Central Withholding Agreements Provide Reduced Withholding for Nonresident Alien Athletes and Entertainers
May 9, 2006
Mauricio Damian Rivero - Miami
Nonresident alien athletes and entertainers can take ad vantage of a Central Withholding Agreement (CWA) that may significantly reduce the amount of U.S. withholding tax imposed on their income. Athletes and entertainers are generally treated in the same manner as other nonresident aliens with respect to their U.S. source income.1 Specifically, a nonresident alien athlete or entertainer is generally subject to withholding tax on their U.S. source income, if they are not engaged in a U.S. trade or business. This withholding tax is imposed at the rate of 30 percent without regard to the expenses associated with the production of the gross income.2 Practically, this means that a nonresident alien athlete or entertainer, who makes payments to agents and promoters in the U.S. for their U.S. performances, would not be able to deduct those expenses against the 30 percent withholding tax.
However, a nonresident alien athlete or entertainer may be able to reduce the amount of tax withholdings under a CWA. If the athlete or entertainer enters into a CWA, the projected income is reduced by the reasonable estimated U.S. expenses to arrive at the income subject to withhold ing. The payor or withholding agent then withholds at regular graduated tax rates on this net amount of income rather than the flat 30 percent rate on the gross income. This could result in substantial tax savings to a nonresident alien athlete or entertainer.
This article addresses: (1) the general rules imposing withholding requirements on different types of U.S. source income received by nonresidents including the effect of income tax treaties; (2) the requirements and procedures to obtain a CWA; and (3) when the use of a CWA would be beneficial for a nonresident alien athlete or entertainer.
1. Withholding Requirements Applicable to Nonresident Alien Athletes and Entertainers
Generally, income derived from labor or services performed inside the United States is treated as U.S. source income.3 This is true irrespective of the payor’s residence, the place in which the service contract was made, or the place of payment.
The U.S. taxes nonresident aliens in a different manner depending upon whether the nonresident alien is engaged in a U.S. trade or business, or merely has U.S.-source income of a certain type. Generally, when a foreign person engages in a trade or business in the United States, all U.S. source income connected with the conduct of that trade or business is considered to be so-called “effectively connected income” (ECI).4 Whether a foreign person’s activities rise to the level of a U.S. trade or business depends on the facts and circumstances of each particular case. A U.S. trade or business is a regular and continuous activity beyond the mere collection of income. ECI is subject to taxation at the normal graduated rates, even by nonresident aliens. Of course, taxation at graduated rates means that deductions that are otherwise permitted may be taken on the required tax return to reduce the income that will be subject to U.S. tax. In most cases, amounts paid to a nonresident alien athlete or entertainer are not treated as part of an ongoing trade or business in the United States, but rather are fixed, determinable and periodic payments. Of course, their treatment depends upon how regular and continuous their activity in the United States may be.
Income of a nonresident alien that is not ECI may, nonetheless, be subject to U.S. income tax if that in come is “fixed or determinable annual or periodic gains, profits, and income” (FDAP). In spite of the reference to annual or periodic gains, FDAP includes a broad range of income, including income from lump-sum payments (such as for a one-time concert appearance), or periodic flows of income (such as for regular appearances in sporting events held in the United States). Unlike ECI, FDAP is taxed on a gross basis, meaning that expenses that would otherwise be deductible do not offset the FDAP income subject to withholding (unless a CWA is used). Absent a reduced rate in an applicable tax treaty, FDAP income is subject to a 30 percent withholding tax imposed on the gross income amount.5 As an example, if a $1 million payment is made to an opera singer for performing in the United States, the $1 million would be FDAP income (of the singer) and the promoter (as withholding agent) would be required to withhold $300,000 in tax from the payment. If there is an income tax treaty between the United States and the payee’s country of residence, a lower withholding rate might apply, but the withholding would remain on the gross amount of the payment, without taking into account any deductions.
2. Requirements and Procedures to Obtain a CWA
What Is a CWA?
