In general, a foreign person is subject to U.S. tax on U.S. source income. Foreign “persons” include nonresident aliens, foreign partnerships, foreign corporations, foreign estates, and foreign trusts. The tax generally must be withheld from the payment made to the foreign person. A withholding agent is the person responsible for withholding tax on payments made to a foreign person or non-resident alien for U.S. tax purposes. First, it is essential for any non-American to understand what U.S. Source income is.
What is U.S. Source Income?
The income of foreign persons subject to U.S. income tax is divided into two categories: certain income that is effectively connected with a U.S. trade or business; and certain U.S. source income that is not effectively connected with a U.S. trade or business. Effectively connected income is taxed at graduated rates. Income not effectively connected with a U.S. trade or business is taxed at a flat 30 percent rate, subject to withholding.
Income is subject to withholding if it is fixed or determinable annual or periodical (FDAP) income
Income is subject to withholding if it is fixed or determinable annual or periodical (FDAP) income. Some examples of FDAP income include: interest, alimony, dividends, royalties, pensions and annuities, original issue discount, and compensation for personal services. There could be other items classified as source income depending on the taxpayer’s business. In addition, a payment may be subject to withholding if it is specifically required to be withheld even though it may not constitute U.S. source income.
Filing Requirement for U.S. Source Income – Form 1042
Every withholding agent or intermediary who receives, controls, has custody of, disposes of, or pays any FDAP must file annually Form 1042 and Form 1042-S:
- Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, reports the withholding agent’s aggregate withholding tax liability under the Tax Code by each week of the year and the total deposits of withholding tax made during the course of the year.
- Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, reports the gross amount of U.S. source income paid to the foreign person, the type of income, the rate of federal tax, the type of any exemptions, the amount of federal tax withheld, and identifying information if the payment was made through a flow-through entity that was not a qualified intermediary.
A separate Form 1042-S is required for each type of income that was paid to the foreign person but only one Form 1042 has to be filed consolidating all Form 1042-S recipient information. The Forms 1042 and 1042-S must be filed by March 15 of the year following the calendar year in which the income subject to reporting was paid. Form 1042 is a calendar year tax return. If Form 1042-S is filed on paper it must be filed with Form 1042-T for transmitting purposes. All forms are filed with the IRS Center in Ogden, Utah.
Hire Act and FATCA Changes for Withholding
In 2010, Congress passed the Hiring Incentives to Restore Employment (HIRE) Act. The new law requires a withholding agent to deduct and withhold a tax equal to 30 percent on any “withholdable payment” made to a foreign financial institution or to a non-financial foreign entity unless certain exceptions are present. Under the HIRE Act, a withholdable payment is, among other things, any payment of interest, dividends, rents, and other payments from sources within the United States.
Withholding generally applies to payments made after December 31, 2012. Withholding is not required if there is an agreement between the IRS and the foreign financial institution to make certain disclosures. The foreign financial institution must agree, among other things, to disclose information about account holders.
What is FATCA Reporting?
The HIRE Act also adds a new reporting requirement for individuals. Under the HIRE Act, individuals with interests in “specified foreign financial assets” must attach to their income tax returns certain information with respect to each asset if the aggregate value of all the assets exceeds $50,000.
The HIRE Act is new and very complex. The new law also overlaps with older laws. The IRS is still working on how to implement the new rules. Our office will keep you posted of developments.