Foreign vendors being paid by U.S. organizations may include foreign enterprises that are engaged in a U.S. trade or business. Income of a foreign vendor that is effectively connected with the enterprise's U.S. trade or business is subject to U.S. income tax after allowable deductions at graduated rates. Such effectively connected income (called "ECI") when paid by a withholding agent is subject to 30 percent withholding (called "NRA withholding") unless the income 1) is not of a type that is subject to NRA withholding or 2) an exemption from NRA withholding is available and procedures for claiming the exemption from withholding are followed. A foreign vendor receiving ECI may be either an entity or a foreign national who is a nonresident alien for U.S. tax purposes. Resident aliens are generally taxed like U.S. citizens. (For an explanation of the rules that determine residency status, see the article, "Tax Residency Rules" in the April 2004 edition of the Crow's Nest.)
Some types of income are deemed to be effectively connected income by U.S. tax law. Examples include, as a general rule, income from personal services performed in the United States (exceptions are described in IRS Publication 515) and sales of U.S. real estate. When a foreign vendor is a resident of a tax treaty country, the Business Profits Article of the applicable treaty might deem the income to be business profits (these treaty deeming rules vary by treaty). Some types of income such as rents from U.S. real property may be treated as ECI by election. Income that is usually from investments and subject to gross basis taxation such as interest, rents of U.S. property and royalties for the use, or right to use, intangible personal property in the United States are also taxed on a net basis if they meet one of two tests, 1) the assets test or 2) the activities test. Income meets the assets test if the income is associated with U.S. assets used in, or held for use in, the conduct of a U.S. trade or business. For example, interest earned on bank deposits in an account used for a U.S. rental property covered by an ECI election is also ECI. Income meets the activities test if the activities of the enterprise conducted in the United States are a material factor in the realization of the income.
The ECI of foreign vendors is subject to reporting to the beneficial owner and IRS on Form 1042-S (whether exempt from withholding or not) unless an exception applies. For example, there is an exception from NRA withholding and Form 1042-S reporting for sales of U.S. real estate by foreign persons because this ECI is subject to a different set of rules for withholding, reporting, and IRS forms. Also, ECI might be exempt from tax under the provision of an available income tax treaty. ECI that is exempted from withholding is reported under Exemption Code 01 (for ECI) or 04 (for treaty-exempt income); otherwise the Exemption Code is 00, indicating that taxes were withheld.
Claiming Exemption from Withholding on ECI
A foreign enterprise that is engaged in a U.S. trade or business during the tax year may request an exemption from NRA withholding on its ECI that is identified on line 9 of a valid Form W-8ECI presented to the payer prior to payment (unless an exemption is not available). To be valid, Form W-8ECI must include the U.S. taxpayer identification number (TIN) of the beneficial owner identified on line 1. If the beneficial owner is an individual, the TIN must be a Social Security number (SSN) or individual taxpayer identification number (ITIN). If the beneficial owner is an entity, the TIN must be an employer identification number (EIN). (See the article, "When a Foreign Vendor Needs a U.S. Taxpayer Identification Number" in the May/June, 2011 edition of the Crow's Nest for more information about forms and required TINs.)
Form W-8ECI requests the U.S. business address of the beneficial owner without further comment. Foreign enterprises with ECI only from the performance of services in the United States frequently lack a U.S. address, however. Informal advice from IRS is to use the name and address of the organization for which the services are being performed.
The beneficial owner of the income (or a representative authorized to sign for the beneficial owner) submitting a Form W-8ECI is certifying that 1) the beneficial owner is not a U.S. person, 2) the income identified on line 9 is effectively connected with the conduct of a U.S. trade or business and 3) the amounts are includible in the gross income of the beneficial owner for the taxable year. Although under U.S tax principles, partners in a foreign partnership are considered the beneficial owners of the income rather than the partnership itself, Form W-8ECI may nevertheless be used by a foreign partnership (or other flow-through entity taxed as a partnership) to avoid NRA withholding. The ECI of the foreign partnership is reported on Form 1042-S in the name of the foreign partnership which must then comply with the section 1446 rules for withholding on and reporting U.S. income allocated to its foreign partners.
ECI Not Exempt from Withholding
A non-U.S. individual may use Form W-8ECI for their ECI such as rents from U.S. real property for which the beneficial owner elected ECI treatment on Form 1040NR. Non-U.S. individuals are restricted by the regulations from using Form W-8ECI for their compensation for personal services performed in the United States. (This restriction is indicated in the form's instructions.) Their U.S.-source compensation income is, therefore, subject to NRA withholding unless the income is exempt from tax under an income tax treaty provision and the beneficial owner presents the payer with a valid Form 8233 prior to payment.
Likewise, a foreign corporation that qualifies as a personal holding company for U.S income tax purposes may not use Form W-8ECI to claim an exemption from NRA withholding. A corporation is a personal holding company if 1) the corporation is or will be receiving amounts under a contract for personal services of an individual whom the corporation has no right to designate, and 2) 25 percent or more in value of the outstanding stock of the foreign corporation at some time during the tax year is owned, directly or indirectly, by or for an individual who has performed, is to perform or may be designated as the one to perform, the services called for under the contract.
Treaty-Exempt ECI
A beneficial owner of ECI resident in a tax treaty country may be able to claim an exemption from tax under an applicable income tax treaty provision. An entity with ECI that is not attributable to a permanent establishment in the United States (as that term is defined by the applicable tax treaty), may make a claim under the Business Profits Article of the applicable treaty (usually article #7). An eligible individual may make a claim under the Business Profits Article if self-employment income is included in that article (it is for new and updated treaties) or under an Independent Personal Services (Self-Employment) Article, if the treaty has a separate article for such income.
A claim for exemption under a tax treaty is made on Part II of Form W-8BEN by an entity or on a Form 8233 by an individual.
U.S. Tax Return Requirement
IRS provides the following alert at the top of Form W-8ECI:
Persons submitting this form must file an annual U.S. income tax return to report income claimed to be effectively connected with a U.S. trade or business (see instructions).
Under U.S. tax return rules, a tax return is required for ECI even if the income is exempt from tax under an applicable income tax treaty provision. Foreign corporations use Form 1120F (using the simplified procedure described in the instructions) and nonresident alien individuals use Form 1040NR with a Schedule C or C-EZ. Although U.S. tax law attributes a permanent establishment of a partnership to its owners, there is no guidance in either IRS Publication 901 U.S. Tax Treaties or the instructions for Form 1040NR on attributing a treaty claim of exemption from tax because a partner's allocable partnership income (normally recorded on Schedule E) is not attributable to a PE under the Business Profits Article. This is especially the case when the Business Profits Article of the applicable treaty does not cover ECI of an individual.
Paula Singer, Esq., Co-founder and Chair of Windstar Technologies, Inc. and partner in the tax law firm, Vacovec, Mayotte & Singer LLP, Newton, MA, has over 30 years of experience providing advice and compliance services to individuals and their employers, and payers on cross-border
matters.
