Foreign organizations doing business with the United States may be classified into those that receive income, gains and/or losses that are effectively connected with the conduct of a United States trade or business, and income, gains and/or losses that are not effectively connected.
Income, gains and losses are held to be effectively connected with the conduct of a United States trade or business if a foreign person or organization (including foreign partnerships and foreign corporations) has an office or other fixed place of business in the United States to which the income, gain and/or loss is attributable. The determination of whether an organization is conducting a United States trade or business is made year by year. The foreign person or organization may, or may not be physically present in the United States to be deemed to be conducting a United States trade or business.
This category of income, gains and/or losses is taxable at domestic United States income tax rates as though the foreign person or organization were a United States person or organization. Advice of United States tax status for this category is provided by completion and submission of Form W-8ECI to the United States organization.
Rental income, dividends, royalties and interest income derived from a United States source which is not effectively connected to a United States trade or business is required to have withholding tax deducted at the rate of 30% by the United States payer, and paid to the Internal Revenue Service.
The 30% withholding tax requirement is an area of Internal Revenue Service scrutiny with the accounts payable functions of many United States organizations being regularly audited and facing heavy penalties for non-compliance. Accordingly, the United States organization will seek confirmation from the foreign entity of the entity’s United States tax status by requesting a completed form, usually either a Form W-8BEN, W-8ECI or a W-9. The onus is on the foreign person or organization, and not the United States payer, to correctly identify its United States tax status and thus the corresponding form to submit to the United States payer.
Under United States tax law corporations are classified as either domestic corporations or foreign corporations. Specific types of corporations to which different rules apply include personal services corporations, closely-held corporations and personal holding corporations, to name some common entities. These are further defined as foreign or domestic, for example, foreign personal service corporation.
Foreign corporations can face federal tax rates as high as a flat rate of 35%, which is the federal rate applicable to personal service corporations. Other types of corporations are taxed on a graduated scale, with federal rates ranging from 15% to 39% (applicable for taxable income between US $100,000 and US $335,000). State taxes also apply for most states in addition to the federal rate.
No system of imputation credits for corporate taxes paid exists for distributions from any type of United States corporation whether the entity is foreign or domestic. Unless the corporation is a pass-through entity, such as an S-corporation, profits are subject to taxation at the corporate level and again to the individual shareholders. However dividends may be taxable to shareholders as qualified dividends at a concessionary rate of between 0-15% instead of as ordinary dividends at the shareholder’s applicable tax rate. Qualified dividends are dividends that meet certain requirements including requirements as to the holding period of the stock prior to the distribution of the dividend.
A Taxpayer Identification Number (TIN) is required to be applied for, and is issued by the Internal Revenue Service to individuals and organizations with a tax presence in the United States and who are not eligible for a Social Security Number (SSN). The TIN does not entitle the taxpayer to social security benefits, as a SSN may, and is used purely for taxation identification purposes. This includes United States payers’ requirements to report payments to foreign persons and organizations in which case the TIN of the payee (if available) be reported to the Internal Revenue Service as part of the reporting of a transaction. An Employer Identification Number (EIN) is the TIN for businesses and is required, amongst other things, for W-8BEN purposes.
Sending employees to the United States
Unless Article 15 of the treaty can be invoked, or a rule known as the commercial traveller rule can be applied to exempt employees’ wages from United States tax, employees who are sent to the United States are required to have federal and state taxes withheld and paid to the IRS, and the state tax department if state tax is imposed.
Social Security and Medicare taxes (collectively known as FICA taxes) at the combined rate of 7.65% are also required to be withheld from the employee’s salary and paid to the Internal Revenue Service. In addition, the employer is also required to match and pay 7.65% to the Internal Revenue Service on top of the amount withheld. Therefore a total of 15.3% in social security taxes and Medicare taxes is collected from both employer and employee. The amount is capped at wages paid of $106,800 for Social Security Taxes (6.2%) with no limit for Medicare tax payable (1.45%). The taxes are not refundable once paid except in certain situations where a refund of core tax that was withheld is applied for.
Federal unemployment tax (FUTA) is also imposed on the employer at the rate of 6.2% on the first $7,000 of wages paid to each employee.
Whilst the marginal income tax rates of the United States can appear to be less than those of New Zealand, these additional taxes can be a hefty business expense and require careful management. This is especially so due to the penalties regime that exists on late and unpaid taxes including employment taxes.
Creation of a permanent establishment
Sending an employee to the United States can also have more widespread implications for the tax status of the organization on whose behalf the employee is sent. The gravity of the employee to the United States operations can result in the formation of a permanent establishment in the United States under the tax treaty. This is one of several ways in which a permanent establishment can be created. For more information on permanent establishments please click here.
A lack of planning can result in an unnecessary and avoidable tax burden being imposed on an entity that engages in transactions with United States entities. This occurs more often than it should, due to the lack of preferential tax treatment available to foreign corporations which engage in business with the United States.
NZ US Tax Specialists can assist with the requisite planning in order to avoid this. Planning should include determination of the most tax-efficient operating structure, and planning for future tax liabilities created by doing business in the United States. This is especially important where personal services are performed through a corporate entity, and employees are sent on assignment.