The CWA provides an alternative method of with holding tax on payments made to a nonresident alien athlete or entertainer. A CWA is a contract between (1) the athlete or entertainer, (2) the withholding agent or payor, and (3) the IRS where the withholding agent is permitted to collect a smaller amount of withhold ing tax with regard to the gross compensation paid to a nonresident alien or athlete than would be normally be allowed under Section 1441.6 Specifically, under a CWA the payor withholds based on the net amount of compensation minus expected expenses rather than the gross compensation. The tax withheld will be based on normal graduated tax rates which can reach a maximum of 35 percent. This rate does exceed the 30 percent withholding tax rate on the gross amount under Sec tion 1441, but given the ability to deduct expenses, an athlete or entertainer’s gross income would be reduced so that even a 35 percent tax on the net amount will usually be less than 30 percent tax on the gross amount.
As an example of how a nonresident alien athlete or entertainer will benefit from a Central Withholding Agreement suppose the above mentioned opera singer contracts with a promoter to perform for $1 million at the Met. As seen above, the promoter, under the general rules, would have to withhold $300,000 (30 percent of $1 million gross income) even if the singer will incur an additional $400,000 in expenses for managers, sound equipment, lighting, lodging, food, etc.7 In contrast, with a CWA, the promoter would only need to with hold on the performer’s net income from the performance. Therefore the $1 million would be reduced by the estimated $400,000 in U.S. expenses to arrive at $600,000 subject to withholding. The withholding tax would be calculated using graduated tax rates, with top rates reaching a maximum of 35 percent. This means that the withholding tax, at most, would be $210,000 (35 percent of $600,000 net income) versus $300,000 – a savings of $90,000 to the opera singer. Clearly, in cases where there is no operative income tax treaty and the athlete or entertainer has substantial U.S. expenses related to U.S. gross compensation, the CWA provides substantial tax savings.
CWAs are not new. The IRS enacted procedures to apply Treasury Regulation 1.1441-4(b)(3) in 1989. However, after the Jobs and Growth Tax Relief Recon ciliation Act of 2003 decreased the marginal tax rates from 38.6 percent to a maximum of 35 percent there is a greater incentive to use graduated tax rates on athletes’ and entertainers’ net income for withholding tax purposes, rather than the flat 30 percent withholding tax rate on gross compensation. Therefore, CWAs have become a much more attractive alternative now than when the graduated rates were higher.
What Are the Requirements and Procedures for a CWA?
In order to obtain a CWA the athlete or entertainer must be a nonresident alien holding a P visa (P-1, P-2, P-3, or P-4) for athletes and entertainers.8 Only expenses incurred in the United States are considered when reducing the gross compensation to the net in come subject to withholding tax. For example, fees paid to promoters, trainers, or others for services performed in the United States would reduce withholding, but if an athlete paid for trainers abroad or even legal assistance to clear the athlete’s travel to the United States, these expenses would not be deductible in estimating tax liability for the purposes of a CWA. An expense must be incurred in the United States and not simply paid in the United States, regardless of the taxpayer’s method of accounting.
The withholding agent must apply for the CWA 90 days before the start of performance for which the foreign athlete or entertainer is to be compensated. If the performance begins after a CWA has been requested but before receiving a final approval of the CWA, the IRS will provide a letter to advise payors they are relieved of their Section 1441 obligations pending the CWA. The request for a CWA must include:
1) the names and addresses of the nonresident aliens to be covered by the agreement
2) copies of all contracts that the covered aliens or their agents entered into that are covered by the agreement
3) copies of any contracts or agreements related to U.S expenses such as exhibition halls, lodging, transportation, and advertising, etc.
4) an itinerary of dates and locations of all performances or events scheduled during the period to be covered by the agreement
5) a budget containing itemized estimates of all gross income and expenses for the period including documents that substantiate or support these estimates
6) identify by name, address and EIN an agent (usually the payor or withholding agent) who will pay expenses, withhold tax, and keep an account of the athlete or
entertainer’s revenue and expenses9
Once this documentation is received by the IRS, the IRS will prepare a withholding agreement that must be signed by each withholding agent, each covered athlete or entertainer and the Associate Chief Counsel (International). By signing the withholding agreement all withholding agents agree to file Form 1042, Form 1042-S, along with the agreed withholding tax. The covered athlete or entertainer agrees to file Form 1040NR as part of the agreement. Once the agreement has been signed it will allow the withholding agent to withhold the lesser agreement amount and claim all allowable expenses which usually is a better result for the athlete or entertainer.
