Exemption Codes indicate the reason that taxes were not withheld on the gross income being reported. Exemption Codes typically used for payments to foreign vendors are 00, 01, 02, 03, and 04. Code 00 in the Exemption Code field indicates the gross income was subject to NRA withholding. Exemption Code 00 is also used to indicate that the gross income was subject to tax withholding at a reduced rate under an income tax treaty claim (discussed below).
Code 01. In some situations, the Exemption Code also indicates whether the recipient has a U.S. tax return filing obligation. For example, a corporation with income exempt from withholding because the income is effectively connected to a U.S. trade or business (Code 01) has a Form 1120-F filing obligation. The gross income reported is reduced by allowable deductions and subject toU.S. tax on a net basis.
Code 02. Exemption Code 02 indicates an exemption from tax under an Internal Revenue Code section (except for portfolio income which is indicated by Income Code 05). Exemption Code 02 is also used to indicate income exempt from withholding but not exempt from tax, because there is no current Exemption Code available for this situation. Income exempt from withholding includes U.S. AID per diem amounts paid for subsistence and forgiveness of indebtedness income in a nonrelated party situation. Per diem payments are typically small amounts, frequently less than the personal exemption amount, in which case no tax is lost if no tax return is filed. Many organizations dealing with recipients of these amounts are aware that these individuals must submit tax returns and set up programs to ensure that the returns are prepared for the recipients. The recipient of forgiveness of indebtedness income might believe based on the Exemption Code description that the amount is “exempt from tax” and not file a tax return and pay the tax owed. Some of these reported amounts could be significant.
Code 03. The IRS has provided Exemption Code 03 for foreign-source income for payers who wish to use such reporting for internal control purposes. Recipients of income under Exemption Code 03 have no U.S. tax return filing obligation unless the recipient is a U.S. person such as a resident alien individual based on a tax return election. Records with Exemption Code 03 could be included in the information exchange with the recipient’s country of residence where the income might be subject to tax, however.
Code 04. Records reporting treaty-exempt income could have one of two codes: Exemption Code 04, which was only valid if the tax rate was 00.00 or Code 00 indicating the income was subject to withholding (albeit at a reduced treaty rate).
Whether a foreign vendor with treaty-exempt income has a tax return filing obligation depends on whether the income is ECI or not. As mentioned above, a tax return is due if the income is ECI even if all of the income is exempt under an income tax treaty. No tax return is due for FDAPI on which the correct amount of tax, including reductions under an income tax treaty, has been withheld. As explained above, ECI and FDAPI are not identifiable when the Income Code is 50. This is the case for rents on tangible personal property because of their disparate treatment by tax treaties. Some recipients will have a tax return due because the rents were exempt from tax as business profits (ECI) while others will have no tax return due because the rents were FDAPI subject to a reduced rate, or elimination, of withholding under either a Royalties Article or an Other Income Article of the applicable treaty. This confusion could be resolved by implementing a different Exemption Code for treaty-exempt ECI.