A foreign corporation is an existing corporation that is registered to business in a jurisdiction (such as a foreign country) other than the one where it was originally incorporated. In order to do business in the U.S., a foreign corporation must be registered at the federal level of a country or at the sub-federal (state or province) level of a country. The use of foreign corporation registration allows a corporation to operate in multiple jurisdictions as the same organization in all of them.
Payments to a foreign corporation:
- Does U.S. law consider this income to be foreign-sourced?
- Does U.S. law consider this income to be effectively connected with a U.S. trade or business?
- Is the foreign corporation a personal holding company under U.S. law?
- Is there any tax treaty provision that applies to this payment?
Effectively Connected Income
Income that is effectively connected with a U.S. trade or business is often connected with the fact that the foreign corporation has a fixed base or permanent establishment in the U.S. (i.e. it has some sort of permanent office, factory, base of operations, etc., in the U.S. from which it generates its U.S. income).
If a foreign corporation's employees are providing the training, the fees are effectively connected income (ECI). Income of a foreign corporation that is effectively connected with a U.S. trade or business is:
- Subject to withholding at the same rates applicable to US taxpayers
- Not subject to withholding is the foreign corporation gives the withholding agent a completed W-8ECI.
Non-Effectively Connected Income:
Income that is not effectively connected with a US trade or business is classified as FDAP income (fixed, determinable, annual or periodical.)
FDAP income that is considered to be US sourced income:
- subject to 30% withholding or withholding at a lower treaty rate
- reportable on a 1042 and 1042-S
- foreign corporation must submit a Form 1120F tax return
FDAP income that is not US sourced income:
- not reportable by the US withholding agent
- not subject to any withholding tax
Sourcing rules about payments made to foreign entities are found in sections 861-865 of the Internal Revenue Code and a brief summary can be found on page 7 of the 1998 edition of IRS Publication 515.
- Examples of foreign-sourced payments:
- Purchase of personal property items that are produced outside of the US by a foreign corporation that has no fixed-base in the U.S. are considered foreign-sourced and not reportable to the IRS; not subject to US withholding tax.
- Payments made to a foreign corporation in exchange for the personal services of nonresident alien individuals performed outside of the US are foreign-sourced and not reportable to the IRS and are not subject to US withholding tax.
- Examples of US-sourced payments:
- Payments to a foreign corporation in exchange for personal services performed in the US by either a US citizen or alien is considered to be US-sourced income and is usually subject to withholding. (Can be wages or self-employment income.)
- Payment to a foreign corporation that consists partially of remuneration of personal services performed in the US and partially of payment for personal property items purchased overseas or of some other kind of income which is foreign-sourced, then the US payer will have to determine what percentage of the payment to the foreign corporation is US-sourced and report it and withhold tax on it.
- Individuals (especially athletes and artists) form foreign corporations to act as the recipients of their income in order to take advantage of the more favorable tax treatment given to corporations than to individuals.
The exemption from 30% withholding tax which might otherwise be given to a foreign corporation whose income is effectively connected with a US trade or business will not apply to any payment to a foreign corporation if the following conditions exist:
- The foreign corporation is a personal holding company (A corporation 60% of whose gross income comes from contracts for the personal services of specified individuals, and such specified individuals own at least 25% of the outstanding stock of such corporation)
- The foreign corporation receives amounts under a contract for personal services of an individual whom the corporation has no right to designate (i.e. the individual himself or his agent have the sole right to contract for the personal services of the individual
- 25% or more in value of the outstanding stock of the foreign corporation at some time during the tax year is owned, directly or indirectly, by or for an individual who has performed, is to perform, or may be designated as the one to perform, the services called for under the contract.
Before allowing an exemption from withholding claimed by a foreign corporation on Form W-8ECI for the personal services of a specified individual or individuals, the withholding agent must determine whether the three conditions named above exist. If such three conditions exist, then the withholding exemption does not apply and the withholding agent must withhold 30% income tax on the payments.
If the foreign corporation will not give the withholding agent sufficient information about whether these three conditions exist, then the withholding agent must withhold 30%.
The personal service articles in tax treaties do not apply to corporations. (These articles only apply when individuals are the beneficial owners of the income.) The foreign corporation may still be exempt from tax under the Business Profits Article or the Permanent Establishments Article (treaty titles vary).
In order to qualify for a treaty exemption under the business profits article, the corporation:
- Cannot have a permanent establishment in the US
- Must have an EIN (which should start with a 98)
- Must otherwise qualify for the business profits article
- Must provide a W-8BEN (signed, with Parts I and II completed)
- Must not be a personal holding company
If the treaty has an article that deals with artists, athletes and entertainers, this supersedes the other articles of the treaty that might apply to their income.