U.S. income tax withholding and reporting obligations
A company’s withholding obligations with respect to U.S.-source compensation paid to a nonresident director depends on whether that director is an executive director (i.e., an employee) or non-executive director (i.e., an independent contractor).
A company is generally required to deduct and withhold U.S. federal income tax on U.S.-source compensation paid to a nonresident executive director at normal graduated rates.15 A company is generally required to report the total amount of U.S.-source compensation paid and U.S. federal income tax withheld to the Internal Revenue Service (IRS) and to the employee on Form W-2, Wage and Tax Statement.16
A company making a payment to a nonresident non-executive director generally has an obligation under U.S. law to withhold U.S. federal income tax on the gross payment of U.S.-source income at a rate of 30 percent, absent treaty relief.17 As a company that fails to properly comply with this obligation may be subject to significant penalties, many companies choose to withhold U.S. tax on a nonresident nonexecutive director’s entire BOD compensation, both U.S. and foreign source. An advantage to this approach is that it ensures both the company and director avoid any reputational or audit risks for noncompliance. However, overwithholding may present a cashflow issue for the individual director. While a director is generally able to recoup any excess U.S. federal income tax withholdings, this cannot be done without the filing of a U.S. tax return after the close of the calendar year.18
A company looking to both comply with its withholding obligations and help make sure its directors are not negatively impacted by excess withholding will want to consider obtaining detailed records of a director’s activities (including travel information, meeting attendance logs, and time spent preparing for or following up on BOD meetings) to support its compensation sourcing determinations in the case of an audit.
With respect to reporting, a company making a payment of U.S.-source income to a nonresident non-executive director must report that income and amounts withheld to the IRS on Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and to the nonexecutive director on a Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding.19
The United States has entered into a number of income tax treaties with other countries, the terms of which may provide nonresident directors with an exemption from U.S. tax on compensation for services performed in the United States, and may relieve a company from onerous U.S. income tax withholding and reporting obligations. Generally, being a tax resident of a country with which the United States has an income tax treaty is a precondition of claiming any treaty relief or benefit, so having insight into the residency statuses of the BOD members is necessary to assess potential treaty relief.
Additionally, as mentioned above, whether a nonresident director is an executive director or a nonexecutive director is relevant in considering whether the director qualifies for relief under the terms of an income tax treaty. This discussion focuses on potential treaty relief for nonexecutive director compensation, which is generally covered under the Directors’ Fees article.20
Under the 2006 United States Model Income Tax Convention (the 2006 Model Treaty),21 which serves as a framework for many U.S. income tax treaties, directors’ fees and other compensation derived by a resident of a Contracting State for services rendered in the United States in his or her capacity as a member of the BOD of a company that is a resident of the United States are not exempt from U.S. federal income tax. 22
However, the Directors’ Fees article in 2006 Model Treaty does not apply in situations where a nonresident nonexecutive director is present in the United States to attend a BOD meeting for a non-U.S. company. In such instances, it would be necessary to look to the Business Profits article (which also generally applies in situations where a U.S. income tax treaty does not have a Directors’ Fees article). The Business Profits article generally limits the U.S. taxing right to situations where the nonresident nonexecutive director has a permanent establishment in the United States.23 A permanent establishment may include any fixed place of business through which the business of the director is wholly or partly carried on (such as a place of management, branch, office, etc.). Given the relatively broad definition, companies may want to consider hosting BOD meetings with nonresident nonexecutive directors in various locations throughout the year as opposed to a single U.S. office.24
While the 2006 Model Treaty may serve as a helpful resource in generally understanding U.S. income tax treaties, every U.S. income tax treaty is unique and it is therefore important to consult the actual language of a treaty in assessing whether relief from U.S. tax may be available.
One final point with respect to income tax treaties: it is important to consider the domestic laws of the two treaty partners in assessing whether relief from double taxation is available. Contracting countries generally interpret treaty provisions consistent with their respective domestic tax laws, which may lead to conflicts as to which country has the right to tax an item of income under the treaty, or the appropriate income sourcing method, resulting in potential double taxation that cannot be alleviated without seeking a competent authority determination.