Section 881: Tax on Foreign Corporation’s U.S. Income

Foreign corporations earning certain types of passive income from U.S. sources are subject to a specific tax. This tax applies to income like dividends or interest and is distinct from the taxation of profits earned from actively operating a business in the U.S. The responsibility for withholding this tax often falls on the U.S. person or entity making the payment to the foreign corporation, ensuring collection even when the recipient is not a U.S. resident.

Determining Applicable Income

The foundation of this tax system is “Fixed, Determinable, Annual, or Periodical” (FDAP) income. This category includes passive investment-style earnings where the amount is either known in advance (fixed) or can be calculated (determinable). Common examples of FDAP income are dividends, interest, rents, and royalties paid from U.S. sources to a foreign corporation.

These payments are taxed on a gross basis, meaning no deductions for related expenses are permitted before the tax is calculated. The scope of FDAP also includes salaries, wages, premiums, and annuities.

A primary exclusion from FDAP is “Effectively Connected Income” (ECI), which is income earned from conducting a trade or business within the United States. ECI is taxed differently, on a net basis with deductions allowed, at the same rates that apply to domestic corporations. Most gains from the sale of property, or capital gains, are also excluded from FDAP income.

This distinction is a key part of U.S. international tax policy. By separating passive investment income from active business profits, the tax code creates two parallel systems for taxing foreign corporations.

Tax Rates and Treaty Reductions

The statutory tax rate applied to a foreign corporation’s U.S. source FDAP income is a flat 30%. The U.S. payer is responsible for withholding this tax from the payment before it is sent to the foreign corporation. This mechanism ensures tax collection at the source.

The 30% tax rate can be reduced or eliminated through an income tax treaty. The United States has over 60 bilateral tax treaties to prevent double taxation and facilitate international commerce. These treaties often specify lower withholding tax rates on certain FDAP income, such as dividends and interest, for residents of the treaty partner country.

The reduced rates vary by treaty and often depend on the income type and the relationship between the payer and recipient. For instance, a treaty might lower the tax on dividends to 15% and on interest to 10% or 0%. To benefit from these lower rates, the foreign corporation must prove its residency in the treaty country and its eligibility for treaty benefits.

A foreign corporation should determine if a tax treaty exists between its country of residence and the United States. Consulting the relevant treaty is necessary to identify the applicable tax rate for each income type. Claiming these benefits is not automatic and requires providing specific documentation to the U.S. payer before payment is made.

Required Documentation for Foreign Persons

To claim a reduced tax rate under a treaty or an exemption from withholding, a foreign corporation must provide the U.S. payer with Form W-8BEN-E, “Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities).” This form is used to certify the corporation’s foreign status and claim treaty benefits.

Completing Form W-8BEN-E requires detailed information about the foreign entity, including its legal name, country of incorporation, and permanent residence address. The form also requires the entity’s Foreign Taxpayer Identification Number (FTIN), its status under the Foreign Account Tax Compliance Act (FATCA), and the specific treaty article used to claim benefits.

The form must be submitted to the withholding agent before the income is paid. Failure to provide a valid and complete Form W-8BEN-E will result in the withholding agent applying the default 30% tax rate to the payment.

Generally, a Form W-8BEN-E remains valid for a period starting on the date it is signed and ending on the last day of the third subsequent calendar year. For example, a form signed on September 30, 2025, would remain valid through December 31, 2028. If any information on the form changes, a new form must be submitted to the payer within 30 days.

Withholding and Reporting by the Payer

Once the U.S. payer, or withholding agent, receives a valid Form W-8BEN-E, they must withhold tax at the correct rate. This will be either the statutory 30% rate or a reduced rate specified by a tax treaty. The withholding agent is liable for the tax, so obtaining proper documentation before making a payment is important.

After withholding the tax, the payer must deposit it with the IRS, usually through the Electronic Federal Tax Payment System (EFTPS). The frequency of these deposits depends on the amount of tax withheld and can range from next-day to quarterly.

The payer also has annual reporting responsibilities. The withholding agent must file Form 1042, “Annual Withholding Tax Return for U.S. Source Income of Foreign Persons,” with the IRS. This form summarizes the total income paid and tax withheld for all foreign recipients during the year. The filing deadline for Form 1042 is March 15 of the following year.

The payer must also file a separate Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding,” for each foreign recipient. This form details the specific income paid and tax withheld for that recipient. A copy of Form 1042-S must be sent to the foreign recipient and the IRS by March 15. This provides the recipient with a record of the income and U.S. tax paid.