Purchasing Services from Foreign Persons
Background
As technological advances have been evolving with a rapid rate, people have become more mobile. The pandemic of 2020 has only accelerated a further movement towards e-commerce. Companies can source services from anywhere in the world; people can provide services from anywhere in the world.
This article will focus only on a limited aspect of this evolution. It will cover a situation whereby a U.S. person purchases services from a foreign person and the applicable U.S. income tax rules. It does not intend to cover all possible variations and permutations of this transaction; however, it intends to provide sufficient information for both a reader who is a beginner and a reader who has advanced knowledge of this subject in order to identify the issues involved and be able to ask clients for more information. If in doubt, contact a professional.
When a U.S. resident purchases services from a foreign person, the following five rules come into play:
- Chapter 3 rules require a 30% withholding tax on any U.S. source payment.
- Chapter 4 FATCA (Foreign Account Tax Compliance Act) rules require a 30% withholding tax on payments (similar to Chapter 3 payments) made to foreign financial institutions.
- A withholding tax is required equal to 2% of the gross amount of the specified federal procurement payment.
- 4.U.S. income tax treaties apply.
- Intergovernmental agreements with respect to FATCA payments also apply.
A payment can be both a Chapter 3 and a Chapter 4 payment. For example, a dividend is both a Chapter 3 and a Chapter 4 payment; so is a payment of interest. A payment for services, however, is generally a Chapter 3 payment only, not a Chapter 4 payment; unless a contract is bifurcated into parts with one part being of a character that falls within Chapter 4. If a payment is both a Chapter 3 payment and a Chapter 4 payment, and a withholding agent makes a withholding of tax under Chapter 4, the amount may be credited against a Chapter 3 obligation.
Prior to making a payment, a U.S. payer must identify the recipient of the payment and the source and character of the payment in order to apply the appropriate withholding tax. A payer can make relevant determinations through know-your-vendor processes such as reviewing a foreign person’s passport, contracts or other business documentation, and statements about a transaction.
As an alternative, the payer can ask for a certification from the payee as to the status and the applicable withholding tax. If the payer relies on a certification and subsequently obtains information that causes the form to be unreliable, the payer can request additional proof, which can be a foreign residency certificate similar to the U.S. residency certificate issued by the IRS.
A payer is anybody who has control and possession of a payment. The payer is liable for the amount of withholding tax plus interest and penalties. If at the time of the payment the source cannot be established, a payer must withhold an appropriate amount of tax. (See Exhibit A for a list of payers and payees, and Exhibit B for a list of reporting, withholding, and certification forms.)
A payment for services is generally sourced where services are performed. To illustrate this rule, it is better to walk through specific examples and discuss various issues.
Examples and Discussions
Example 1 – Professional services. In this example, a foreign corporation provides marketing and engineering services to a U.S. corporation. The services are performed in a foreign jurisdiction. Based on our facts, a payment by the U.S. corporation should not be subject to a withholding tax because services are performed outside of the U.S. and, therefore, treated as a foreign source payment.
| | Additional information, however, can change the above analysis—if, for example, as part of the service contract there is a transfer of an intellectual property, and compensation for this property is contingent upon its use. The sourcing of income from an exploitation of intellectual property is where the property is used. If intellectual property is used in the United States, the payments will be subject to a U.S. withholding tax. If a foreign company’s employee travels to the United States to facilitate the performance of the contract, a portion of the payment can be deemed a U.S. source and subject to the regular U.S. income tax rules. If the employee performs services both in the United States and in the foreign jurisdiction, the sourcing of the employee’s compensation will be determined based on the time spent in the United States and in the foreign jurisdiction. |
If a foreign company has an unincorporated branch in the United States and the branch participates in the performance of the contract, some of the payment could be attributed to the U.S. branch and considered a U.S. source income. In this case, a U.S. payer could request and receive Form W-8ECI.
If a foreign payee is a holding company of a larger group, this might make a payment to such an entity subject to both Chapter 3 and Chapter 4 analyses.
