Understanding Critical Elements of Nonresident Withholding Form 1042-S

Understanding when U.S. tax must be withheld from a payment made to a non-U.S. person and understanding when a payment made to a non-U.S. person must be reported on a Form 1042-S are critical elements in preparing complete and accurate forms.

U.S. persons are subject to tax on their worldwide income. The IRS relies on billions of information returns filed each year—primarily 1099 and W-2 forms filed by payers and employers—to know that a U.S. person has income that should be reported on an income tax return. So long as the IRS receives an information return with a payee’s correct name and taxpayer identification number, or TIN, it can confirm that the income reported on that information return is properly reported on the payee’s income tax return and any requisite income tax is paid. Payors generally require U.S. payees to furnish a W-9 to certify their U.S. tax status and their TINs. It is very unusual for a payer to be required to impose withholding on a payee who has furnished a W-9.

Non-U.S. persons and nonresident aliens—NRAs—are subject to U.S. tax on income they earn in the U.S., also known as U.S. source fixed or determinable, annual, or periodical (FDAP) income. U.S. source FDAP income includes interest paid by U.S. borrowers, dividends paid by U.S. corporations, rent paid for the use of U.S. real property, royalties, licensing fees paid for use inside the U.S. of a non-U.S. person’s intangible property, and payments for services rendered in the U.S. U.S. source income paid to a non-U.S. person is generally subject to 30% withholding and 1042-S reporting.

Important things to note:

• For tax purposes, a person includes anyone and any entity. Individuals, corporations, partnerships, and limited-liability companies are all persons for U.S. tax purposes.
• Someone who makes a payment to a non-U.S. person is generally known as a withholding agent.
• While corporations and tax-exempt entities are typically exempt recipients and do not receive 1099 forms other than Form 1099-K, there are no NRAs who are exempt recipients for 1042-S purposes.

Non-U.S. persons generally document their tax status on one of several types of W-8 forms. Unfortunately, many withholding agents believe that if they collect a W-8 from a non-U.S. person, they are not required to withhold on or report payments to that person. That is simply not true. Instead, when a withholding agent makes a payment to a non-U.S. person, they must consider four additional steps:

• First, determine whether the payment is FDAP income. FDAP income includes interest, dividends, rents, royalties, licensing fees, and payments for services rendered. For payments made by an accounts payable group, a good rule of thumb is to ask whether the payment would be reportable on a 1099 if it was paid to a U.S. nonexempt recipient. If the answer is yes, it is most likely FDAP income. Likewise, if it is a payment for merchandise, equipment, raw materials, or inventory, it is not FDAP income and is not subject to U.S. reporting or withholding. However, beware of hidden charges for shipping, repairs, assembly, etc.
• Second, if the payment is FDAP income, determine where it was earned by the non-U.S. person. Rental payments are earned in the U.S. if the rented property is located in the U.S. Royalties and licensing fees are earned in the U.S. if the intangible property, e.g., software, is used in the U.S. Finally, payments for services are U.S. source if the services were rendered in the U.S., i.e., if the NRA came to the U.S. to perform services. This includes payments to board members who travel to the U.S. to attend board meetings and payments to professional services firms that send personnel to the U.S. Where a withholding agent does not know whether income is U.S. or foreign source, the tax rules presume the income to be from a U.S. source.
• Third, if the payment is U.S. source FDAP income, withholding at a rate of 30% is generally required. However, if the beneficial owner of the income provides a valid treaty claim on either a Form W-8BEN or W-8BEN-E, a reduced withholding rate will most likely apply. Although uncommon, the beneficial owner may also claim that the income is effectively connected with their conduct of a trade or business in the U.S. via Form W-8ECI or is otherwise exempt from withholding on a W-8EXP. It is the responsibility of a withholding agent to ensure that any claim for reduced withholding is valid, and a withholding agent is always liable for any tax they should have withheld but did not.
• Fourth, if the payment is U.S. source FDAP income, it is reportable on a 1042-S regardless of whether it was subject to withholding. Completing a 1042-S is not a simple task. The form contains numerous fields that require codes to report such things as income type, reason for exemption, the withholding agent’s chapter 3 and chapter 4 status, and the recipient’s chapter 3 and chapter 4 status. Chapter 3 refers to the general NRA withholding and reporting rules, while chapter 4 is a reference to FATCA, which applies an additional layer of information reporting and withholding compliance applicable to “financial payments.”

A few tips for completing Forms 1042 and 1042-S correctly:

• As stated above, Form 1042-S requires codes for several items. These codes are updated annually, and processes need to be refreshed to make sure the correct updated codes are being captured on each 1042-S. The instructions to the form provide ordering rules to address instances in which more than one code could be applied.
• The 1042-S instructions provide a list of required fields. A withholding agent must ensure that all required fields are completed.
• A 1042 is required even if no tax was withheld. The aggregate amount of gross income paid and the tax withheld as reported on the 1042-S forms filed must match the aggregate amounts reported.
• The IRS has developed an online tool for 1042-S validation that can be used before a file is submitted to the IRS to identify certain errors. The agency is also using data analytics to identify withholding agents for audit and to receive inquiries to reconcile certain amounts reported on Forms 1042 and 1042-S.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Debbie Pflieger is a Principal in EY’s Financial Services Organization. Debbie is EY Americas’ Tax Information Reporting and Withholding Services leader and consults with clients in the information reporting and withholding arena, assisting them to understand and comply with their many obligations in this area.

Tara Ferris is a principal in the financial services office of EY Americas. In this role, Ferris advises multinational financial institutions and asset managers on customer tax reporting and withholding.

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