I received an email via Hackernews and figured I would answer it here, because this is a common question. This is likely to be the first of many discussions of this topic. For what it is worth, my username on HN is philiphodgen.

Question

Lightly edited (and ignoring the “how much would it cost to hire you?” question), here is what X.Y. (not his real initials, of course) on HN asked:

I am a $COUNTRY resident running a Hong Kong based software business, and a US based client tells me he needs to withhold 30% foreign taxes on the payments made to my company. I am sure this is not the first time you have seen this, and I wonder what’s the typical procedure in this case. (There are no mentions of taxes in our contract, it is first time both parties have engaged in this type of transaction.)

The power to tax comes from the barrel of a gun

Starting from first principles is the best way to understand a problem. So sorry, X.Y., but I am going to go deep.

We start with the basic principle: life or death.

Nonresidents of the United States (in this case, the Hong Kong corporation) cannot be taxed by the United States, unless there is some legal “hook” by which the United States tax “fisherman” can catch the nonresident corporation “fish”.

Bluntly put, the power to tax comes from the barrel of a gun. The United States can only tax you or your corporation if an enforcer has the ability to put a gun to your head and force you to pay the money. We are quite civilized in the United States, so only a few tax officers have guns. The usual threat is prison.

The other threat, again enforced by the power of the gun, is the threat of confiscating your wealth.

If you never physically enter the United States and all of your money is outside of the United States, then the American threat to your freedom or your wealth can be ignored.

Important: This is changing with FATCA and similar laws, so the protection that you have by being on the other side of the border (your country also has men with guns who deeply resent the U.S. government’s men with guns from collecting money by force) from the U.S. tax authorities will continue to erode with time. Also, I do not discount the proclivity of the U.S. government to go cowboy at times and ignore international law, when it suits some random politician. But for the moment, and for small ant-like objects like you and me, it is fair to assume that you will be ignored by the dancing elephant that is the United States government, and its minions.

Not to be too cynical about it, but I had lunch in February with a gentleman in Singapore and he joked that governments are the biggest gangsters of all. If you understand this basic principle and pay the protection money tax they demand, you will be safe. Until, of course . . . [warning: YouTube]:

Darth Vader: Calrissian. Take the princess and the Wookie to my ship.

Lando: You said they’d be left at the city under my supervision!

Darth Vader: I am altering the deal. Pray I don’t alter it any further.

But I digress.

U.S. customer puts his head in the lion’s mouth

As soon as you have a U.S. customer, you have put your head into the mouth of the lion. There is money within reach of the U.S. tax authorities, and if they decide that they want some of that money, they can grab it — with or without your co-operation.

You are comfortable sitting in your home in $COUNTRY. The Hong Kong government (as proxy for the PRC) is quite comfortable protecting its business entities against overly-invasive U.S. government types. You are not at risk.

But your U.S. customer is at risk. Your customer is in the United States, so he is personally at risk: the physical threat of loss of liberty, and the economic threat of confiscation of wealth. Your U.S. customer has an incentive to co-operate with the U.S. government, because it is an easy choice for your U.S. customer. Who should he make happy — you, or the U.S. government? That is an easy question to answer.

By buying software from your Hong Kong corporation, the U.S. customer has put his head in the mouth of the lion, and he must now ensure that the lion does not bite him.

How to make the lion not bite

The U.S. government cannot reach you or your Hong Kong corporation with threats against your liberty or wealth. But it can threaten your U.S. customer. The threat is simple:

“We — the United States government — cannot reach far enough to threaten X.Y. or his Hong Kong corporation, but you have some of his money because you are his customer. Give 30% of that money to us, or you, the U.S. customer, will suffer.”

The “suffer” threat is quite simple: someone who should withhold tax — but does not — must pay that tax out of his own pocket.

Your customer, therefore, is making decisions that are primarily motivated by fear. Logic is expensive and risky. The rational U.S. customer will therefore select the least-bad action as dictated by the fear module implanted in his brain. The rational U.S. customer will piss you off by withholding 30% of the payment and giving that money to the U.S. government

The way your U.S. customer eliminates fear is by withholding 30% of the payment he makes to your Hong Kong corporation. It is a simple (and understandable) action: by withholding 30% of the payment and giving it to the U.S. government, your U.S. customer is safe — whether the tax withholding is legally required or not.

  • If the tax withholding is legally required (a difficult exercise of logic and interpretation of tax law), then the U.S. customer has done the right thing, and will not be required to pay  X.Y.’s tax out of the U.S. customer’s own pocket.
  • If the tax withholding is not legally required (a difficult exercise of logic and interpretation of tax law), then the U.S. customer says to himself “Well,  X.Y. can apply for a refund and if he is legally entitled to receive the refund, he will get it.”

In other words, there is no incentive for your U.S. customer to co-operate with you. In the Fear vs. Greed war (fear of the U.S. government, or greed from making money by using your software), fear wins.

From the U.S. customer’s perspective, the lion will now not bite his head off. This makes your U.S. customer happy. You, however, are a little bit unhappy.

Tax logic used to defeat withholding

Now we get to the hard work. How can you use tax law and logic to eliminate the possibility of U.S. tax? And how can you then provide an easy, understandable, and safe alternative to the U.S. customer so he will (1) not withhold tax on payments to your Hong Kong corporation and (2) not have the lion bite his head off?

Go back to the first principle of tax — that the power to tax comes by a real threat that can be enforced if necessary. For income you receive, this is a territorial concept. The United States — like almost every country in the world — says that if you earn income from inside the U.S. borders, then the U.S. can and will tax that income.

The jargon used in tax law is “source of income” and there is a body of statutes that attempts to define U.S. source and foreign source.

The United States will not attempt to tax foreign source income (income earned outside the United States), but will attempt to tax U.S.-source income (income earned inside the United States).

Income is not “U.S. source income” just because it comes from a U.S. customer. Income is not “U.S. source” just because the money is wired to you from a U.S. bank.

Only U.S. source income is taxable to nonresident humans or non-U.S. corporations.

Your job, therefore, is to configure your business so that the payment received from your U.S. customer is NOT U.S. source income. Then your next job is to persuade your U.S. customer of that fact, so that the customer does not withhold tax anyway, due to fear.

If you successfully configure your business operations so that your income is not U.S. source income, you are safe either way:

  • If your customer does not withhold tax, then you receive payment in full, with no U.S. tax withheld; or
  • If your customer does withhold tax, then you will have the ability to file a claim for a refund from the U.S. government, and you will (in my experience) ultimately receive that refund.

Next episode

That’s enough for this blog post — it is getting too long. I will address the question of how to achieve the result in a future blog post: when is money earned from a software business “U.S. source” and when is it “foreign source”?