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The IRS has designated the obligation of U.S. withholding agents to report and withhold on U. S. -source fixed or determinable annual or periodic (FDAP) income as a Large and Mid-Size Business (LMSB) Division Tier 1 issue. Tier 1 issues are issues of high strategic importance to the LMSB and have a significant impact on one or more industries. The IRS is concerned that some taxpayers have used strategies to minimize withholding taxes, such as securities lending, payments to foreign vendors, and potential use of total return swaps. The IRS is also focusing on the quality of the overall reporting and withholding systems and procedures of the withholding agents to ensure proper classification of payments, sourcing, and validity of documentation of foreign persons.
Background
Generally, foreign persons are subject to federal income tax on their U.S.-source income under the following rules:
1. Income that is effectively connected with a U.S. trade or business is taxed on a net basis at U.S. graduated tax rates; and
2. FDAP income is subject to gross taxation at a flat 30% tax rate if it is derived from U.S. sources and is not taxable as U.S. effectively connected income under rule ( 1 ). (Note that a tax treaty may reduce or eliminate the flat 30% tax rate.)
FDAP income is all income except for gains from the sale of property (including market discount and option premiums but not including original issue discount) and items of income excluded from gross income without regard to the owner's U.S. or foreign status, such as tax-exempt municipal bond interest and qualified scholarship income. Examples of FDAP income include compensation for personal services, dividends, interest, original issue discount, pensions and annuities, alimony, real property income (such as rents) other than gains from the sale of real property, royalties, taxable scholarship and fellowship grants, and commissions.
Withholdings on FDAP income
Generally, a withholding agent must withhold 30% tax on...