International Tax Withholding | Chapter 3 Of The Internal Revenue Code

• Published date: 11 October 2022
• Subject Matter: Tax, Income Tax, Tax Authorities, Property Taxes
• Law Firm: Freeman Law
• Author: Mr TL Fahring

One of the more confusing areas of international tax law is determining when withholding is required. Getting it wrong can have dire consequences.

Currently, U.S. international withholding provisions can be found in Chapters 3 and 4 of the Internal Revenue Code. Chapter 3 contains the withholding provisions that are intended to approximate a foreign person's U.S. federal income tax liability. Chapter 4, on the other hand, deals with withholding provisions put in place by the Foreign Accounts Tax Compliance Act of 2010 and is primarily aimed at obtaining information regarding account holders of foreign financial institutions and owners of certain foreign entities.

In this post, we'll focus on Chapter 3 withholding, setting aside Chapter 4 for another time.

But first . . .

Why International Tax Withholding?

Legally, the reason for international tax withholding can be blamed mainly on a common law doctrine known as the revenue rule.

Put most simply, the revenue rule provides that a country may refuse to apply or enforce the tax laws or judgments of another country. ¹ This doctrine can, and on occasion has, been overridden by treaty. ² But, in the absence of a treaty, a country's only recourse in collecting taxes on an item of income earned within its territory by foreign persons located outside of its territory is to collect the tax while that item is still within its territory or within the custody of its nationals³

Hence, international tax withholding-a country's way of snatching the money before it gets away.

Chapter 3 Withholding

Chapter 3 of the Internal Revenue Code contains three primary withholding regimes affecting foreign persons with U.S. source income: fixed or determinable annual or periodical income ("FDAP") withholding, Foreign Investment in Real Property Tax Act ("FIRPTA") withholding, and foreign partner withholding.

FDAP Withholding

In the United States, nonresident aliens and foreign corporations are subject to federal income tax on U.S. source income and certain items of foreign source income that are effectively connected with the conduct of a U.S. trade or business. ⁴ These persons owe tax at a flat rate of 30% on most types of income that aren't effectively connected with the conduct of a U.S. trade or business. ⁵ On the other hand, such persons owe tax on income that is effectively connected with the conduct of a U.S. trade or business at the rates generally applicable to U.S. persons. ⁶

And here's where withholding comes in. Any...