How to Avoid Tax Traps When Paying Foreign Vendors Part 1: Overview

In a world where cross-border transactions have become a necessity of life, US companies find they are turning more frequently to foreign-based contractors and vendors to maintain a competitive edge.  BUT beware, there are compliance requirements associated with foreign-based contractors and vendors that may be quite costly if not properly addressed from the beginning.

In particular, I would like to focus in this post on payments made to foreign contractors/vendors and the domestic payer’s (that’s you) potential tax withholding responsibility.

What is the domestic payer responsible for?
Whenever dealing with foreign payees, you, as a US payer, are responsible for withholding tax from payments made to them.

What constitutes a payment to a foreign contractor/vendor?
Payments include, but are not limited to compensation for:

  • Services
  • Interests
  • Dividends
  • Rents
  • Royalties

How to avoid being personally liable for tax withholdings?
Without a properly filled out Form W-8 on file, which is similar in nature to Form W-9, you may end up being personally liable for withholdings.

There are several types of Forms W-8 serving different types of payments, but the two most commonly used forms are:

  • Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding
  • Form W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States

Form W-8BEN is one of the most frequently used forms and you should have it on file prior to making a payment to a foreign payee.  If a foreign payee refuses to furnish a completed Form W-8BEN, you are obligated to withhold taxes at a 30% rate. However, do not ask for Form W-8BEN if your payee informs you that this income is effectively connected with the conduct of a trade or business in the US. In this case, the payee is to furnish you Form W-8ECI that effectively exempts him from withholding as he is to file his own US tax return.

This is the first post in a 3-part series.  Part 2 is a more detailed Form W-8BEN Overview and Part 3 is a more detailed Form W-8ECI Overview.  These are the federal rules, but it is paramount to also take into account state rules governing withholding from foreign payees.  As always, please make sure you seek professional advice for any specific circumstances as this post is meant to be used as a general overview only.