3. When Is a CWA Beneficial?
CWAs are worth including in a list of considerations for any nonresident alien athlete or entertainers, although whether a CWA is advisable will depend upon a number of factors, including how extensive deductible costs incurred in the United States will be, and the total amount of the compensation the nonresident alien athlete or entertainer will receive. CWAs are best suited for athletes and entertainers who incur substantial U.S. expenses in relation to their U.S. source compensation. Without these expenses the gross compensation will not be sufficiently reduced to make the graduated withholding tax on the net amount lower than a flat 30 percent tax on the gross amount. For example if our famous opera singer above incurred only $100,000 of expenses against her $1 million compensation she would pay more tax under a CWA than with the flat 30 percent rate ($315,000 vs. $300,000). Additionally, since the CWA is based on documentation submitted to the IRS showing the expenses to be incurred in the U.S., it re quires a withholding agent with good recordkeeping and bookkeeping skills to be able to provide documentation accurate forecasting of expenses.
Tax treaties between the U.S. and various countries can substantially alter the withholding tax rates imposed on nonresident athletes and entertainers. For example, the United States-United Kingdom Income Tax treaty replaces the de minimis exemption under Section 861 (a)(3) of $3,000 of gross income with $20,000, of gross income.10 This means a U.K. athlete or entertainer who earns less than $20,000 regardless of the time he or she spent performing in the U.S., would not be subject to the 30 percent withholding tax.11 However, if the athlete or entertainer receives gross income in excess of $20,000 the entire amount is subject to the 30 percent (or lower treaty) withholding tax not just the excess over $20,000. Great care is needed to ensure under standing of the effect of income tax treaties on both the application of U.S. taxation of certain forms of income and the withholding tax rates of this income received by an athlete or entertainer.
Athletes, entertainers and their advisors need to consider these variables in deciding whether to enter into a CWA. However, in many situations, use of a CWA can greatly reduce the total withholding tax paid by a nonresident athlete or entertainer. Because of the lead time required to obtain a CWA, the possibility of using a CWA
should be considered at an early stage when entering into contracts for
performance in the U.S.
For more information, e-mail Michael Silva at
michael.silva@hklaw.com, Joseph Fletcher at
joseph.fletcher@hklaw.com, or Mauricio Rivero at
mauricio.rivero@hklaw.com, or by calling toll free, 1-888-688-8500.
1 A nonresident alien, for tax purposes, is an individual who is not a U.S. citizen, is not a lawful permanent resident (i.e., a “green card” holder), and who is not present in the United States for a period of at least 183 days, taking into account the “substantial presence test” and counting the days present in the United States during the current year, plus 1/3 or the days present in the United States during the prior year, plus 1/6 of the number of days present in the United States during the next most recent year. Certain special rules exist regarding the counting of these days. IRC § 7701(b). All references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
2 IRC § 1441.
3 IRC § 861(a)(3).
4 IRC § 864 (c); IRC § 871(b)(1). This income is called “effectively connected income,” because it is effectively connected with the U.S. trade or business.
5 IRC §§ 1441(withholding on payments to non-resident aliens) and 1442 (withholding on payments to foreign corporations).
6 Treas. Reg. § 1.1441-4(b)(3) generally authorizes withholding agree ments of this type involving the withholding agent, taxpayer and IRS. However, Rev. Proc. 89-47 specifies athletes and entertainers are eligible for such agreements under the regulation.
7 This calculation assumes there is no operative income tax treaty in effect.
8 A resident is not eligible for a CWA, but then, a resident alien pays U.S. income tax at the normal graduated rates in any event.
9 Rev. Proc. 89-47; This information is sent to: Chief, Special Programs (International) Internal Revenue Service SB/SE, Stakeholder Liaison S:SE:CLD:SLHQ:SP 1111 Constitution Ave. NCFB C2-233 Washington, D.C. 20224
10 Article 16 of the U.S.-U.K. Income Tax Treaty.
11 The United States-Canada treaty also provides an exemption amount totaling $15,000 while the U.S.-Spain treaty has a still lower exemption of $10,000.
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