IRS targets U.S. source income paid to foreign persons IRM 4.10.21, U.S. Withholding Agent Examinations – Form 1042
IRS has issued a new Internal Revenue Manual () section, IRM 4.10.21, U.S. Withholding Agent Examinations – Form 1042, on reporting and withholding requirements for U.S. source income that’s paid to foreign persons.
Background. Certain income received by foreign persons is subject to U.S. gross basis taxation. The income must be U.S. sourced and fixed, determinable, annual or periodic; and it must not be included in the foreign person’s gross income as effectively connected with any U.S. trade or business of that person. If these conditions are met, the income will generally be subject to the withholding rate under Code Sec. 1441 or Code Sec. 1442 (generally 30%). The withholding rate can be reduced or eliminated based on a treaty or Code section (e.g., the portfolio interest exception under Code Sec. 1441(c)(9)). Other exceptions also apply to when withholding is required for U.S. source fixed, determinable, annual or periodic income. (Reg. § 1.1441-2) The rules on when and how the tax is withheld and reported are covered in Code Sec. 1441 through Code Sec. 443 and Code Sec. 1461.
Commercial banks and brokerage firms are examples of financial institutions that act as U.S. withholding agents. Certain of these institutions act as intermediaries for their clients’ investments in securities and deposits. As a result, these institutions may make investments and receive payments in a fiduciary or custodial relationship with their clients. For example, when a foreign person’s account is credited by a broker-dealer with U.S. source fixed, determinable, annual or periodic income that the broker-dealer has received on the foreign person’s behalf, the financial institution may have nonresident alien (NRA) reporting and withholding responsibilities for the income.
Guidance in IRM. In IRM 184.108.40.206, IRS explains the basic principles of reporting and withholding on U.S. source income that’s paid to foreign persons and cover two types of U.S. withholding agent audits. The IRM provides general guidance for audits of U.S. financial institutions, which may have NRA withholding tax and reporting requirements in connection with their custodial or brokerage activities. The IRM also provides general guidance for audits of U.S. nonfinancial entities that may have NRA withholding and reporting responsibilities for their payments to foreign persons for obtaining services or other entitlements.
Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, is the return used for reporting liability for NRA withholding tax, the amounts withheld, the reportable amounts paid to foreign persons and any credit claimed for amounts withheld by other withholding agents. This return is due on March 15th (or the next business day if the 15th falls out on a nonbusiness day) of the following year. IRM 220.127.116.11 stresses that Forms 1042 are required to be filed on a calendar year basis, and consolidation of separate legal entities for Form 1042 filing purposes is not allowed. For Forms 1042 filed before April 15 following the end of the calendar year, the form is considered filed on April 15 for purposes of the statute of limitations on assessment. (Code Sec. 6501(b)(2))
Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, is an information reporting form that a withholding agent files with IRS and issues to each foreign recipient (NRA) of a reportable amount. It shows, among other things, the amount and type of income paid to the recipient, the tax withheld, and any applicable withholding exemption. Forms 1042-S should have the same due date as the Form 1042.
IRM 18.104.22.168 advises IRS examiners that Form 1099 reporting and backup withholding also needs to be considered as part of an integrated audit. Auditing Form 1042 information can result in collateral adjustments to Forms 1099 and 945 when, for example, persons classified as foreign by a withholding agent need to be reclassified as U.S. persons subject to backup withholding and Form 1099 reporting. Additionally, deficiencies in a withholding agent’s Form 1042 related systems may indicate a generic problem in its tax reporting systems.
Gross income and net tax liability reported on Form 1042 should agree with the gross income and taxes withheld as determined by combining the amounts from all Forms 1042-S filed. To verify this, an examiner should obtain the taxpayer’s reconciliation workpapers and Forms 1042-S. An examiner can also request a computer audit specialist () to perform a reconciliation in certain cases of payments contained in computer sensitive files.
IRM 22.214.171.124 can be found on the IRS web at https://www.irs.gov/irm/part4/ch09s24.html
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