This is part of the Brains Across Borders series – where I talk about tax problems that pop up when the person doing the work is in one country, and the person getting the work done is in another country. And one of those countries is the United States.
This episode looks at one of the burdens on U.S. employers who hire foreign freelancers, and the interesting problem of how you prove that you don’t have to do anything. It’s stressful to be fairly sure you don’t have to do something, but then that little voice in the back of your head keeps second-guessing you…
The U.S. tax system loves withholding. “Me first” is the IRS motto,1 and in a perfect world the IRS would get their money off the top before you get any.
There are four sets of withholding rules to worry about when paying a person who works for you. For the moment, I don’t care whether the service provider is a freelancer, independent contractor, employee, full-time or part-time, etc. All I care about is that human is doing work and getting paid for it.
The four rule sets are referred to as Chapter 3, Chapter 4, Chapter 61, and Section 3406. The chapters refer to parts of the Internal Revenue Code. For those of you who like to nerd out on Federal legal taxonomy, this refers to three different Chapters in Title 26, Subtitle A, Chapter 3, Chapter 4, and Chapter 61 of the United States Code.2
Section 3406 is the odd man out. It refers to Internal Revenue Code Section 3406, which is found in Title 26, Subtitle C, Chapter 3 of the United States Code. Subtitle A is where you find all of the Federal income tax laws. Subtitle C is where you find employment taxes–Social Security, Federal Unemployment tax, etc.
Of course, the employer has paperwork associated with each set of withholding rules.
And woe betide the employer who fails to withhold when required, or fails to file the mandated paperwork.
This episode deals with one of the four withholding rule sets: Chapter 4. Specifically, it shows you how you walk through the
Internal Revenue Code one step at a time to figure out that you don’t have to do something, when there is a void of clues.
Chapter 4 contains the vividly awful FATCA withholding. Unlike all of the other withholding rules, these withholding rules are not intended to collect tax. Rather, they are intended to bludgeon foreign banks and governments into polishing Uncle Sam’s boots.
The central feature of the FATCA withholding rules is the general idea that (almost) every time that money leaves the United States and goes to a foreign bank, the person making the payment must withhold 30% and give it to the IRS unless the right kind of paperwork is in place.
This is grossly oversimplified. The FATCA law is a massive, steaming pile of poo,3 full of acronyms and replete with rococo
definitions, exceptions, and counter-exceptions. If you’re a FATCA expert, great. Have fun. We’re not going to split FATCA atoms today.
Consider, hypothetically, a Pasadena international tax lawyer who hires a web designer who lives outside the United States, in oh, let’s say … Canada. All of the work is done in Canada. The Pasadena-based lawyer wires money to the web designer for the work done. It goes to the web developer’s bank account in Canada.
Simple story. Canadian human in Canada does work in Canada for an American human living in America. Money flows north.
Let’s look at FATCA, and see how the Pasadena international tax lawyer decided that he did not need to withhold 30% of the payment to the Canadian web developer under the rules of Chapter 4. Remember, the same analysis needs to be done to prove withholding is unnecessary under the other three rule sets.
Start at the beginning. Find the rule that imposes the pain, then work backwards from there to find out if it applies to you.
There are two basic rules in Chapter 4 that impose 30% withholding on a payment. One looks at payments to a “foreign financial institution”:
In the case of any withholdable payment to a foreign financial institution which does not meet the requirements of subsection (b), the withholding agent with respect to such payment shall deduct and withhold from such payment a tax equal to 30 percent of the amount of such payment.4
The other looks at payments to “non-financial foreign entities”:
In the case of any withholdable payment to a non-financial foreign
(1) the beneficial owner of such payment is such entity or any other non-financial foreign entity, and
(2) the requirements of subsection (b) are not met with respect to such beneficial owner,
then the withholding agent with respect to such payment shall deduct and withhold from such payment a tax equal to 30 percent of the amount of such payment.5
Don’t worry about knowing the meaning of “foreign financial institution” and “non-financial foreign entity”. Put simply, these two rules say:
“If there is a withholdable payment and (GARBLE! GARBLE! GARBLE!) then the withholding agent must withhold 30%”.6
Our intrepid Pasadena international tax lawyer decided that he had no FATCA-driven withholding requirements. He did this by ignoring the GARBLE! GARBLE! GARBLE! and focusing on the two relatively understandable defined terms: “withholding agent” and “withholdable payment”.
