What Is NRA Withholding and How Does It Work?

The U.S. tax system includes a specific mechanism for collecting tax on income earned by foreign persons from U.S. sources. This system, known as Non-Resident Alien (NRA) withholding, ensures the U.S. government can collect its share of taxes even when the income recipient is not a U.S. citizen or resident. It acts as a primary method for the Internal Revenue Service (IRS) to secure tax revenue from U.S.-sourced payments made to foreign individuals and entities. This process simplifies tax collection for the U.S. government by placing the responsibility on the payer of the income.

Understanding Non-Resident Alien Withholding

A “Non-Resident Alien” (NRA) refers to any individual who is not a U.S. citizen or national and does not meet the criteria to be considered a resident alien for tax purposes. An individual is typically a resident alien if they meet either the “green card test” or the “substantial presence test.” The substantial presence test generally requires physical presence in the U.S. for a significant period over three years. If neither of these tests is met, the individual is generally classified as a non-resident alien.

NRA withholding is the process where a payer of U.S.-sourced income to a foreign person deducts and remits tax to the IRS on behalf of that foreign person. This is generally a flat 30% tax on specific types of income. This rate applies to the gross amount of income, meaning no deductions or expenses are typically allowed to reduce the taxable amount, unless a tax treaty or a specific statutory exemption provides otherwise.

The entity or individual making the payment to the NRA is known as the “withholding agent.” This agent has the responsibility to collect necessary documentation from the foreign person, determine the correct amount of tax to withhold, and then remit that tax to the IRS. The withholding agent acts as an intermediary, ensuring the U.S. tax obligation is met before the income reaches the foreign recipient. This method simplifies the tax compliance process for the foreign person, as their U.S. tax liability on certain income types is often satisfied through this withholding.

Income Subject to Withholding

NRA withholding primarily applies to U.S.-source income classified as Fixed, Determinable, Annual, Periodical (FDAP) income. This category includes passive income streams not effectively connected with a U.S. trade or business. Examples of FDAP income commonly subject to this withholding include interest (with some exceptions), dividends, rents from real property, royalties, annuities, and compensation for personal services performed in the U.S. The term “fixed” means the amount is known in advance, “determinable” means there is a basis to calculate the amount, and “annual or periodical” refers to income paid from time to time.

The “U.S. source” aspect is important; only income considered to originate from within the United States generally falls under NRA withholding. For instance, rent from a property located in the U.S. is U.S.-source income, as are dividends paid by a U.S. corporation. Income sourced outside the U.S. is typically not subject to U.S. tax for non-resident aliens.

It is important to distinguish FDAP income from “effectively connected income” (ECI). ECI is income directly linked to a foreign person’s U.S. trade or business. Unlike FDAP income, ECI is taxed on a net basis, allowing for deductions of related expenses, and at the same graduated rates that apply to U.S. residents. Therefore, ECI is generally not subject to the 30% NRA withholding at the source.

Reducing or Eliminating Withholding

The standard 30% NRA withholding rate can often be reduced or entirely eliminated through several mechanisms. Income tax treaties between the U.S. and various foreign countries allow for reduced withholding rates or exemptions on certain types of FDAP income. To claim these treaty benefits, the non-resident alien must be a tax resident of the treaty country and meet all specific provisions outlined in the relevant treaty article.

To formally claim these benefits, a non-resident alien typically provides the withholding agent with a completed Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals). This form certifies the individual’s foreign status and their eligibility for treaty benefits or other exemptions from withholding. The form requires specific details, including the individual’s name, foreign address, foreign tax identifying number (TIN), and country of residence for tax purposes. The withholding agent relies on this form to apply the correct withholding rate.

Beyond tax treaties, specific statutory exemptions can also reduce or eliminate withholding. For instance, “portfolio interest” is generally exempt from NRA withholding when paid to foreign persons, provided certain conditions are met. Additionally, interest on deposits with U.S. banks, savings and loan associations, and credit unions is typically exempt from U.S. tax and therefore from withholding, as long as it is not effectively connected with a U.S. trade or business. Capital gains from the sale of personal property are generally not considered FDAP income and are usually not subject to the 30% withholding. Income from personal services can also have specific rules and potential exemptions.

Reporting Withheld Amounts

Once withholding has occurred, or it has been determined that no withholding is necessary due to valid documentation like a Form W-8BEN, the withholding agent has specific reporting obligations to the IRS and to the foreign person. The primary form used to report amounts paid to non-resident aliens and any tax withheld is Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. A separate Form 1042-S is generally required for each type of income and recipient. The withholding agent must send a copy of Form 1042-S to the foreign recipient and file it with the IRS.

In addition to individual Forms 1042-S, the withholding agent must also file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. This form summarizes all amounts withheld under Chapter 3 and Chapter 4 of the Internal Revenue Code throughout the tax year and reconciles the tax liability with the deposits made to the IRS. Form 1042 is filed directly with the IRS and is not provided to the foreign income recipient.

Both Form 1042-S and Form 1042 have specific deadlines. Generally, Form 1042-S must be furnished to the recipient by March 15th following the calendar year in which the income was paid. Form 1042 is also typically due to the IRS by March 15th.