The term “NRA withholding” is not a reference to deductions from a person’s paycheck to support the National Rifle Association. Instead, it is a general term that refers to federal tax withholdings on payments of U.S.-sourced income to foreign persons under Sections 1441 to 1443 of the Internal Revenue Code. Foreign persons should be mindful of their tax filing and payment obligations under this regime.
NRA Withholding, Generally
As a general matter, a foreign person is subject to U.S. federal taxes on its U.S.-sourced income. A foreign person’s U.S. income (with certain exceptions) is subject to a U.S. tax rate of 30 percent.1 The applicable federal tax is generally withheld (i.e., the NRA withholding) from the total payment submitted to the foreign person. Taxpayers should consider the following relevant areas associated with NRA withholdings:
Who Is Subject to NRA Withholding?
Payees who are “foreign persons” are subject to NRA withholding. Conversely, payees who are “U.S. persons” avoid the NRA withholding requirement. Generally, a person determines whether the payee is a “foreign person” or a “U.S. person” based on the documentation provided by the payee (e.g., Form W-8, Form W-9, etc.).2 To the extent a person does not have sufficient documentation to make the determination of a U.S. or foreign person, then the person should apply certain “presumption rules” as outlined below:
|Presumption Rules3||Regulation Section|
|Payee’s status, generally||1.1441-1(b)(3)
|Effectively connected income||1.1441-4(a)(2)|
|Partnership and its partners||1.1441-5(d)
|Estate or trust and its beneficiaries or owner||1.1441-5(e)(6)|
|Foreign tax-exempt organizations||1.1441-9(b)(3)|
What Income Is Subject to NRA Withholding?
Generally, income is subject to NRA withholding if it is sourced within the United States and is fixed, determinable, annual, or periodical (“FDAP”) income. According to the Internal Revenue Service, FDAP income is all income, except:
- Gains derived from the sale of real or personal property (including market discount and option premiums, but not including original issue discount);
- Items of income excluded from gross income, without regard to the U.S. or foreign status of the owner of the income, such as tax-exempt municipal bond interest and qualified scholarship income.4
Income is fixed when it is paid in amounts known ahead of time. Income is determinable whenever there is a basis for figuring the amount to be paid. Income can be periodic if it is paid from time to time. It does not have to be paid annually or at regular intervals. Income can be determinable or periodic, even if the length of time during which the payments are made is increased or decreased.5
Are Withholding Agents Necessary?
To the extent NRA withholding is necessary, a withholding agent is required. A withholding agent is a U.S. or foreign person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person subject to withholding. Withholding agents may be individuals, corporations, partnerships, associations, trusts, or any other entity (including any foreign intermediary). Multiple persons may be withholding agents for a single payment; however, the applicable tax is only required to be withheld once.6
A withholding agent must withhold an amount sufficient to cover at least 30 percent of the amount subject to withholding. Generally, the withholding occurs at the time of payment; however, there may be circumstances where withholding occurs without the actual transfer of cash or property to the foreign person (e.g., payment to a creditor of the foreign person).7
Withholding agents should also note that they are personally liable for any tax required to be withheld. That is, much like trust fund recovery penalties related to federal employment taxes, both the withholding agent and the foreign person are liable for the applicable tax (plus penalties and interest).8
What Returns Are Required for NRA Withholding?
Every withholding agent is required to file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, to report payments subject to NRA withholding (unless an exception applies). These returns are due by March 15 each year. Additionally, Forms 1042 and 1042-S should not be filed when the payment income is required to be reported on other applicable forms (e.g., Form W-2, Form 1099, Form 8805, Form 8288-A, Form 945, Form 1099-R, etc.).9
The term “NRA withholding” should be top of mind for parties involved in payments to foreign persons, especially as globalization increases. The Internal Revenue Service has provided Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, for a more in-depth review of withholding requirements. Understanding the withholding and reporting requirements related to such cross-border payments, as described above, is crucial. Failure to make the necessary withholding payments to the IRS is a situation to avoid. Otherwise, the withholding agent will be personally liable for the taxes along with the foreign payee.
1 This tax rate, however, may be lower depending on other applicable sections of the Internal Revenue Code or whether a tax treaty exists between the United States and the foreign person’s country.
2 Persons Subject to NRA Withholding, IRS, https://www.irs.gov/individuals/international-taxpayers/persons-subject-to-nra-withholding.
3 Presumption Rules, IRS, https://www.irs.gov/individuals/international-taxpayers/presumption-rules.
4 Fixed, Determinable, Annual, Periodical (FDAP) Income, IRS, https://www.irs.gov/individuals/international-taxpayers/fixed-determinable-annual-periodical-fdap-income.
6 Withholding Agent, IRS, https://www.irs.gov/individuals/international-taxpayers/withholding-agent.
9 Returns Required, IRS, https://www.irs.gov/individuals/international-taxpayers/returns-required.