Twice in the past 24 hours, clients have asked this question so I thought others would benefit from the answer. The question is how should a domestic U.S. business treat payments to a foreign independent contractor for services performed outside the U.S.?
Is a Form 1099 required?
Is withholding required?
Does the foreign based, independent, non US contractor need to file a US tax return?
The answer is this – as long as the foreign contractor is not a U.S. person and the services are wholly performed outside the U.S., then no Form 1099 is required and no withholding is required. Sometimes US taxpayers get concerned about how to substantiate the deduction if no Form 1099 needs to be issued to the foreign contractor.
The simple answer is that you substantiate the deduction the same way you substantiate all other deductions — by maintaining books and records evidencing how much was paid, why it was paid, and to whom it was paid. Filing a Form 1099 is not required to substantiate a deduction. Please refer to Treas. Reg. §1.6001-1(a).
Foreign based, independent, non US contractor
So, how do you “know” that the foreign contractor is not a U.S. person? Ask them. Then get them to sign appropriate W-8 form certifying that they are foreign –
The Form W-8BEN is not filed with the I.R.S. It is kept on file with the U.S. payor in case the U.S. payor is audited. If audited, the Form W-8BEN supports why no Form 1099 was issued and why no tax was withheld.
No need for Form 1042 either. Form 1042 is required only for payments of “U.S. source income.” If the payments are for services and the services are performed outside the U.S., then the payments will be foreign source income (Code §861(a)(3) and Treas. Reg. §1.861-4), and no Form 1042 will be required.
When in Doubt, Withhold
IF in doubt, withhold. Use Form 1042. If you do not withhold tax on the payments to the foreign contractor but you are required to withhold, then you, as the payor (i.e., the “withholding agent”), can be held liable for the tax that you did not withhold. Treas. Reg. §1.1441-1(b)(7). If the foreign contractor does not owe U.S. tax, then he or she can file a U.S. tax return and claim a refund for the tax that was withheld.