Author: Heather M. Smithson, CPA, Tax Manager
Remember Form 1042 (Annual Withholding Tax Return for US Source Income of Foreign Persons) needs to be filed for 2015 by March 15, 2016. This form reports 2015 payments of U.S. sourced income to non-US persons. This is an area of focus by the IRS as they try to capture U.S. source income which may be escaping tax. They are looking to U.S. businesses to report such income on Form 1042 (similar to a Form 1099) to help with this enforcement effort.
Generally, if your company is paying foreign vendors for anything other than tangible goods and the payment is for U.S. sourced income, it is likely you have a Form 1042 filing requirement regardless of whether tax is withheld or not.
Sourcing rules vary depending on the nature of the income. Some general rules of sourcing include:
- Services are sourced where the service is performed
- Interest is sourced at the tax residence of payer/ debtor
- Rent is sourced where property is located
- Royalties (patents, license fees, copyrights) is sourced where property is used
If payment to foreign vendors is not U.S. source income (ex. payment for services rendered outside of the U.S.), no other reporting is required. We recommend that you have documentation to support this position. Support may include a note from your vendor on each invoice that indicates “These services were performed entirely outside of the United States and accordingly all of the fees constitute non-U.S. source income.” If you do not have appropriate documentation it will be considered U.S. sourced income.
If you determine the payments to non-U.S. vendors is U.S. sourced, then the next step is to determine if any/how much withholding is required – some treaties provide exemptions and/or reduced rates of withholding depending on the type of income. This determination should be made prior to any payment being remitted to the vendor.
- A U.S. entity hired a consultant who lives in Germany and performs all work for the project in Germany – this is NOT US source income- no Form 1042 required.
- A U.S. entity hired a consultant who lives in Germany and performs all work for the project in the US – this is US source income – Form 1042 required/determine withholding rate.
- A U.S. entity paid a director fee/management fee to the parent company in France. The invoice indicates that all services are performed in France – this is NOT US source income. Form 1042 is not required.
- A U.S. entity paid a director fee/management fee to the parent company in France. All services are performed in the U.S. – This is U.S. source income. Form 1042 is required/determine withholding rate.
- A U.S. entity paid has a note payable and paid interest to a foreign related party. Regardless if withholding is required based on the treaty, a Form 1042 is required.
- A U.S. entity paid a royalty or license fee to a foreign related party for use of the property in the U.S. Regardless if withholding is required based on the treaty, a Form 1042 is required.
If you paid U.S. sourced income to a non-U.S. person you should have a completed Form W-8 (various types of W-8s depending on taxpayer type). The Form W-8 will support why tax was not withheld or why a reduced rate was withheld if questioned by the IRS. Affiliated foreign entities are not excluded from the withholding certificate requirement.
Please contact us if your company made any U.S. sourced income payments to non-U.S. persons in 2015 and you need assistance with filings. 804.747.0000.