If you are a U.S. withholding agent for such payments, you must collect, deposit and report the income and the withholding taxes to the IRS. In certain instances, the 30 percent withholding rate may also be reduced if there are other statutory rates (see Publication 515) or the item paid is to a foreign resident covered by a tax treaty that provides for a lower rate. However, if the U.S. source income paid to a foreign person is determined to be from the conduct of a trade or business within the United States it is considered “effectively connected income” (ECI).
What is Effectively Connected Income?
Effectively connected income is subject to the graduated income tax rates applicable to U.S. persons and not the 30 percent withholding rate. A foreign person receiving effectively connected income is required to file a U.S. income tax return because they are conducting a trade or business within the United States. When payments are deemed to be effectively connected income, the U.S. payer, or withholding agent, has reporting requirements as opposed to a withholding obligation.
Therefore, a U.S. withholding agent must consider two categories of payments to foreign persons in determining its compliance responsibilities to the IRS:
- Payments that are U.S. source non-business income (that is Fixed or Determinable, Annual or Periodic – also known as FDAP) are subject to withholding taxes; and
- Payments that are related to a trade or business activity in the United States or Effectively Connected Income (ECI) are taxed at graduated rates.
Non-Business FDAP Income
If a foreign person is engaged in a trade or business in the US, income that would normally be deemed non-business FDAP income may become effectively connected income if:
- The income is derived from assets used in or held for the use in the conduct of that trade or business; or
- The activities of that trade or business in the US are a material factor in the realization of that income.
Hence, rather than being subject to a 30 percent withholding tax, the non-business FDAP income would be combined with the ECI income and taxed at the regular graduated tax rates.
Who is a U.S. Withholding Agent?
You are a withholding agent if you have control, receipt, custody, or payment of any item of income belonging to a foreign person that is subject to withholding. A withholding agent is often described as the last person in the United States who has control over the money before it is paid to the foreign person. The term “withholding agent” includes, but is not limited to individuals, U.S. corporations, foreign intermediaries, and U.S. branches of a foreign entity.
What is the Purpose of an IRS Withholding Agent?
Aside from owing the amount of tax that should have been withheld and interest, a withholding agent can face such civil penalties as:
- The 100 percent penalty equal to the total amount of tax evaded;
- The 20 percent accuracy-related penalty of the amount of the underpayment of withheld tax in the case of negligence;
- A 75 percent penalty for the underpayment of withheld taxes in the case of civil fraud;
- Additional taxes of five percent to a maximum of 25 percent for the negligent failure to file a return; and
- Additional taxes of 15 percent to a maximum of 75 percent for the fraudulent failure to file a return.