If a foreign contractor/vendor (payee) claims that payments are made for income that is effectively connected with a US trade or business, you are required to obtain from him a 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, which effectively exempts him from tax withholding as he is to file his own US tax return. In this case, you are not responsible for withholding US tax from your payments to this foreign contractor/vendor. You need Form W-8ECI in order to:
- Establish his foreign status,
- Claim that such person is the beneficial owner of the income for which the form is being furnished, and
- Claim the income is effectively connected with the conduct of a trade or business in the US.
What’s the catch?
The catch is although he is responsible to file his own US tax return, the no tax withholding rule does not apply to personal services income and income subject to withholding for dispositions of U.S. real property interests or foreign partner’s share of effectively connected income.
Factors to be considered to determine whether FDAP (Other fixed or determinable annual or periodical gains) income and similar amounts from U.S. sources are effectively connected with a U.S. trade or business include whether:
- The income is from assets used in, or held for use in, the conduct of that trade or business, or
- The activities of that trade or business were a material factor in the realization of the income.
Effectively connected income after allowable deductions is taxed at graduated rates applicable to US citizens and US resident aliens rather than at a flat 30% rate. This income will be reported on their annual US income tax or information returns.
These are the federal rules, but it is paramount to also take into account state rules governing tax withholding from foreign payees.
As always, please make sure you seek a professional advice for any specific circumstances as this post is meant to be used as a general overview only.
This was the third and final post in a series. Get all the goodness of the full series here: How to Avoid Tax Traps When Paying Foreign Vendors Part 1: Overview and How to Avoid Tax Traps When Paying Foreign Vendors Part 2: Form W-8BEN Overview.