In June 2016, the IRS released a new International Practice Unit to help IRS examiners determine the source of fixed or determinable annual or periodical income – also known as FDAP income. Withholding agents especially need to pay close attention to these rules, because if payments to foreigners aren’t confirmed as foreign source, they will be assumed U.S. source and subject to withholding tax.
Common types of FDAP income are interest, dividends, rents, royalties and personal services. Unless there is a treaty or other exception, payments of U.S. source FDAP income to foreign persons are generally subject to 30% withholding tax. The general sourcing rules are provided in the practice unit as follows:
- Interest: Residence of taxpayer
- Dividends: Nationality/place of incorporation of payer/issuer
- Substitute dividends or substitute interest, as paid in securities lending and repo transactions: The same source as the interest or dividend paid on the transferred securities
- Rents: Location of property
- Royalties – Natural resources: Location of property
- Royalties – Patents, copyrights, etc.: Where property is used
- Business income – Personal services, whether paid to an entity or an individual: Where services performed
Although the above are the general guidelines for sourcing, the IRS practice unit provides more details and resources for transactions that may be unique or need further clarity. If a payer doesn’t have adequate support to show the payment is foreign sourced, 30% tax must be withheld at the time of payment. Otherwise, the payer could be held responsible for the tax, along with penalties and interest. Please consult with a qualified tax professional who can guide you on these types of payments and any compliance requirements.
Jill A. Helm, CPA