Income Not Effectively Connected

This section discusses the specific types of income that are subject to chapter 3 withholding and where withholding under chapter 4 is required. The income codes contained in this section correspond to the income codes used in the current-year revision of Form 1042-S (discussed later).

For purposes of chapter 3, you must withhold tax at the statutory rates shown in Chart C unless a reduced rate or exemption under a tax treaty applies. For U.S. source gross income that is not effectively connected with a U.S. trade or business, the rate is usually 30%. In most cases, you must withhold the tax at the time you pay the income to the foreign person. See When to withhold , earlier.

Interest

Interest from U.S. sources paid to foreign payees is subject to chapter 3 withholding and is a withholdable payment (except when the interest is paid with respect to a grandfathered obligation or another exemption under chapter 4 applies). When making a payment on an interest-bearing obligation, you must withhold on the gross amount of stated interest payable on the interest payment date, even if the payment or a part of the payment may be a return of capital rather than interest.

A substitute interest payment made to the transferor of a security in a securities lending transaction or a sale-repurchase transaction is treated the same as the interest on the transferred security. Use income code 33 to report these substitute payments.

Interest paid by U.S. obligors—general (income code 1). With specific exceptions, such as portfolio interest (for purposes of chapter 3), you must withhold on interest paid or credited on bonds, debentures, notes, open account indebtedness, governmental obligations, certain deferred payment arrangements (as provided in section 483), or other evidences of indebtedness of U.S. obligors. U.S. obligors include the U.S. Government or its agencies or instrumentalities, any U.S. citizen or resident, any U.S. corporation, and any U.S. partnership.

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If, in a sale of a corporation’s property, payment of the bonds or other obligations of the corporation is assumed by the buyer, that buyer, whether an individual, partnership, or corporation, must deduct and withhold the taxes that would be required to be withheld by the selling corporation as if there had been no sale or transfer. Also, if interest coupons are in default, the tax must be withheld on the gross amount of interest whether or not the payment is a return of capital or the payment of income.

A resident alien paying interest on a margin account maintained with a foreign brokerage firm must withhold from the interest whether the interest is paid directly or constructively.

Interest on bonds of a U.S. corporation paid to a foreign corporation not engaged in a trade or business in the United States is subject to withholding even if the interest is guaranteed by a foreign corporation.

Domestic corporations must withhold on interest credited to foreign subsidiaries or foreign parents.

For withholding under chapter 4 on the interest payments described in this section, see the definition of withholdable payments in Regulations section 1.1473-1(a).

Original issue discount (income code 30). Original issue discount paid on the redemption of an obligation is subject to chapter 3 withholding and is a withholdable payment (except when paid with respect to a grandfathered obligation). Original issue discount paid as part of the purchase price of an obligation sold or exchanged, other than in a redemption, is not subject to chapter 3 withholding unless the purchase is part of a plan the principal purpose of which is to avoid tax and the withholding agent has actual knowledge or reason to know of the plan. However, such original issue discount is a withholdable payment (except when paid with respect to a grandfathered obligation). Withholding is required by a person other than the issuer of an obligation (or the issuer’s agent).

The original issue discount that is subject to chapter 3 withholding and is a withholdable payment (except when paid with respect to a grandfathered obligation) is the taxable amount of original issue discount. The taxable amount for both chapters 3 and 4 withholding purposes is the original issue discount that accrued while the obligation was held by the foreign beneficial owner up to the time the obligation was sold or exchanged or a payment was made, reduced by any original issue discount that was previously taxed. If a payment was made, the tax due on the original issue discount may not exceed the payment reduced by the tax imposed on the part of the payment that is qualified stated interest.

If you cannot determine the taxable amount, you must withhold on the entire amount of original issue discount accrued from the date of issue until the date of redemption (or sale or exchange, if subject to chapter 3 withholding or a withholdable payment) is determined on the basis of the most recent published Pub. 1212 .

For more information on original issue discount, see Pub. 550 .

Chart C. Withholding Tax Rates for Purposes of Chapter 3

Note: You must withhold tax at the following rates on payments of income unless a reduced rate or exemption is authorized under a tax treaty. The President may apply higher tax rates on income paid to residents or corporations of foreign countries that impose burdensome or discriminatory taxes on U.S. persons.

