Home > California CPA Magazine > March/April 2009 > Sourcing Income

Sourcing Income

Conducting business throughout the world creates tremendous benefits, but knowing and complying with your responsibilities is key.

By Steven M. Frankiel, CPA
California companies conduct business with vendors and capital providers worldwide, which creates benefits and responsibilities. Chief among the responsibilities are to report and, often, withhold and remit as income taxes a portion of payments to foreign vendors.

CPAs may assist their employers and clients by having a basic understanding of how federal requirements associated with such payments apply. While issues such as withholding on partnership profits, real estate sales by foreign sellers and California’s requirements need to be considered, we’ll focus on federal requirements.

What You Need to Know
Payments by U.S. companies to foreign vendors and capital providers often are U.S. source income. The Internal Revenue Code categorizes payments as U.S. or foreign source based on the nature of the payment. Congress imposes a 30 percent tax on payments of U.S. source income to foreigners. Payers must withhold, remit and report the withheld amounts.

Generally, payments for purchases of inventory and equipment are not subject to withholding. Different rules apply to payments for services, licensing of intangibles, rents, interest and dividends (IRC secs. 861-2). General rules source various types of income as follows:

1. Services: Country in which services are rendered.
2. Intangible licenses: Country in which the intangible is permitted to be used.
3. Rents: Country in which the property is located.
4. Interest and dividends: Country in which the payer is incorporated.

Cross-border transactions can contain nuances, such as services rendered both in and out of the United States and intangible licenses permitting use both in and out of the United States. At times, the nature of certain payments may be unclear, such as computer software licenses. Statutory exceptions and regulations provide guidance for the proper sourcing of payments.

Income tax treaties play a large role in this arena, as many override U.S. statutes providing for the sourcing of income and withholding rates to be applied. Treaties often decrease the withholding rate and, at times, eliminate the withholding requirement. IRS Publication 515 (pages 53-54) lists tax treaties in effect.

Another withholding exception occurs when vendors with headquarters in foreign countries directly operate businesses in the United States. Such companies often claim exemptions from withholding because their income will be included in U.S. income tax returns as effectively connected income [IRC Sec. 1441 (c)(1)].

Following the Rules
Substantiating proper compliance begins with identifying foreign payees and requesting proper documentation. Payers may rely on regulatory presumptions in determining which payees are domestic or foreign, absent any actual knowledge or reason to know otherwise.

Payers may presume a payee is domestic if the payee provides a U.S. address and payments are made in the United States. Payers should presume payees are foreign if communication with the payee is in a foreign location, payments are made outside the United States or the payee’s federal identification number begins with 98, which is reserved for foreign companies.

To establish foreign status, payees generally must submit a completed Form W-8BEN to the payer prior to payment. Properly establishing foreign status is a prerequisite to utilizing an income tax treaty to reduce or eliminate withholding.

Establishing foreign status eliminates the requirement to prepare Form 1099 Misc for services rendered entirely overseas. Vendors provide completed Form W-8ECI to payers prior to payment when seeking to prevent withholding because they operate a business in the United States. Payees requesting treaty benefits or claiming to receive effectively connected income must provide the U.S. taxpayer identification number (TIN) on the appropriate Form W-8. A foreign service provider rendering all services outside the country does not need to provide a TIN.

Withholding agents remit to the U.S. Treasury amounts withheld from payments to foreign vendors and capital providers. The deposit frequency varies with the amount withheld. For example, withholdings exceeding $2,000 at the end of a quarter month period must be deposited within three days after the quarter-month period.

Companies making payments to foreign vendors annually report on forms 1042, 1042S and 1042T amounts subject to withholding or payments exempt from withholding by treaty or because of effectively connected income. The reports are due March 15 following the calendar year of payment.

Failing to properly withhold, remit or report can be costly. The payer may be required to pay the tax that was not withheld, along with any penalties the IRS may impose. In July 2008, the IRS provided more guidance to its examiners about auditing withholding from payments to foreign vendors and capital providers (Internal Revenue Manual 4.10.21), so these matters will likely receive more attention in future examinations.
Steven M. Frankiel, CPA is a Los Angeles-based tax accountant.