• IRS' New Withholding Rules for Nonresident Aliens
  • May 5, 2003 | Author: Duane E. Schroeder
  • Law Firm: Fredrikson & Byron, P.A. - Minneapolis Office
  • On January 1, 2001, a new set of regulations for withholding and information reporting under Sections 1441 and 1442 of the Internal Revenue Code became effective. The new regulations require that every individual, partnership, corporation, nonprofit organization or other entity that makes, receives or processes a taxable US payment to a non-US individual or entity (including U.S. branches of certain foreign banks and insurance companies in certain circumstances) has some reporting responsibilities, regardless of whether they are the beneficial owner of the payment. Failure to withhold can result in either or both penalties and liability for the amount not withheld. Although the regulations are over 120 pages in length, this article summarizes the most important part of the rules as they relate to the payers' responsibilities under the Internal Revenue Code and applicable bilateral income Tax Treaties in which the United States is a party.

    How Do the New Rules Work?

    The new withholding system for payments to non-US taxpayers is largely document driven. The system is designed to distinguish payees who beneficially own the income from those who receive the payment and act only as intermediaries. Generally, the payer ("withholding agent") must withhold 30-percent of the gross amount due the non-U.S. payee on any amount subject to withholding, unless either: (i) the payee files with the withholding agent the proper tax forms to establish whether the payee is a U.S. resident for U.S. tax purposes (or is entitled to reduced withholding requirements under a income tax treaty with the U.S.), or (ii) the foreign payee assumes responsibility for withholding as a "qualified intermediary." If the new rules are not followed, the payer must withhold at the highest rate (e.g., 30% or 31%) on the gross amount.

    Determining the Proper Tax Forms to Use

    Although the new system is document intensive, it is designed to be integrated with the backup withholding requirements for U.S. citizens and residents and the domestic payment reporting system (i.e., Form 1099s). Effective January 1, 2001, the older forms W-8, 1001 and 4224 can no longer be used. Instead the forms listed below must be used. Which form to use will depend on both the type of payee and the type of income to be paid. Most of these forms must be filed every three years, and require a tax identification number (TIN). Thus, if the payer is a qualified intermediary, the foreign payee must apply for a TIN with the IRS to be able to use these forms and get the benefits of the exemption from the withholding rules.

    (1) Form W-8BEN: This form is to be used for a variety of purposes where the beneficial owner of the payment is claiming an exemption from withholding under either: a tax treaty, the domestic "portfolio interest exemption" under Internal Revenue Code (IRC) Sections 871(h) or 881, bank deposit interest under IRC 871(i), certain U.S. source dividends paid by certain foreign corporations, and a number of other passive types of income.

    (2)Form W-8ECI: This form is used when a foreign person is claiming an exemption from withholding because the income is (or is deemed to be) effectively connected with a trade or business in the U.S. However, Form W-8ECI does not need to be filled out and filed with the IRS if the beneficial owner of the U.S. source income claims an exemption from tax under an income tax treaty because the income is not attributable to a permanent establishment in the U.S.

    (3) Form W-8IMY: This is a new form for foreign intermediaries, brokers, agents, nominees, custodians, trustees or partnerships and U.S. branches of foreign banks or insurance companies, where a payment is made to the intermediary by the payer. Even though filing this form will exempt the intermediary from having the 30% gross amount withheld, the intermediary may nevertheless have a withholding requirement on its subsequent payment to a non-U.S. taxpayer. Therefore, unless the intermediary is "qualified" (see below), the intermediary should have the non-U.S. taxpayer fill out one of the other forms listed, otherwise the intermediary must withhold 30% (or 31% in appropriate cases) of the gross amount due the payee.

    (4) W-8EXP: This form replaces Form 8709 and is used by foreign governments and international organizations.

    (5) W-9: Although W-9 is not a new form, and continues to be used by taxpayers to obtain a TIN, the new version of the form will contain a block to indicate the status of the payee (U.S. or foreign). The new version of W-9 will allow the payer that receives a W-9 from a non-U.S. taxpayer to rely on it as the basis that it is not required to withhold on 30% of the gross amount. This form has also replaced Form 1078, which was used by aliens claiming residence in the United States, requesting TINs, certifications, and claims for exemption.

    (6) Form 8233: Form 8233 is currently used by nonresident aliens to claim treaty benefits on fees paid for independent personal services. However, the new version of the form will have an expanded purpose to include those nonresident aliens claiming treaty benefits for dependent personal services. An example of latter purpose is when a non-U.S. taxpayer who has been employed by a U.S. company as an employee, is in the U.S. for less than 183 days in a tax year or is exempt from withholding requirements under a tax treaty. However, before this form is used, an employer should first determine whether the person it is paying is a independent contractor or employee for tax purposes under the Internal Revenue Code, case law, and income tax treaty.

    Qualified Intermediaries

    The second method in which a payer will not have to withhold 30% of the gross amount of the payment is when the foreign payee assumes responsibility for withholding because it is a "qualified intermediary." A qualified intermediary is either a foreign entity, foreign branch of a U.S. of a U.S. financial institution (or clearing organization), a foreign financial institution, foreign clearing organization, a foreign corporation asserting an exemption on behalf of its shareholders, or other person acceptable to the IRS that enters into an agreement with the IRS for withholding and reporting obligations of its customers. The agreement must specify the certifications and documentation (Forms such as W-9, W-8ECI, etc.) on which it can rely on to determine the classification (e.g., individual, corporation, partnership) and status (i.e., U.S. or foreign) of the beneficial owners and payees who ultimately receive the payments collected by the qualified intermediary from the payer. The required documentation may include, in certain circumstances, the names and addresses of foreign customers; especially if those foreign customers are claiming a benefit under a tax treaty. In addition, the qualified intermediary must file a Form W-8IMY, unless it meets certain procedural terms required to in the agreement. Under recently issued transitional guidance by the IRS (Notice 2001-4, 2001-2 IRB), certain transitional rules apply where the QI does not have a TIN, and circumstances where the QI can rely on old Form W-8, Form 1001, Form 1078, Form 4224, and Form 8709 for Year 2001.