One of the most confusing areas of international tax law is determining when withholding is required. Getting it wrong can have disastrous consequences.
Currently, US international withholding provisions are found in Chapters 3 and 4 of the Internal Revenue Code. Chapter 3 contains the withholding provisions that are intended to approximate the US federal income tax of a foreign person. Chapter 4, on the other hand, deals with the withholding tax provisions put in place by the Foreign Accounts Tax Compliance Act 2010 and is primarily aimed at obtaining information on foreign financial institution account holders and owners of certain foreign entities.
In this article, we’ll focus on holding back Chapter 3, putting Chapter 4 aside for another time.
But first. . .
Why International Withholding Tax?
Legally, the reason for international withholding tax can be traced primarily to a common law doctrine known as the income rule.
Put simply, the tax rule provides that a country may refuse to apply or enforce the tax laws or judgments of another country. 1 This doctrine can, and sometimes has been, overridden by treaty. 2 But, in the absence of a convention, the only recourse for a country to levy taxes on an item of income earned in its territory by foreign persons located outside its territory is to levy the tax while this item is still on its territory or in the custody of its nationals3
Hence international withholding tax – the way a country seizes money before it escapes.
Chapter 3 Withholding Tax
Chapter 3 of the Internal Revenue Code contains three main withholding tax regimes affecting foreign persons with U.S.-source income: fixed or determinable annual or periodic income (“FDAP”) withholding tax, withholding tax under the Foreign Real Estate Investment Tax Act (“FIRPTA”) and foreign withholding tax. retained partner.
In the United States, nonresident aliens and foreign corporations are subject to federal income tax on U.S.-source income and certain foreign-source income items that are effectively connected with the conduct of a business or of a company in the United States.
4 These individuals must pay a 30% flat tax on most types of income that are not actually related to carrying on business or commerce in the United States. 5 On the other hand, such persons are liable for income tax which is effectively connected with the carrying on of a trade or business in the United States at the rates generally applicable to American persons. 6
And that’s where restraint comes in. Anyone who receives most types of U.S.-source FDAP income intended for a nonresident alien, foreign partnership, or foreign corporation must withhold and remit 30% of that item, unless that rate is reduced or eliminated. by treaty. seven FDAP income includes interest, dividends, rents, salaries, wages, bonuses, annuities, compensations, salaries and emoluments8
Generally, a nonresident alien’s or foreign corporation’s gain or loss from the disposition of U.S. real property is treated as if it were actually connected with the conduct of a trade or business. a company in the United States.9
Thus, when a foreign person disposes of an interest in US real property, the transferee is generally required to deduct and withhold tax equal to 15% of the amount realized on the disposition. ten
A U.S. real estate interest includes:
- any interest in real property located in the United States or the Virgin Islands (but not in other territories or possessions of the United States for any reason), and
- any interest (other than as a creditor) in a domestic corporation, unless the transferor of the interest establishes that the corporation was not a U.S. real estate holding company at any time during the period five-year period ending with the disposition of such interest. 11
A U.S. real estate holding company, in turn, is defined as any domestic corporation whose fair market value of U.S. real estate interests is at least 50% of the fair market value of its U.S. real estate interests, its interest in real estate non-U.S. property and any other assets held for use in its trade or business. 12
Foreign partner Deduction
A partnership is not taxed as such. 13 Instead, members of a partnership are subject to income tax on any income earned by the partnership. 14
Partnerships are required to withhold tax if they have taxable income that is effectively connected with the conduct of a trade or business in the United States that is attributable to a foreign partner during the year of taxation. 15 The amount to be withheld is the portion of the effectively linked taxable income attributable to the foreign partner during that year multiplied by the highest tax rate applicable to that partner. 16 Thus, for non-resident foreign partners, the withholding rate would be 37% and for foreign partner companies, the withholding rate would be 21%. 17 However, this rate may be reduced by treaty.
The sale of an interest in a partnership may also be subject to withholding tax if a nonresident alien or a foreign company holds an interest in the partnership and the partnership is engaged in a trade or a company in the United States. 18 The amount to be withheld would be 10% of the amount realized from the disposition of the interest in the partnership. 19
What happens if there is no direct debit?
