Source Of Income And Why It Matters
Payers making payments to foreign nationals have the additional task of determining if the payee is a nonresident alien, in which case special U.S. tax withholding and reporting rules apply.Payers must also determine the source of the income as defined by the Internal Revenue Code. Source of income is important because nonresident aliens are subject only to U.S. income tax and U.S. withholding and reporting on U.S-source income. Foreign nationals who are resident aliens for federal tax purposes are subject to U.S. income tax on worldwide income (as are U.S. citizens) and to the same U.S. withholding and reporting requirements as U.S. citizens. Foreign-source income of nonresident aliens (regardless of the type of income) is not subject to U.S. tax, withholding, or reporting. The source of income depends in large part on the character of the income. Withholding and reporting rules also vary by income type. 1. Compensation for Services
The source of income for any payment for which the recipient is required to perform services (employment or self-employment) is the location where the services are performed. Compensation for services performed in the United States is U.S.-source income with a few exceptions. For example, compensation for services provided in the United States by a foreign national in F, J, M, or Q status for a foreign employer is exempt from tax under Section 872(b)(3) of the Code as long as the compensation is not transferred to the books of a U.S. organization. Compensation for services performed abroad by a nonresident alien is foreign-source and not subject to U.S. tax, withholding or reporting. But the compensation could be subject to tax (and withholding and reporting) in the country where the services are performed. Special payroll rules apply to U.S.-source wages paid to nonresident aliens (described in IRS Publication 15, Circular E, Employer’s Tax Guide). U.S.-source self-employment compensation paid to nonresident aliens is subject to 30 percent withholding (absent a tax treaty exemption) and reporting on Form 1042-S (Income Code 16). 2. Scholarship and Fellowship Grants
The source of income for a scholarship or fellowship grant for which no services are required is generally the residence of the grantor. If the grantor is a foreign organization or government, the grant is foreign-source and not subject to U.S. tax for a nonresident alien recipient. Foreign-source grants paid by U.S. organizations acting merely as agents for the foreign grantor keep their foreign-source character. Noncompensatory scholarship and fellowship grants made by U.S. grantors are U.S.-source income with one exception. Grants for study or research abroad are deemed to be foreign-source by Treas. Reg. 1.863-1(c). In short, the only time a non-compensatory scholarship or fellowship grant is considered U.S.-source is when both the location of the grantor and the activity being supported are in the U.S. All other combinations result in the grant being foreign-source. U.S.-source grants paid to, or on behalf of, nonresident alien recipients who are in F, J, M, or Q status who are candidates for a degree at an educational organization are subject to 14 percent withholding if no treaty exemption applies, as are grants made by certain grantors specified by Section 1441(b)(2) of the Code. Taxable grants to recipients in any other immigration category are subject to 30 percent withholding. They generally do not qualify for a treaty exemption because, based on their immigration status, they did not enter the United States for the purpose of study, research, or training. Taxable grants of nonresident aliens (regardless of the withholding rate) must be reported to the recipient and the IRS on Form 1042-S (Income Code 15). Taxable grants paid to, or on behalf of, resident aliens (and U.S. citizens) are not subject to withholding, nor are they required to be reported on an information return. However, these grant recipients must report their taxable grants on their Form 1040 if their total income exceeds the income threshold for their filing status. To avoid underpayment penalties, taxpayers can submit estimated tax payments. 3. Prizes and Awards
Prizes and awards paid to nonresident aliens are U.S.-source income if the grantor is a U.S. resident with one exception. Under Treas. Reg. 1.863-1(c), an award for past humanitarian activities in a foreign country is deemed to be foreign source. (This regulation originally included an exception for past academic achievements in a foreign country as foreign-source income but this exception is no longer included in the regulation.) U.S.-source prizes and awards paid to nonresident alien recipients are subject to 30 percent withholding if no treaty exemption is available and must be reported on Form 1042-S under Income Code 50. Prizes and awards paid to resident aliens (and U.S. citizens) are reportable on Form 1099-MISC in box 3 and are subject to 28 percent backup withholding if the recipient fails to provide an SSN or ITIN. Treaty Exemptions from Tax
Foreign nationals, both nonresident aliens and, in some circumstances, resident aliens, but not U.S. citizens, could be exempt from tax under an applicable income tax treaty with their country of tax residence (not citizenship). To claim an exemption from tax under a treaty, foreign nationals must meet the conditions of a treaty provision (called an “article”), which provides a specific treaty exemption for the type of income being paid and must provide the appropriate withholding certificate – Form 8233, W-8BEN, or annotated W-9 – prior to payment. To be valid for a treaty claim, the form must include an SSN or ITIN, or, in the case of Form 8233, meet the exceptions for no SSN or ITIN at the time of submitting the form.
Paula N. Singer, Esq. chairman of Windstar Technologies, Inc. and partner in the tax law firm, Vacovec, Mayotte & Singer, Newton, MA, has over 25 years of experience providing advice and compliance services to employers on cross-border employment matters. She is also the editor of "US Tax Compliance For Immigrants And Employers: The Lawyer's Complete Guide". To learn more, see: http://www.ilw.com/books/tax.shtm. For more information, visit www.windstar.com. For additional information, call 1-800-259-6398 or email: firstname.lastname@example.org.
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