As is evident from the assignment of income codes in the two overview tables and the discussions about specific types of income in IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, Income Codes are used primarily to differentiate reduced rates of tax under income tax treaty provisions. This makes sense from a payer’s perspective since gross income not eligible for a tax treaty reduction is either subject to NRA withholding generally at a 30 percent rate or exempt from tax for a different reason as described by the Exemption Code.
Income Codes are also used for two purposes by the recipient: 1) to determine if a tax return is required because of the nature of the payment, and 2) to determine where to record the income on their tax return, if a return is required. The regulations under IRC Section 6012 require that a U.S. tax return be submitted by foreign persons with income effectively connected to a U.S. trade or business (called “ECI”) even if the income is exempt from tax under an income tax treaty. ECI is recorded on page 1 of Form 1120-F, or page 1 of Form 1040NR or 1040NR-EZ in the case of individual recipients.
Also, nonresident alien individuals, whose only ECI is wages that are less than the amount of one personal exemption under IRC Section 151, are not required to file a tax return if that is their only U.S.-source income for the year. A recipient whose only U.S.-source income is fixed or determinable annual or periodic income (called “FDAPI”) on which the correct tax was withheld (including reduced withholding under a tax treaty provision) is not required to submit a U.S. tax return. A return is required if the withheld amount should have been computed at the 30 percent rate but a lower amount was withheld.
Income Codes for records could also be used by information return processors (including the IRS) to verify that Form 1042-S records include a valid tax rate under the applicable treaty indicated by a record’s Country Code, a task that would be easier if all records with treaty-exempt income used an Exemption Code indicating treaty-exempt income (discussed below). Income Codes may also be used by foreign tax authorities to identify income being paid to their tax residents through records received through information exchange under a tax treaty or information exchange agreement.