Payments to Foreign Corporations

Article Written By an Issue Specialist, IRS Foreign Payments Branch, Washington, DC.

The matter of withholding taxes on payments to foreign corporations is not quite as simple as it might seem. Basically, four questions have to be answered about the income you are paying to a foreign corporation: (1) does U.S. law consider this income to be foreign-sourced, (2) does U.S. law consider this income to be effectively connected with a U.S. trade or business, (3) is the foreign corporation a personal holding company under U.S. law, and (4) is there any tax treaty provision which applies to this payment?

The income of a foreign corporation which is effectively connected with a U.S. trade or business is subject to U.S. tax at the same rates applicable to U.S. taxpayers. This income should be reported on a U.S. income tax return (form 1120F for foreign corporations). This income is not usually reportable to IRS by a withholding agent and is not subject to withholding if the foreign corporation gives to the withholding agent form 4224 Exemption From Withholding of Tax on Income Effectively Connected With the Conduct of a Trade or Business in the United States. (Please note that form 4224 is being replaced during 1999 by the new form W-8ECI). Income which is effectively connected with a U.S. trade or business is often connected with the fact that the foreign corporation has a "fixed base" or "permanent establishment" in the USA. That is, it has some sort of permanent office, factory, base of operations, etc. in the USA from which it generates its U.S. income.

Income of a foreign corporation which is not effectively connected with a U.S. trade or business is classified as "Fixed, Determinable, Annual, or Periodical" (called FDAP for short). FDAP income which is considered to be U.S.--sourced income is subject to 30% withholding, or withholding at a lower tax treaty rate, and is reportable on forms 1042 and 1042-S. However, FDAP income which is not U.S.--sourced income is not reportable by the U.S. withholding agent, and is not subject to any withholding tax. The sourcing rules about payments made to foreign entities are found in sections 861--865 of the Internal Revenue Code; and you will find a brief summary of them on page 7 of the 1998 edition of IRS Publication 515 Withholding of Tax on Nonresident Aliens and Foreign Corporations.

Payments made to a foreign corporation to purchase personal property items which are produced outside of the USA by a foreign corporation which has no fixed base or permanent establishment in the USA are usually considered to be foreign--sourced income of the foreign corporation and are not subject to U.S. reporting or withholding. Payments made to a foreign corporation in exchange for the personal services of nonresident alien individuals performed outside of the U.S. are considered to be foreign-sourced income, and are not reportable to the IRS and are not subject to U.S. withholding tax. On the other hand, payments to a foreign corporation in exchange for personal services performed in the USA by either U.S. citizens or aliens is considered to be U.S.--sourced income and is usually subject to withholding. The type of withholding will depend on the employment relationship between the workers and the U.S. payor or the foreign corporation. If the U.S. payor or the foreign corporation is considered to be an "employer" under U.S. law, then such employer will have to file forms 941,W-2, etc. and withhold U.S. taxes at the graduated rates on the wages paid to the employees. (Please consult Revenue Ruling 92-106).

If no employment relationship exists between the workers and the U.S. payor or the foreign corporation, then the payments are probably in the nature of self-employment income paid to independent contractors (independent personal services), and will be reported on forms 1042 and 1042-S if paid to nonresident aliens, and will be subject to 30% withholding, or withholding at a lower tax treaty rate. If the payment to the foreign corporation consists partially of remuneration for personal services performed in the USA and partially of payment for personal property items purchased from overseas or of some other kind of income which is foreign-sourced, then the U.S. payor will have to determine what percentage of the payment to the foreign corporation is U.S.--sourced and report that portion and withhold tax on it. If the U.S. payor cannot determine which portion of the payment is taxable or nontaxable, then the U.S. payor will withhold 30% on the entire payment. The reporting will usually be on forms 1042 and 1042-S (showing the foreign corporation as payee) and the withholding will usually be at 30% or lower tax treaty rate which may apply, unless the foreign corporation can show the U.S. payor that it has already reported the income and paid U.S. tax on it.

