The IRS recently issued an International Practice Unit (IPU) that outlines for its examiners the general rules for determining the source of fixed, determinable, annual or periodical (FDAP) income.
The tax agency stated that source determination is “critically important,” as the U.S. only has jurisdiction to tax FDAP income sourced to the U.S. A withholding agent that is unable to establish the source of FDAP income would generally be required to presume the income is U.S. sourced and obliged to withhold tax.
Generally, IPUs identify strategic areas of importance to the IRS and can provide insight on how examiners may approach a particular issue or transaction on audit. IPUs aren’t official pronouncements of law or directives and can’t be used as such.
Chapter 3 withholding
Non-U.S. persons (whether individuals or corporations) are taxed by the United States under two separate regimes:
- Passive income. The U.S. Internal Revenue Code (IRC) imposes a flat 30% tax on nonresident alien (NRA) and non-U.S. corporations on the gross amount of FDAP income that they receive from sources within the U.S. This gross amount may not be reduced by deductions or personal exemptions. The tax is subject to reduction under an applicable U.S. income tax treaty or exemption under the IRC. The tax generally is collected by tax withholding at source. The regulations contain detailed rules for implementing this law (commonly referred to as Chapter 3 withholding or the NRA regs).
- Income from a trade or business in the U.S. (USTB). The IRC imposes a U.S. tax on net (rather than gross) income that’s effectively connected with a U.S. trade or business (called effectively connected income or ECI).
The U.S. tax on ECI is imposed at the graduated rates applicable to individuals and corporations. The net income calculation takes into consideration applicable deductions and exemptions. ECI can include both U.S.- and foreign-source income under the “force-of-attraction” rule. This rule reflects the idea that a USTB attracts to itself virtually all U.S.-source income whether or not it actually generated that income.
In general, income taxable under these provisions includes interest, dividends, royalties, rents, compensation, and other “fixed or determinable annual or periodical gains, profits, and income” (that is, FDAP).
To be subject to the NRA regs, the payment must be made to a non-U.S. payee. The key issue when looking at the payment and the payee is determining the beneficial owner of a payment, defined as the person who is required to include the payment in gross income under U.S. tax principles.
In general, the new IPU assumes that a withholding agent pays the FDAP income to an NRA or foreign corporation. It focuses on how to determine the source of the income and offers the following example of when a withholding agent may not be able to determine the source:
If a U.S. corporation engages a foreign law firm to provide legal advice, the firm’s fee may be treated as FDAP income. Whether the compensation for the legal services is sourced to the United States or outside of it generally depends on where the services are performed. If the corporation, as the withholding agent, can’t confirm that the law firm performed the services outside of the United States, it “must withhold on the entire undetermined amount of income.” In other words, the fee paid to the law firm would be net of a U.S. withholding tax.
The corporation may keep the withheld amount in escrow until it can determine the source (for no more than one year). However, if the foreign law firm supplies proper documentation, such as a valid Form W-8ECI (“Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States”) (a type of withholding certificate), to the corporation to assert that the fee is ECI, no U.S. withholding tax is required.
Source of FDAP income
The IPU reminds IRS examiners that Chapter 3 withholding must usually occur when a gross payment is made to the foreign person. A withholding agent must generally withhold 30% if it can’t determine the character and source of payments before they are made.
According to the IPU, withholding agents have created different methods of reviewing payment to determine character and source. For this purpose, a withholding agent might:
- Split its payments into those made to U.S. vs. foreign persons,
- Consider whether each payment to a foreign person is FDAP income, and
- Consider whether the income is U.S. vs. foreign source.
What is and isn’t FDAP income?
The IPU lists items of income that are “usually FDAP” and describes the general factors in determining the source of each item (noting that exceptions may apply):
- Interest income is generally sourced to the residence of the payer.
- Dividend income is generally sourced to the place of incorporation of the payer/issuer.
- Substitute dividends or interest, as paid in securities lending or sale-repurchase transactions, is generally sourced the same as the interest or dividends paid on transferred securities.
- Rental income is generally sourced to the location of the property.
- Royalty income arising from natural resources is 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” is generally sourced to where the property is used.
- Compensation for personal services (as in the illustration above) is generally sourced to where the services are performed.
“In most cases, dividend and interest income is from U.S. sources if it is paid by domestic corporations, U.S. citizens or resident aliens, or entities formed under the laws of the United States or a state,” the IPU explains.
It also lists items of income that are “usually not FDAP,” such as salaries, wages, and gains from sales of inventory, real property, natural resources, and personal property. It also describes the general factors in determining the source of each item, noting that exceptions apply.
If you have questions about FDAP income in your situation, consult with your tax advisor.