You find out that you are a “withholding agent” when you read this:
The term “withholding agent” means all persons, in whatever capacity acting, having the control, receipt, custody, disposal, or payment of any withholdable payment.7
Concede the obvious. Assume if you’re touching money, you are at risk.
Note that the rules only impose the 30% withholding requirement on a withholding agent (that would be
me the Pasadena lawyer) if there is a “withholdable payment” (and there is a bunch of gibberish, too, which we are cheerfully ignoring).
A “withholdable payment” is defined, of course:
Except as otherwise provided by the Secretary–
(A) In general. The term “withholdable payment” means–
(i) any payment of interest (including any original issue discount), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income, if such payment is from sources within the United States, and … .8
Imagine if you’re just a regular person trying to figure out what you’re supposed to do. “WTF?” would be your only response when contemplating that paragraph. You see “salaries” and “wages” and
“compensations” in there, but … Vogon poetry comes to mind when reading the Internal Revenue Code. You shudder and turn away.
Well, I know what those words mean. I have spent time contemplating the glory that is Internal Revenue Code Section 871(a). I know that payment for services rendered can fit within that pleasant prose. I’m also pretty sure I can run a logic tree on that and prove that paying a guy working in British Columbia is not a “withholdable payment” as defined above.9
But I want to be sure. It’s my wallet on the line if I’m wrong. I need Ultimate Truth.10
We delve into the Treasury Regulations in search of Truth. And we find it!
(1) In general. Except as otherwise provided in this paragraph (a) and § 1.1471-2(b) (regarding grandfathered obligations), the term withholdable payment means–
(i) Any payment of U.S. source FDAP income (as defined in paragraph (a)(2) of this section) … .11
Trust me on this, or we’ll be here all day. That reference to “U.S. source FDAP income” has the same meaning as the Vogon poetry I just quoted.
But now we come to the (semi)-clarity. See that “except as otherwise provided in this paragraph (a)” phrase? Further down
in paragraph (a) the Treasury Regulations give a list of things that are explicitly NOT “withholdable payments”:
(4) Payments not treated as withholdable payments. The following payments are not withholdable payments under paragraph (a)(1) of this section–
(iii) Excluded nonfinancial payments. Payments for the following: services (including wages and other forms of employee compensation (such as stock options)), the use of property, office and equipment leases, software licenses, transportation, freight, gambling winnings, awards, prizes, scholarships, and interest on outstanding accounts payable arising from the acquisition of goods or services…12
Here, finally, I find some closure. Payments made by a withholding agent (me) for web design work are payments are for services (duh). This makes the payments “excluded nonfinancial payments” that are not treated as “withholdable payments”.
I, the withholding agent, am not making a “withholdable payment”. No matter what the GARBLE GARBLE GARBLE part of the FATCA withholding requirements mean, I do not have to demand paperwork from my Canadian web developer, and I do not have to withhold 30% of my payments to him.
That’s an example of a quick answer to a tax question. Is it any wonder that Mr. Gumby’s brain hurts? (Warning: YouTube).
I know that I don’t have to withhold 30% of the payment to my freelance web designer friend in British Columbia. But is there
paperwork required anyway?
Figuring that out is something we will do another day. (Hint: Form 1042, Form 1042-S is where you live, if at all.) The paperwork obligations need to be handled properly, but that’s not the scope of this episode.
I will, however, say one thing about paperwork. It’s almost certain that you (as a payer of money to someone else as a service
provider to you) will want to have either a W-8BEN or a W-9 in your files. When you look at all of the different places where withholding is required, you’ll probably find that it is required or if not required it is a really good idea to have that W-8BEN or W-9 on hand as a way to ward off the tax vampires.
As usual … I’m not your lawyer, and this is not legal advice. Hire someone to tell you the answer.
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