What Are the Chapter 3 Withholding Requirements?

Chapter 3 of the U.S. Internal Revenue Code establishes a tax withholding system on income paid to foreign individuals and entities. The purpose of this regulation is to ensure the collection of U.S. tax on income generated from U.S. sources. This obligation falls upon the U.S. person or entity making the payment, designated as a “U.S. withholding agent,” who must deduct and remit a portion of the payment to the Internal Revenue Service (IRS).

This system captures tax revenue at the point of payment, simplifying collection from individuals and businesses located outside of the United States. The withholding agent is liable for the tax, whether or not it was actually collected from the foreign payee, and failure to comply can result in financial penalties.

Identifying Payments Subject to Withholding

The responsibility for Chapter 3 withholding begins with the U.S. withholding agent, which is any U.S. person or entity that has control, receipt, or payment of any income item of a foreign person. A foreign person can be a nonresident alien individual or a foreign entity, such as a corporation or trust. If you are making a payment from the U.S. to a recipient outside the country, you are likely considered a withholding agent.

Chapter 3 withholding primarily applies to payments of U.S. source income that is “Fixed, Determinable, Annual, or Periodical,” commonly known as FDAP income. This is a broad category that includes passive income types such as dividends, certain interest, rents, and royalties. It also covers salaries, wages, and other forms of compensation for services performed within the U.S.

It is also important to understand what is not subject to this withholding. Income that is “Effectively Connected Income” (ECI), which is earned by a foreign person from a U.S. trade or business, is not subject to Chapter 3 withholding. This type of income is taxed differently, as the foreign person is required to file a U.S. tax return and pay tax on their net income. If a payment is FDAP income, the agent must withhold tax, but if it is ECI, the agent does not withhold, provided they have received proper documentation.

Required Documentation from Foreign Payees

Before a withholding agent makes a payment to a foreign person, they must collect specific documentation. The purpose of this paperwork is to establish that the payee is a foreign person and to allow the payee to claim a reduced rate of, or exemption from, withholding if a tax treaty applies. Failure to secure valid documentation before payment requires the withholding agent to withhold at the maximum statutory rate.

For foreign individuals, the document is Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals). This form requires the individual to provide their identifying information and country of citizenship. If claiming benefits under a tax treaty, they must complete a specific section certifying they meet the treaty’s conditions.

For foreign entities, the required document is Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities). This form is more complex, as it requires the entity to detail its status under both Chapter 3 and Chapter 4 (FATCA) of the tax code. The entity must identify its specific entity type and certify its status for tax purposes.

A different form, Form W-8ECI, is provided by a foreign payee to declare that a specific income item is ECI. By providing a valid Form W-8ECI, the payee certifies that they will report the income on a U.S. tax return, thereby exempting the payment from the 30% Chapter 3 withholding.

Calculating and Depositing the Withheld Tax

The default withholding rate under Chapter 3 is a flat 30%. This rate must be applied to the gross amount of the payment if the withholding agent does not have a valid withholding certificate from the payee or if the documentation on file does not establish a claim for a lower rate.

A reduced rate of withholding can be applied if the payee has provided a valid Form W-8BEN or W-8BEN-E that claims benefits under an income tax treaty. These treaties often provide for lower withholding rates on specific types of income, such as interest or dividends, with rates commonly ranging from 0% to 15%. The withholding agent is responsible for applying the correct treaty rate as specified on the form.

After withholding the tax, the agent must deposit the funds with the IRS. The frequency of these deposits depends on the amount of tax accumulated, and the schedules are based on the following thresholds:

• If the total undeposited tax is less than $200 at the end of the calendar year, it can be paid with the annual tax return.
• If the accumulated tax is $200 or more but less than $2,000, deposits must be made monthly.
• For accumulated taxes of $2,000 or more, deposits are required on a quarter-monthly basis.

These deposits must be made electronically through the Electronic Federal Tax Payment System (EFTPS). Failure to make timely deposits can result in penalties.

Annual Reporting Requirements

At the end of the calendar year, the withholding agent must complete annual reporting, which involves summarizing the payments made and taxes withheld. Two primary forms are used for this annual reporting.

The first is Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. A separate Form 1042-S must be prepared for each foreign payee who received a payment subject to Chapter 3 withholding, regardless of whether tax was actually withheld. The form details the type of income paid, the gross amount, the rate of withholding, and the total tax withheld, and a copy must be sent to the payee and the IRS.

The second form is Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. This form serves as a summary and reconciliation for the agent’s entire year of activity. On Form 1042, the agent reports the total amount of income paid and taxes withheld, and the total tax liability reported should match the total tax deposits made throughout the year.

Both Form 1042 and the accompanying Forms 1042-S must be filed with the IRS by March 15 of the year following the calendar year in which the income was paid. This deadline is firm, although extensions may be available if requested in a timely manner.