Chapter 3 vs. Chapter 4 Withholding: Key Differences
Navigate U.S. withholding on foreign payments by understanding the distinct goals of tax collection versus information reporting compliance regimes.
Withholding agents making payments to foreign individuals or entities must follow two separate sets of U.S. tax regulations: Chapter 3 and Chapter 4 of the Internal Revenue Code. These rules dictate when a payer must withhold taxes from payments and remit those funds to the U.S. Treasury. Understanding the distinct purpose and application of each chapter is necessary for maintaining compliance and avoiding potential liabilities.
Understanding Chapter 3 Withholding
Chapter 3 withholding is designed to collect U.S. tax on specific types of income sourced from the United States that are paid to foreign persons. This regime primarily targets income that is Fixed, Determinable, Annual, or Periodical, commonly referred to as FDAP income. Examples include dividends from U.S. corporations, interest, royalties, and rental income from U.S. real estate. These rules apply when this income is not effectively connected with the conduct of a U.S. trade or business.
The default withholding rate under Chapter 3 is a flat 30% of the gross payment. This rate is applied unless a specific exemption or a reduced rate is available through an income tax treaty. To benefit from a tax treaty, the foreign payee must provide the U.S. withholding agent with proper documentation certifying their foreign status and eligibility for treaty benefits. This allows the agent to apply a lower rate, such as 15%, 10%, 5%, or 0%, depending on the treaty and income type.
Understanding Chapter 4 Withholding (FATCA)
Chapter 4 withholding was introduced under the Foreign Account Tax Compliance Act (FATCA) and serves a different purpose than Chapter 3. FATCA is an information reporting regime aimed at preventing U.S. persons from using foreign accounts to evade U.S. taxes. The withholding aspect of Chapter 4 acts as an enforcement mechanism, imposing a 30% tax on “withholdable payments” made to non-compliant foreign entities.
The core of Chapter 4 involves identifying and documenting foreign payees, classified as either a Foreign Financial Institution (FFI) or a Non-Financial Foreign Entity (NFFE). An FFI, such as a foreign bank, must agree to report information about its U.S. account holders to the IRS. An NFFE must either certify that it has no substantial U.S. owners or identify any it does have.
Withholding under Chapter 4 is triggered when these foreign entities fail to provide the necessary documentation. For example, an FFI that does not register with the IRS to obtain a Global Intermediary Identification Number (GIIN) will be subject to 30% withholding. A passive NFFE that fails to provide information about its U.S. owners faces the same consequence.
Key Documentation for Determining Withholding Obligations
Before a withholding agent can make a payment to a foreign person, they must collect specific documentation to determine the correct amount of tax to withhold. The IRS Form W-8 series is the primary tool for this purpose. Failure to obtain a valid form before payment requires the agent to withhold at the highest applicable rate.
The Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals), is used by foreign individuals. By completing this form, an individual certifies their non-U.S. status and, if applicable, claims a reduced rate of withholding under a tax treaty. This form provides the necessary details to apply the correct Chapter 3 withholding rate.
Foreign entities, such as corporations or partnerships, must provide a Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities). This form is more complex because it addresses both Chapter 3 and Chapter 4 status. On this form, the entity must declare its Chapter 3 status for treaty benefit claims and its Chapter 4 status, identifying itself as a specific type of FFI or NFFE.
Other forms in the series serve more specialized purposes. A Form W-8ECI is provided by a foreign person to certify that income is “effectively connected with the conduct of a trade or business within the United States.” This income is not subject to the 30% gross basis withholding. A Form W-8IMY is used by intermediaries or flow-through entities receiving income on behalf of others.
Coordination and Reporting Rules
When a payment could be subject to withholding under both Chapter 3 and Chapter 4, specific coordination rules apply to prevent double taxation. The regulations establish a clear hierarchy: Chapter 4 takes precedence. If a withholding agent correctly withholds 30% on a payment under Chapter 4, no additional withholding is required under Chapter 3.
Withholding agents have an annual reporting obligation to the IRS using Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. These forms are due by March 15 of the year following the payment. Form 1042 is a summary return where the agent reports the total amount of payments, tax liability, and deposits made throughout the year. For each foreign recipient, the agent must also file a separate Form 1042-S detailing the income paid and tax withheld. A copy of the Form 1042-S must also be sent to the foreign recipient.