If a person is required to withhold from a payment to a foreign person under Chapter 3 but fails to do so, that person may become liable for the tax that was required to be withheld. 20On the positive side, if a person withholds correctly, he is indemnified against any claim and demand from any person for the amounts withheld21 So at least that’s something.
This is just a brief overview of what U.S. international tax withholding has in store for you, and more specifically Chapter 3. There are many ins and outs and many potential pitfalls. If you have any questions about international withholding tax, please call us for a free consultation.
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Readers might be interested in Freeman Law International Tax Symposiumis scheduled to take place virtually on October 20 and 21, 2022. Attendees will qualify for CLE, CPE, and CE and the list of presenters includes acclaimed speakers and panelists, such as the IRS Commissioner, a former attorney in head of the IRS, a former acting assistant attorney general in the tax division of the United States Department of Justice, and many others in government and private practice.
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1 Brenda Mallinak, The Tax Rule: A Common Law Doctrine for the 21st Century, 16 Duke J. Comp. & Int’l L. 79, 79 (2006). Although this is common law doctrine dating back to the 18th century, Mallinak cites Justice Learned Hand as the first to justify the income rule:
Even in the case of ordinary municipal liabilities, a court will not recognize those that arise in a foreign state, if they go against the “established public order” of its own. Thus, an examination of responsibility is necessarily always in store, and the possibility that it may be found not to be in accordance with domestic state policy. This is not a cumbersome or delicate inquiry when it comes to a matter between private individuals, but it takes on a whole different face when it comes to the relations between the foreign state and its own citizens or even those who may be temporarily within its borders. Transmitting the public order provisions of another state is, or at any rate should be, beyond the powers of a court; it is about the relations between the States themselves, which the courts are incompetent to deal with, and which are [e]entrusted to other authorities. It can engage the domestic state in a position that would seriously embarrass its neighbor. Tax laws follow the same reasoning; they affect a state in areas as vital to its existence as its criminal laws. No court should undertake an inquiry that it cannot continue without determining whether these laws conform to its own notions of what is appropriate.
Identifier. at 79, 86 (citing Moore v. Mitchell, 30 F.2d 600, 604 (2d Cir. 1929) (Hand, J., concordant)). Thus, Hand sees the income rule as being rooted in concerns about diplomatic relations with other states, which is beyond the jurisdiction of the courts.
Interestingly, the application of the income rule in
Moore was used to prevent New York from enforcing Indiana tax laws. Mallinak, above at 85. The United States Supreme Court modified this result with Milwaukee County v ME White Co., 296 US 268, 268 (1935), in which the Court held that a sister state tax ruling was entitled to recognition under the Constitution’s full faith and credit clause. Mallinak,
above at 87-88.
2 Identifier. at 95 (citing U.S. tax treaties with Canada, Sweden, Denmark, and the Netherlands as having provisions permitting cooperation regarding the enforcement of each nation’s tax laws).
3 See Harvey P. Dale, Withholding tax on payments to foreigners36 Tax L. Rev. 49, 50-52 (1980) (noting the existence of the tax rule and various mechanisms for collecting tax from foreigners almost in rem (actions against assets of the foreign person in the United States) or
in person (actions against a foreign person located in the United States), but recognizing that the most important tool for collecting these taxes is withholding).
4 See 26 USC §§ 871(a)(1), (b), 881, 882.
5 See identifier. §§ 871(a), 881. For
6 See identifier. §§ 871(b), 882.
seven See identifier. §§ 1441(a), (b), 1442(a). One theory of how the FDAP income contours have been delineated is that it only includes income with a where net income roughly equals gross income (in other words, few associated deductions ). Harvey P. Dale, Withholding tax on payments to foreigners36 Tax L. Rev. 49, 59 (1980) (citing Rev. Rul. 80-222 (in which IRS guesses Congressional intent in defining FDAP)).
8 See identifier. §§ 1441(b), 1442(a).
9 26 USC § 897(a).
ten Identifier. § 1445(a).
11 See identifier. §§ 897(c)(1), 1445(a).
12 Identifier. § 897(c)(3).
13 Identifier. § 701.
15 Identifier. § 1446(a).
16 Identifier. § 1446(b)(1), (2).
17 Identifier. §§ 1(j), 11(b).
18 See identifier. §§ 864(c)(8), 1446(f).
19 Identifier. § 1446(f).
20 Identifier. § 1461.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.