, who has primary liability for these taxes as the withholding agent. Furthermore, the IRS has limited ability to collect the tax from foreign persons. Thus, in most cases, the IRS will attempt to collect the gross basis tax on FDAP income from the U.S. payer, particularly since U.S. payers are subject to the jurisdiction of U.S. courts. Failure to collect and report the appropriate amount of tax on FDAP income may expose a U.S. withholding agent to substantial penalties and interest (further described below). However, U.S. withholding agents generally do not need to withhold on ECI payments, except where a U.S. partnership makes an ECI payment to a foreign partner.

FATCA: Under the Foreign Account Taxpayer Compliance Act of 2010 (FATCA) (passed as part of the Hiring Incentives to Restore Employment Act of 2010, P.L. 111-147), payments made to certain foreign persons may be subject to a 30% gross basis withholding tax. This tax applies to payments of FDAP income and to gross proceeds from the sale of securities that generate U.S.-source interest and dividend income. However, any tax withheld for purposes of the gross basis withholding tax on FDAP income may be used as a credit against amounts due under FATCA rules. Withholding agents are required to report amounts paid and withheld under the same rules that apply to the tax imposed on FDAP income under Sec. 881.

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