IRS Publication 515, Table 1, Withholding Tax Rates on Income Other Than Personal Service Income Under Chapter 3, Internal Revenue Code, and Income Tax Treaties, assigns Income Codes to the categories of income described in the table for reduced rates of tax by treaty country. Income Codes for some income not included in Table 1 (or Table 2 discussed below) are described in the text. For example, Income Code 50 is used for reporting U.S.-source FDAPI not reportable under any other category such as grants, prizes and awards.
As described below, determining how to report some U.S.-source income payments made by A/P can be particularly problematic. This is the case for three types of income that have not been assigned separate Income Codes: rents on tangible personal property, transportation income, and contingent gains on sales of intangible property.
Rents on Tangible Personal Property. Many older treaties include rents for “scientific, technical, and commercial equipment” in the definition of royalties and generally apply the rate for Industrial Royalties (Income Code 10). Presumably, the rents on other types of tangible personal property are covered by the Business Profits Article of these treaties if the income is effectively connected to the conduct of a U.S. trade or business. That the rents are ECI will be identified by Exemption Code 01 on Form 1042-S. Rents on tangible personal property other than on equipment that are not ECI are covered by the Other Income Article (called Miscellaneous Income by some treaties). However, the Other Income Article of most of the older treaties allows the U.S. to tax income not otherwise dealt with by the treaty, and some older treaties have no Other Income Article.
Under most current treaties, equipment rents are not included in the definition of royalties. Rather rents on tangible personal property are covered by the Business Profits Article if they are ECI (or classified as ECI by the Business Profits Article or its Treasury explanation). As ECI, the rents are either subject to tax on a net basis or exempt from tax under the Business Profits Article provided they are not attributable to a permanent establishment that the owner has in the United States. The Income Code for such rents is not discussed in IRS Publication 515. If Table 1 coding is followed, rents that are ECI would be assigned Income Code 10 (Exemption Code 01 if not treaty-exempt and Exemption Code 04 if treaty-exempt). The only other choice is to use Income Code 50 (Other Income) for business profits.
Most treaties that do not include such rents in the Royalties Article allow an exemption from tax under the Other Income Article, provided the income is not effectively connected to a U.S.trade or business, in which case the Income Code is 50. However, if Income Code 50 is also used by the payer to report rents on tangible personal property that are exempt from tax under the Business Profits Article (Exemption Code 04), the forms will not distinguish whether a tax return is required or not.
The obvious dilemma for payers making such rent payments that are not treaty-exempt is which Income Code to assign, Income Code 10 or 50. Until this dilemma is resolved, payers will make inconsistent choices, adding to the confusion of recipients who may (or may not) have a U.S.tax return obligation.
Transportation Income. Multinational organizations make payments to foreign vendors that are international shipping and air freight carriers. Non-profit organizations make occasional payments to such foreign vendors as well. Some of this income may be excluded from income under IRC Section 883, some may be exempt from income under either a Business Profits Article or Shipping and Air Transport Article of an applicable tax treaty, some may be subject to an excise tax rather than income tax (unless it is ECI), but some of this income may be subject to NRA withholding such as rents for containers if such rents do not meet the conditions of these exceptions. Until this income is defined and assigned appropriate codes by the IRS, most transportation income will probably be excluded from Form 1042-S reporting (and NRA withholding) by payers whether it should be or not.
Contingent Gains. All treaties except one (the treaty with China, PRC) include in the definition of royalties, gains that are contingent on the productivity, use, or disposition of the property. This is consistent with IRC Section 871(a)(1)(D) and 881(a)(4) which treat such U.S.-source contingent gains as royalties.
It is clear from Table 1 that treaty-exempt contingent gains should be assigned Income Code 10 (Industrial Royalties). However, the proper Income Code for non-treaty exempt contingent gains is less clear because Publication 515 lists them under Gains (Income Code 09). Assigning Income Code 09 to a contingent gain eligible for a treaty benefit but on which taxes were withheld (because the Form W-8BEN for the treaty claim was not provided or was invalid) will cause a problem for a recipient seeking a tax refund for the treaty exemption on a Form 1040NR or 1120-F tax return. The IRS processors will likely not believe that gross income reported on Form 1042-S as gains (Income Code 09) should be allowed a treaty exemption under the Royalties Article (Income Code 10).
FDAP-Like ECI Payments. The proper Income Code to use when income which is FDAP-like (interest and royalties) is actually ECI also needs to be addressed by Publication 515. For example, the Royalties Article in most treaties states that the reduced rate applies unless the royalty is attributable to a permanent establishment (PE) that the beneficial owner has in theUnited States. In that case, the income is subject toU.S. tax on a net basis after deductions. The royalty is reported under Exemption Code 01 if it is attributable to a PE and Income Code 04 if it is exempt under a treaty, in this case, as FDAP income. It is not clear which Income Code should be assigned, the FDAP-like royalty that is ECI, Code 10, 11, or 12 (depending on the type of royalty) or Code 50 because the income is taxed as business profits attributed to a permanent establishment.
Motion Picture and Television Royalties. Payments for the right to use Motion Pictures and Television recordings (Income Code 11) are generally covered under the Royalties Article of treaties. However, a few treaties specifically exclude such payments from the Royalties Article and instead classify the income as part of the business profits of the organization in the Business Profits Article. Payers making treaty-exempt payments under one of these treaties must decide which Income Code to use: 11 or 50.