Updated: Oct 5, 2022
It used to be that the phrase “The Long Arm of the Law” applied to catching fugitives but more recently the term “fugitive” could be replaced with “US taxpayer”. Since the passing of Foreign Account Tax Compliance Act (FATCA) in March 2010, in order to catch US tax cheats who hide assets and money offshore, many US taxpayers abroad have voluntarily filed tax returns and reports to the appropriate US authorities to divulge their foreign assets and pay any taxes owing to avoid hefty civil penalties and in some extreme cases, criminal penalties. Unfortunately, FATCA not only affects US citizens and US resident aliens with foreign investments, it also affects many foreign individual and businesses with US source income resident in countries that have agreed to FATCA such as Canada, the U.K and China.
Absent an exception under US tax law or US tax treaty, a foreign (non-US) person or entity that has any US source income is generally subject to US income tax. There are two types of taxable US source income: 1) fixed, determinable, annual, or periodical (FDAP) income, and 2) effectively connected income (ECI). To avoid getting too technical and for simplicity reasons let us define ECI as US source business income and FDAP as all other US source income excluding gains from property.
Even before FATCA, the IRS had implemented methods of making foreign (non-US) taxpayers pay US income tax through a withholding tax system in which the US tax laws automatically “volunteers” the US payer of income to become the withholding agent of the IRS. A withholding agent that fails to withhold on payments to foreign recipients could be liable for the withholding tax. Even if the withholding agent is caught by the IRS and forced to pay the withholding tax that it failed to collect and remit, it does not relieve the foreign payee from being liable for the same withholding tax. In those cases, the IRS could potentially receive a windfall in collecting the withholding tax twice.
For FDAP income the default withholding rate is 30% unless reduced by a US Tax Treaty with the foreign taxpayer’s country of residence. Depending on the specific US tax treaty and type of income, the withholding tax could be reduced to zero.
For foreign corporations that have US ECI or US business income, there is no US withholding tax if the Corporation provides proof to the US payer that such income is ECI. This tells the US payer that the Corporation is subject to US corporate income tax on such income and therefore withholding is not required. For foreign corporations with US ECI, the gradual US federal tax rates ranged from 15% to 35% prior to 2018. The Trump Administration enacted a flat 21% US federal corporate tax rate beginning in 2018 applicable to both US domestic and foreign corporations with US ECI.
What if you had US ECI from a partnership with foreign non-US partners? The US withholding regulations also have that covered. Partnerships are considered flow-through entities and do not pay US federal income tax at the partnership level and instead the partners pay tax on their share of the partnership’s profits. If any partnership has foreign partners, the partnership is deemed the withholding agent and must withhold at the top tax rate for that particular foreign partner. If the foreign partner were a foreign corporation, the withholding would be at the 35% maximum corporate rate prior to 2018 and 21% for 2018 and after. For individuals, the withholding would be at the maximum 39.6% prior to 2018 and 37% for 2018 and after.
Withholding tax is required even when you sell property situated in the US, such as a US vacation property. Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), the buyer becomes the IRS’s withholding agent and must withhold 15% of the amount realized (usually gross proceeds). Certain withholding rate reductions and exemptions may apply to FIRPTA so you should contact your US tax advisor for more information.
Before FATCA, the IRS had an army of withholding agents and now after FATCA, it has another ally in foreign (non-US) financial institutions such as your local bank. Under FATCA, each foreign financial institution must put into its internal controls a system to find US taxpayers. Once a red flag is triggered, such as a US mailing address, the bank will send the account owner a form to complete. Once that form is complete and a US taxpayer is identified, under FATCA the bank could send the information to the IRS or to the resident country’s tax authority to be sent to the IRS depending on the FATCA agreement signed with the taxpayer’s resident country. A red flag can be triggered if the account balance is over a certain amount or the recipient is receiving US income from the financial institution so even non-US residents and non-US corporations are receiving these forms. Each bank may have its own variation of the form but the information requested is essentially the same.
If you receive these forms from your financial institution and you are a US citizen or green card holder and have not filed returns, please contact an international tax specialist as soon as possible. Even if you are not a US citizen or resident, do not ignore them since failure to respond could result in a 30% withholding tax on your US source income or account closure. If you have been “on the run” from the IRS it has now become even harder to escape their “long arms”.
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