In our last post we identified that a valid US tax form is required to reduce or eliminate withholding tax on certain payments of US source income made to fund investors, but why is there US withholding tax?
If a non-US person (including individuals and entities) is engaged in a US trade or business, profits from that activity are subject to US business tax like any other US business and the non-US person is required to file US tax returns. However, if a non-US person earns investment income from US sources this income is subject to a default tax rate of 30%, which is withheld from the payment leaving the US. As there are two levels of US federal income tax, one at the business level and the other at the level of the US Investor (owner/shareholder), this withholding tax attempts to put non-US investors on par with US investors.
Persons making a payment of US source income to non-US persons are considered “withholding agents” and must withhold tax on the payment or be personally liable for the requisite tax, penalties and interest. In general, withholding is required if:
1. A payment is made to a non-US person
2. The payment is US source income
3. The amount is subject to US withholding (generally passive investment income like dividends and interest)
4. The payment is not income connected to a US trade or business of the recipient
5. There is no applicable exception
The investment income that is subject to US withholding is any fixed or determinable annual or periodical income (FDAP). There are different withholding rates and exemption requirements depending on the type of FDAP payment. I will cover this topic in our next post.