One further complication exists under U.S. law for payments made to foreign corporations. Some individuals (especially foreign athletes and entertainers) form foreign corporations to act as the recipients of their income in order to take advantage of the sometimes more favorable tax treatment given to corporations than to individuals. Under U.S. law a corporation 60% of whose gross income comes from contracts for the personal services of specified individuals, and such specified individuals own at least 25% of the outstanding stock of such corporation, is known as a "personal holding company". The exemption from 30% withholding tax which might otherwise be given to a foreign corporation whose income is effectively connected with a U.S. trade or business will not apply to any payment to a foreign corporation if the following conditions exist: (1) the foreign corporation is a personal holding company; (2) the foreign corporation receives amounts under a contract for personal services of an individual whom the corporation has no right to designate (i.e., the individual himself or his agent have the sole right to contract for the personal services of the individual); and (3) 25% or more in value of the outstanding stock of the foreign corporation at some time during the tax year is owned, directly or indirectly, by or for an individual who has performed, is to perform, or may be designated as the one to perform, the services called for under the contract. Thus, before allowing an exemption from withholding claimed by a foreign corporation on form 4224 or form W-8ECI for the personal services of a specified individual or individuals, the withholding agent must determine whether the three conditions named above exist. If such three conditions do exist, then the withholding exemption does not apply, and the withholding agent must withhold 30% income tax on the payments. If the foreign corporation will not give the withholding agent sufficient information about whether these three conditions exist, then the withholding agent must withhold 30%. If the foreign corporation demonstrates that the three conditions named above do not exist, and that the income is really effectively connected with the conduct of a U.S. trade or business, then a withholding exemption claimed on form 4224 or W-8ECI may be allowed.

Once you have determined that a payment to a foreign corporation is taxable and subject to withholding under U.S. law, then you must consider the question of whether the payment might be exempt or taxable at a lower tax rate under a tax treaty. You should consult IRS Publication 901 U.S. Tax Treaties to determine whether a tax treaty exists with the country of which the foreign country is a resident. If no tax treaty exists with that country, then simply treat the payment as it should be treated under U.S. law. If a tax treaty does exist with that country, then you will usually need to read the tax treaty articles on "Business Profits" and "Permanent Establishments" (the article titles may vary from treaty to treaty) in order to discover how the treaty determines the taxation of the business profits of a corporation resident in one country which earns profits from business in the other country. In addition, most tax treaties have separate articles dealing with the income of "artistes", athletes, and entertainers. These separate articles usually supersede the other articles of the treaty which might apply to the income of athletes and entertainers. IRS Publication 901 does not contain the actual text of all the tax treaties, and so you will need to consult a commercial publishing service (usually found in a law library or other university library) which publishes the actual text of the tax treaties.

When in doubt about whether a payment is taxable under U.S. law, or whether a tax treaty provision applies, the U.S. withholding agent should withhold the 30% tax and report the income and withholding on forms 1042 and 1042-S. If the foreign corporation later demonstrates that withholding should not have taken place, then the U.S. withholding agent can refund the withheld tax within the same calendar year as it was withheld. However, if the end of the calendar year arrives, and the withheld tax has not been refunded to the foreign corporation by the U.S. payor, and the payment and withholding have already been reported on forms 1042 and 1042-S, then the withholding agent cannot refund the withheld taxes and the foreign corporation will have to file form 1120F with IRS to get its refund. The U.S. withholding agent cannot refund tax withheld in a prior calendar year after forms 1042 and 1042-s have been filed. If the withholding was erroneous because of a tax treaty, then the foreign corporation may file form 1001 with the U.S. withholding agent before the end of the calendar year to ask for a refund of its withheld taxes. However, please be aware that IRS form 1001 will expire on 12-31-99 and will be replaced by IRS form W-8BEN. In fact, IRS has already printed and issued the new forms W-8BEN, W-8ECI, W-8EXP, and W-8IMY. These new forms are intended to replace the old IRS forms W-8, 1001, and 4224. The new forms should be used immediately; and the old forms W-8, 1001, and 4224 should no longer be used.

Welcome to the wonderful world of international taxation!