with the IRS. Annually by March 15, the U.S. payor must file an IRS Form 1042 and 1042S reporting the amounts paid and U.S. taxes withheld and remitted to the IRS, and must provide a copy to the foreign recipient. If the 1042 and 1042S is properly completed, that obviates the need for the foreign recipient to file a U.S. tax return.


Practical considerations When there is a failure to withhold U.S. tax on payments to foreign recipients it is often because the payments are to related parties or related entities coupled with a failure to request W-9s or W-8s. Tis may arise in relation to payments of intercompany interest, royalties or service fees. Complications can also arise in determining how the payment should be characterized under U.S. income tax principles, because different types of payments have different sourcing rules. What characterizes the payment is what it is in substance, not what the payment is called in the contract. For example, determining what constitutes a service fee (sourced where the service is provided) and what constitutes a royalty payment (sourced where the intellectual property is exploited) can be tricky and tends to hinge on who retains the right to the property produced. It can also be a challenge to clean up past failures. Trying to get U.S.


withholding tax back from a foreign recipient can be next to impossible, which can result in additional cost to the U.S. payor plus a gross-up on the additional U.S. tax payment. However, if there are ongoing payments with the foreign recipient, provided the contract governing the transaction permits, there may be an opportunity to true up on subsequent payments. It may be well worth the time and


effort to review all payments to ensure that proper documentation is in place and that proper U.S. tax is being administered, including ensuring that forms W-9 and W-8 are obtained from all payees. Te IRS announced a voluntary


disclosure program to try to get more taxpayers to comply with U.S. withholding and reporting associated with foreign payments by not penalizing taxpayers that enter the program. Technically, the program expired in early 2021. Te IRS, however, has continued to informally accept and receive taxpayers into the voluntary disclosure program, but, as of January 2022, it has not formally announced extension of the program. Visiting the IRS website can provide additional information about this voluntary disclosure program.


1


Tere may be other U.S. withholding situations not discussed in this column: for example, when a foreign person sells a U.S. real estate interest or a partnership interest that has a U.S.


trade or business operated directly or indirectly by the partnership. Further, U.S. withholding can also apply to payments made to foreign financial institutions (the Foreign Account Tax Compliance Act or “FATCA”), which is also not discussed herein.


2 Foreign individuals typically complete Form


W-8BEN and foreign entities complete Form W-8BEN-E. Other W-8 series forms may apply in other situations.


3


For example, if the payor knows the forms or information provided on these forms is incorrect – perhaps because the contract governing the payments indicates otherwise – then the forms cannot be relied upon. Other available information can also call into question the accuracy of the forms. In essence, the payor is under some duty of care to make sure the forms are completed by the payee correctly.


4


Te FATCA section of W-8 forms also should be completed by the payee. Te FATCA section can appear quite daunting. However, unless payments are being made to a foreign financial institution of some type (a bank, mutual fund, investment fund, insurance company, etc.), an exception from withholding is typical in most business payment situations to an active or passive nonfinancial foreign entity. Te FATCA withholding and reporting provisions are beyond the scope of this article.


5


Payment of deferred compensation is sourced where the compensation was earned. Further, the rules and potential treaty provisions related to pension payments can be complex and are outside the scope of this article.


6 In certain situations, the U.S. tax code exempts


certain payments from U.S. tax, such as interest on portfolio debt. Discussing these exemptions is outside the scope of this article.


July/August 2022


CPAFOCUS


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