In recent guidance to auditors, the IRS discusses what happens when a payor Withholding Agent pays items to a foreign payee when the withholding agent is uncertain whether the payment is U.S. source.
By way of background, Code Sections 1441 and 1442 impose a 30% withholding obligation (less under treaties) on payors of U.S. source fixed or determinable annual or periodical income (FDAPI). In most cases, the payor will know if the source is U.S. source. The guidance notes these common rules:
- Interest income is Generally Sourced to the residence of the payor;
- Dividend income is Generally sourced to the place of incorporation of the payor/issuer;
- Substitute dividends or substitute interest, as paid in securities lending or sale-repurchase transactions, are generally sourced the same as the interest or dividend paid on the transferred securities;
- Rental income is generally sourced to the location of the property;
- Royalty income arising from natural resources are generally sourced to the location of the property;
- Royalty income arising from patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and “other like property” are generally sourced to where the property is used; and
- Compensation for personal services is generally sourced to where the services are performed.
If the withholding agent cannot determine the source of the payment, it must assume it is U.S. source and withhold (although there is a procedure of escrowing it up to a year to provide time to determine the source). Withholding agents that should have withheld but didn’t may be subject to penalties and responsibility for the tax.
The guidance outlines one fact pattern that can be a trap for the unwary. It describes a payment to a foreign attorney for services. Since the attorney is foreign and situated abroad, the withholding agent may assume that the payment is for services rendered abroad and thus is foreign source compensation and not subject to withholding. The guidance warns that the withholding agent must first determine where the attorney actually performed the services, to see if any were performed in the U.S. – absent such a determination, the withholding agent falls into the “cannot determine source” rule above and needs to withhold on 100% of the payment.
Thus, in any situation where compensation is being paid for services rendered, the withholding agent should conduct due diligence to determine where in fact those services were performed, to avoid risk of penalty and liability for tax.
International Practice Service Concept Unit RPW/CU/P_08.1_04 (2016)