An ongoing issue for US citizens and resident aliens and foreign nationals whose US investment portfolio is in the name of a foreign bank or investment advisor is whether the proper amount of US income tax is being withheld and if it is over withheld can they obtain a refund.

Under what circumstance is US income tax withheld?

Any person who realises US source income is subject to US income tax on such income (with some exceptions). The Internal Revenue Service is cognizant that when such US source income is being sent to a person who lives outside the US the chances of such person filing a US income tax return and paying income tax on such income is remote. So the above noted Code Sections were passed requiring that the disbursing agent withhold a 30 per cent income tax. If the individual files a US income tax return the 30 per cent withholding can be claimed as a credit. And if the actual income tax is less obtain a refund.

How does the disbursing agent know when to withhold?

They do not unless you inform them. If a disbursing agent does not know if the recipient is a US citizen or a foreign national they are inclined to withhold 30 per cent on the payment. Why? If they fail to properly withhold they are then required to not only send the 30 per cent tax that should have been withheld to the IRS but they are also subject to 100 per cent penalty of the amount that should have been withheld. So if the income to be disbursed is $10,000 and they fail to withhold they owe the IRS $6,000. I do not know how much a disbursing agent is paid for each payment but it likely pales in relation to the consequences for failure to withhold.

How are they informed?

We frequently are asked why am I being asked to complete a Form W-8 or Form W-9? Answer, to allow the disbursing agent to know if income tax should be withheld from a payment to you. US citizens and resident aliens are asked to complete Form W-9 and this informs the disbursing agent that as the recipient is a US citizen or resident alien that withholding is not required. Foreign Nationals are asked to complete Form W-8 and this informs the disbursing agent that withholding is required (with some exceptions).

How does the IRS know what the disbursing agent did?

The disbursing agent will send the US citizen a Form 1099 (with a copy to the IRS) indicating the amount of income paid and the type of income (dividend, interest, capital gain, etc) and the foreign national will usually receive a Form 1042-S (with a copy to the IRS) indicating the amount of income paid and the type of income (dividend, interest, capital gain, etc) and the amount of income tax withheld.

So if I am a foreign national and receive a Form 1042-S I do not have to file?

Technically, yes. Prior to deciding that you are not going to file a US income tax return because you do not have to we recommend that you first review the Form 1042-S you received to ascertain if proper withholding, or, more likely over withholding has taken place. Given the dire penalty for making a mistake we have noticed that disbursing agents have been over withholding. So you may actually have a refund due you and the only way of obtaining it is by filing a US income tax return and requesting a refund. Please note that you only have three years in which to request a refund. Thereafter, the IRS gets to keep the money.

If I do not receive a Form 1042-S how do I know that the proper tax was withheld?

You likely do not. An issue for both US citizens and foreign nationals is a situation where your portfolio is purchased in the name of a local bank or investment advisor. As far as the disbursing agent knows they are the owners and all statements go to them with their identification number on Form 1042-S.

This creates several problems. We have seen individuals receive monthly statements from their local bank or investment advisor showing only net dividends after withholding. But if the statement does not mention withholding a US citizen will report the net amount and will in essence pay tax on the amount twice. We have seen other statements where both the gross income and withholding are shown but when the US citizen claims the withholding tax as a credit the IRS rejects the claim because they have no knowledge of withholding for that social security number.

Refunds of US income tax withheld

Internal Revenue Code Sections 1441 to 1443 which deal with withholding on payments of US sourced fixed or annual or periodical income to foreign persons and Internal Revenue Code Sections 1471 to 1472 dealing with withholding on certain payments to nonparticipating foreign financial institutions and certain nonfinancial foreign entities are being changed and the IRS will no longer process a refund or credit claim where the withholding agent has failed to deposit the tax withheld.

The IRS will process a refund claim by matching your social security number or individual tax identification number with the number on Form 1042S. If there is no match there is no refund.

Pursuant to the requirements relating to practice before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (I) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner.

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own US tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.

James Paul Sabo, CPA, is the President of ETS Ltd., PO Box HM 1574, Hamilton HM GX, Bermuda. Questions should be sent to: jsabo@expatriatetaxservices.com