U.S. organizations making payments to vendors must determine whether the vendor is a U.S. person or a non-U.S. person because only payments to U.S. persons (actual or presumed) are covered by Form 1099 rules and procedures. The term, U.S. persons, includes U.S. citizens, resident aliens (based on I.R.C. Section 7701(b), the tax residency rules) and domestic entities. Domestic entities are entities organized under the laws of one of the 50 states or the District of Columbia. (For more details, see U.S. Person or Foreign Person July/August 2010 edition of Windstar’s A View from the Crow’s Nest.) Non-U.S. persons include nonresident aliens and foreign entities (collectively, foreign vendors).
Payments to foreign vendors are subject to 30% withholding (absent an exception), but only on their U.S.-source income. Income (and taxes withheld, if any) must be reported on a Form 1042-S information return. In order to withhold and report correctly on payments to foreign vendors, a payer must know the source of the income – U.S. or foreign – as defined by U.S. tax rules. If the source of income is not known at the time the payment is made, the payer must presume it to be U.S.-source income and withhold accordingly (see Treas. Reg. 1.1441-2(a)).
Source of Income Rules
U.S. sourcing rules vary with the type of income being paid, as do U.S. rules for a lower rate of, or exemption from, withholding. In addition, a payer must correctly record the Income Code on Form 1042-S so that the foreign vendor may submit a correct U.S. tax return (if one is required). Therefore, a payer must know the nature of the income in order to withhold and correctly report on income paid to foreign vendors.
IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, includes discussions on many common types of payments. It also includes a table of source rules for income including pay for personal services, interest, rents, royalties, income from natural resources, scholarship and fellowship grants, and guarantees of indebtedness. The task of identifying income being paid is easy if the type of income named on an invoice is discussed in Publication 515 and the name used is the same as that used in Publication 515. For example, royalty income is discussed in Publication 515 but a royalty (which is a payment for the use of, or right to use, intangible personal property) might be called something else such as a license fee, endorsement or sponsorship.
However, not all types of income are discussed in IRS Publication 515. For example, income from electronic commerce is not mentioned. The type of income represented by electronic commerce is particularly difficult to identify even though IRS published guidance is available to assist with this task (Treas. Reg. 1.861-18) because electronic commerce is evolving so much faster than IRS guidance.
In order for payments to foreign vendors to be timely made and correctly withheld and reported, accounts payable (AP) personnel need to know the nature of the income before payment is made, ideally before the invoice is received. Since many payments are based on the terms of the agreement, this can best be determined at the outset of the agreement with the vendor by those involved in the procurement or contracting process. For most organizations, this is currently not a responsibility of procurement or contracting. When the nature of the income is not known when an invoice is presented for payment, the payment must either be: 1) delayed until the nature of the income can be determined (a process that might involve legal counsel); or, 2) treated as an uncategorized payment which is fixed or determinable annual or periodic (FDAP) income subject to 30% withholding (reported under Income Code 50, Miscellaneous Income).
Whether AP is able to obtain sufficient information in order to investigate the nature of the income from those involved in the procurement or contracting process (or once such information is obtained) will vary with the organization. Although the vendor might be willing to provide the relevant facts or agreement, or even legal advice as to the nature of the payment, in an audit, the IRS will look to the agreement with the organization regardless of representations made by the vendor (because income recipients have an incentive to categorize payments in a manner that would support a claim for exemption from withholding).
When an income payment is one amount that covers more than one type of income, the payment must be reasonably allocated among all of the types of income covered by the payment. For example, a single payment to a foreign vendor for the purchase of equipment (which is not subject to 30% withholding) might include shipping and services for installation and training. Whether the shipping or services income is subject to withholding (or not) depends on relevant facts associated with the type of income (such as where services are physically provided). If a purchase of equipment is paid on an installment basis, the related interest is subject to 30% withholding.
When a reasonable allocation by type of income is not provided on an invoice, the full amount is subject to 30% withholding. The foreign vendor might have the opportunity to allocate the income on their U.S. tax return and obtain a refund of some of the withheld tax. However, the IRS has recently tightened the process for tax return refund claims (currently treaty related) not supported by a Form 1042-S by requesting that the taxpayer obtain supporting information from the payer before a refund will be issued. The IRS could extend this process to other types of refund claims, especially when the refund will be sent outside the United States.
AP must also know whether the income being paid is U.S.-source (or not) in order to withhold and report correctly. On an audit, the IRS will request evidence supporting foreign-source payments such as contracts, invoices, expense reports and so forth. If a payment to a foreign vendor includes both U.S. and foreign-source income and no breakdown is provided, the payer must withhold on the full amount. For example, a royalty payment made for use of an intangible both in and outside the United States is subject to 30% withholding unless an allocation between U.S. and foreign sources is provided based on where the intangible was used.
Exemptions from Withholding
Whether an exemption from tax under either income tax rules or an applicable income tax treaty applies depends on the character of the U.S.-source income being paid (as defined by U.S. tax rules). For example, a foreign vendor with income that is effectively connected to a U.S. trade or business (called ECI), is exempt from withholding (but not reporting) as long as the vendor provides the payer with a valid Form W-8ECI and describes the income on line 9. Another common exemption from withholding is a claim under an applicable provision of an income tax treaty with the country of tax residence of the beneficial owner of the income. Such a claim must be made by the vendor on a valid Form W-8BEN or a Form 8233 in the case of treaty claims by individuals on compensation for personal services. For a claim from withholding to be valid, the withholding form must include a U.S. taxpayer identification number.
Tax treaties provisions (called articles) set forth the conditions for exemptions from, or reductions in, withholding for specific types of FDAP income such as dividends, interest and royalties. The treaty rates for these types of income are illustrated in Table 1 in IRS Publication 515. Certain income types (such as income from real property and natural resources) are not exempt from tax under treaties and are excluded from this table. The rules for equipment rents were added as a column of this table for the 2011 edition. Table 1 footnotes explain how exemptions apply (or not). Income not dealt with (i.e., mentioned) by a specific article might be exempt from tax under an Other Income Article (if any). The conditions for treaty exemptions from withholding for compensation for services of individuals and for scholarship and fellowship grants made to individuals are set forth in Table 2 of IRS Publication 515.