Category: International; Compensation & Employee Benefits
Subject: Withholding
Title: Foreign Service Providers
IRC Sections: 7701(b)(3), 1441, 1442
Filename: 1160.html
Date Produced: 7/96

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

I refer to your letter of July 11, 1996 requesting assistance with matters related to tax withholding obligations with respect to amounts paid to foreign service providers. As I understand it, the taxpayer is a U.S. limited liability company. All services are provided in the U.S. The payees for the services are 1) a Canadian corporation, 2) a United Kingdom corporation, 3) a United Kingdom individual treated as an independent contractor of the taxpayer, and 4) a United Kingdom individual treated as an employee of the taxpayer.

With respect to the United Kingdom resident individuals, I assume they are not lawful permanent residents of the U.S. (i.e., they do not have a so-called "green card") and I assume further that their presence in the United States will not be such that for the periods in question, these individuals would be considered U.S. residents for tax purposes by virtue of the "substantial presence test" of Internal Revenue Code Section 7701(b)(3).

Specifically for determination of whether certain tax treaty benefits apply, I assume that the individuals will not by present in the United States for more than 183 days.

Finally, I assume that all payments in question will be made prior to 1998. There are proposed regulations on the books that change some of the conclusions set forth below. These regulations, if they are finalized in their current form, would be effective for payments made after 1997. As we discussed, the client should be apprised of this.

General Rule
The United States taxes nonresident individuals and foreign corporations only on income that has some nexus with the U.S. Services performed within the United States by foreign service providers are U.S.-source income and are deemed to have sufficient nexus with the United States to subject such income to U.S. taxation. As a means of ensuring that foreign parties which might be beyond the reach of U.S. courts report and pay tax on their U.S.-source income, U.S. tax law imposes a system of withholding at the source on certain types of income paid to alien individuals and foreign corporations.

Internal Revenue Code Section 1441 provides that amounts paid to nonresident individuals for (among other things) compensations and remunerations are subject to withholding at a rate of 30%. IRC Section 1442 provides that same rule with respect to amounts paid to foreign corporations. These general rules are subject to a number exceptions provided by statute, regulations, or tax treaties to which the United States and the home country of the recipient of such income are signatories.

Payee: Canadian Corporation/U.K. Corporation
If the payee is a foreign corporation, whether Canadian or U.K. resident, no withholding is required if certain exemption certificates are properly filed prior to payment.

Section 1441(c)(1) and 1442(a) provide income of a foreign corporation which is effectively connected with a U.S. trade or business is not subject to withholding. The payee must file Form 4224 in duplicate with the payor prior to the time the income is paid. The payor retains one copy of Form 4224 and files the other with the IRS along with Form 1042S. Note that the existence of a properly completed Form 4224 filed prior to the payment of the income in question is the only thing that prevents the payor from being liable for the withholding amount.

Payee: U.K. Individual as Independent Contractor
If the payee is an individual treated as an independent contractor, withholding at the rate of 30% would be required under the general principles of Section 1441 as discussed above.

In the case of a U.K. individual, provisions of the U.S.-U.K. tax treaty provide that if certain conditions are met, the independent contractor is not taxable in the United States with respect to the payments in question. Article 14 of the treaty provides that income paid to a U.K. resident for work perform as an independent contractor in the United States is not subject to U.S. taxation unless A) the contractor is present in the U.S. for 183 days or more during the taxable year; or B) the contractor maintains a fixed base regularly available to him and the income is attributable to that fixed base.

Under Regulation Section 1.1441-4(b)(1)(iv), withholding is not required if the amount in question is treaty exempt. Under Regulation Section 1.1441-4(b)(2), a nonresident alien may claim an exemption from withholding by reason of a tax treaty for compensation from independent personal services by completing a statement and submitting it with Form 8233, Exemption from Withholding on Compensation for Independent Personal Services of Nonresident Alien Individual, to the person required to withhold tax on the payments to him. If the withholding agent agrees that an exemption is warranted, the statement is accepted, and within five days of acceptance, the agent forwards the form to the Service in Washington, D.C. The exemption from withholding tax becomes effective for payments made at least ten days after the withholding agent mails the form to the Service. If it later comes to the withholding agent's attention that a statement on the Form 8233 is false, or that the alien's claim to exemption cannot be clearly determined, the withholding agent must immediately inform the Assistant Commissioner, International, and resume withholding on any remaining payments. A separate statement is submitted for each tax year. The statement must contain the following information.

the individual's name, address, U.S. identification number, and U.S.
passport number, if any;

the country that issued the passport and the individual's permanent
address if in Canada or Mexico;

the applicable tax year and compensation;

that the individual is not a U.S. resident;

the number of personal exemptions being claims;

that the income is exempt by treaty and why the income is exempt;

the treaty provision that exempts the income; and

facts that justify the exemption.

Payee: U.K. Resident Treated as an Employee
If the U.K. resident service provider is deemed an employee of the U.S. payor, federal income taxes at regular graduated income tax rates are applicable. Internal Revenue Code Section 3402 and Regulation Section 31.3401(a)(6)-1(a). Unlike the situation described above with respect to an independent contractor, amounts paid to an employee under the circumstances set forth above are not exempt from U.S. taxation under the U.S-U.K. tax treaty. Article 15 of the treaty provides as follows.

Income derived from the performance of services as an employee in one country by a resident of the other country will not be taxable in the source country if three requirements are met: (1) the individual is present in the source country for not more than 183 days during the taxable year; (2) compensation is not paid by, or on behalf of, an employer who is a resident of the source country; and (3) the compensation is not borne by a permanent establishment of the employer in the source country.

It seems to me that the second requirement is clearly not met: the compensation in this case is paid by a resident of the source country, i.e., Prism. Accordingly, amounts paid to a U.K. resident employee for services rendered in the U.S. are not treaty exempt in this case.

With respect to the amount of income tax withholding required, a number of fine points should be noted.

1) nonresident aliens are only taxable on compensation allocable to U.S. business days; (2) nonresident aliens who are married must use the single wage withholding tax tables; and (3) nonresident aliens in general may only claim one withholding exemption.

FICA withholding is an issue as we discussed. The employer is clearly subject to FICA with respect to U.K. employees. There is a significant unresolved question as to whether the employee portion of FICA applies. Also, it may be possible that the employees have certain options with respect to application of FICA and the effect that might have on their home-country Social Security benefits. These matters should be addressed if Prism actually has U.K. resident employees.