Example 2 – Independent contractors. In this example, a foreign resident comes to the United States to perform drawing and design services. If a foreign resident is present in the United States for a period not exceeding 90 days during the year and compensation does not exceed $3,000, he will not be subject to a withholding tax. If, however, the foreign resident exceeds either of the above thresholds, he becomes subject to the regular U.S. income tax rules (i.e., graduated tax rates). A U.S. income tax treaty with a foreign jurisdiction might provide a better answer. If a treaty is needed to minimize the U.S. withholding tax, either an article on permanent establishment or on personal services might be helpful.
| | A payer can request a Form W-8ECI to establish whether or not a person’s activities in the United States fall outside of the above exemption. If so, she would be considered to be engaged in a U.S. trade or business activities subject to the regular U.S. income tax rules. The IRS indicates that certain activities and services that occur in the U.S. for a period of up to 60 days solely because of the coronavirus (COVID-19) pandemic should not affect certain U.S. trade or business determinations and relevant treaty analyses. |
Example 3 – Financial payments. In this example, a U.S. corporation borrows money from a U.S. bank. A foreign parent guarantees the loan. The U.S. corporation pays the parent a guarantee fee. Under these facts, a guarantee fee should be subject to reporting and withholding. Even though the service of guarantee is performed in a foreign jurisdiction, the payment is nevertheless treated as a U.S. source payment. The guarantee agreement can have an interest payment component for a late fee. The interest might be an additional U.S. source payment.
| | This transaction was litigated a few years ago. The tax court determined that the guarantee fee is more analogous to be treated as a service payment and should be sourced to the residence of the guarantor because performance of the guarantee was based on the guarantor’s assets and the reputation of its management in a foreign jurisdiction. The result, however, was changed by a statute, and effective for loan guarantees issued after September 27, 2010, the fee is a U.S. source payment subject to the U.S. withholding tax.
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Three additional points should be made with respect to this example:
- In the case of an accrual method taxpayer, the payment is not deductible until actually paid.
- The guarantee fee might be within the scope of the new Base Erosion Anti-Abuse Tax, but might be exempt if it complies with the arm’s-length principles.
- If the U.S. corporation is insolvent and there is an additional loan outstanding from the foreign parent, the guarantee fee might be re-characterized as an interest payment.
Example 4 – Cloud and digital content. In this example, a U.S. corporation purchases space on a cloud of a foreign corporation to store information in order to operate its own IT systems. This transaction can be characterized in several different ways, including a service, a lease, a sale of tangible property, or a sale of intangible property.
| | A characterization of each individual payment (or of an aggregate) will determine sourcing. The components of the contract would not necessarily be clear about the character. Surrounding facts and circumstances must be considered. The determination of sourcing will drive reporting and withholding obligations. It might be helpful to use analogies of everyday events for these transactions in order to determine their character; such events could be leasing a car or buying a book from Barnes & Noble. |
In summary, the above examples have covered situations mostly in the context of corporations. However, they can arise in the context of other U.S. payers such as the ones listed in Exhibit A. If you want to explore this area further or you if have any questions, please visit https://antipovalaw.com or contact yelena.antipova@antipovalaw.com, and I will be honored to help.
Exhibit A
Payers and Payees
| U.S. payers – withholding agents
| Foreign payees
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Exhibit B
Compliance Forms
| Reporting and withholding
| Certifications
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The information contained in this document is for general purposes only and is not intended, and should not be construed as legal or tax advice or opinion provided by Antipova Law to the reader. This document may not be applicable or suitable for the reader’s specific circumstances or needs. Therefore, the information should not be used as a substitute for consultation. Please contact a professional at Antipova Law before taking any action based on this information.
Yelena Y. Antipova, Esq., is a founding member of Antipova Law. She structures international operations for businesses and individuals. Yelena has approximately 18 years of experience in tax matters, especially in international tax issues. She works with individuals, small/startup businesses, private equity and investment management firms, and midsize corporate clients.