*21% in the case of certain distributions by corporations, partnerships, trusts, or estates.

Reduced Rates of Withholding on Interest

Caution: Notwithstanding the exception from withholding under chapter 3 on interest described under this heading, withholding may still apply under chapter 4 when the payment is a withholdable payment and an exception from withholding under chapter 4 does not apply.

Certain interest is subject to a reduced rate of, or exemption from, withholding.

Portfolio interest exempt from chapter 3 withholding. Interest and original issue discount that qualifies as portfolio interest is exempt from chapter 3 withholding. However, these amounts are not exempt from withholding under chapter 4 when the interest is a withholdable payment, unless an exception from chapter 4 withholding applies. To qualify as portfolio interest, the interest must be paid on obligations issued after July 18, 1984, and otherwise subject to chapter 3 withholding.

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Note: The rules for determining whether interest is portfolio interest changed for obligations issued after March 18, 2012. Before March 19, 2012, portfolio interest included interest on certain registered and nonregistered (bearer) bonds if the obligations meet the requirements described below.

For obligations issued after March 18, 2012, portfolio interest does not include interest paid on debt that is not in registered form, except for interest paid on foreign-targeted registered obligations issued before January 1, 2016, as described in Foreign-targeted registered obligations , later.

Obligations in registered form. Portfolio interest includes interest paid on an obligation that is in registered form, and for which you have received documentation that the beneficial owner of the obligation is not a U.S. person.

Generally, an obligation is in registered form if (i) the obligation is registered as to both principal and any stated interest with the issuer (or its agent) and any transfer of the obligation may be effected only by surrender of the old obligation and reissuance to the new holder, (ii) the right to principal and stated interest with respect to the obligation may be transferred only through a book entry system maintained by the issuer or its agent, or (iii) the obligation is registered as to both principal and stated interest with the issuer or its agent and can be transferred both by surrender and reissuance and through a book entry system.

An obligation that would otherwise be considered to be in registered form is not considered to be in registered form as of a particular time if it can be converted at any time in the future into an obligation that is not in registered form, except as otherwise provided in Notice 2012-20, 2012-13 I.R.B. 574, available at IRS.gov/irb/ 2012-13_IRB#NOT-2012-20, as described in the following section.

Dematerialized book-entry systems and effectively immobilized obligations. An obligation will be considered to be in registered form if it is issued through either a dematerialized book entry system maintained by a clearing organization (or agent thereof) or a clearing system in which the obligation (including a global obligation in bearer form) is effectively immobilized. See Notice 2012-20 , amplified by Notice 2013-43, 2013-31 I.R.B. 113, available at IRS.gov/irb/2013-31_IRB#NOT-2013-43 . Under dematerialized book-entry systems, bonds are required to be represented only by book entries, and no physical certificates are issued or transferred. The bonds are transferred only by book entries.

An obligation will be considered to be effectively immobilized if (1) it is represented by one or more global securities in physical form that are issued to and held by a clearing organization (or by a custodian or depository acting as an agent of the clearing organization) for the benefit of purchasers and under arrangements that prohibit transfer except to a successor clearing organization subject to the same terms, and (2) beneficial interest in the underlying obligation is transferable only through a book-entry system maintained by the clearing organization or its agent.

These bonds are considered to be in registered form if the holder may only obtain a physical certificate in bearer

form when (1) the clearing organization that maintains the book-entry system goes out of business without a successor, (2) the issuer defaults, or (3) definitive securities are issued at the issuer’s request upon a change in tax law adverse to the issuer. See Notice 2012-20 and proposed regulations in 82 FR 43720 , for more information on regis- tered form requirements.

Foreign-targeted registered obligations. A registered bond issued after March 18, 2012, and before January 1, 2016, will also be considered to be in registered form if it is targeted to foreign markets, and portfolio interest treatment may apply even when you do not receive documentation regarding the beneficial owner of the bond.

If the registered obligation is not targeted to foreign markets, you must receive documentation on which you may rely to treat the payee as a foreign person that is the beneficial owner of the interest. A registered obligation is targeted to foreign markets if it is sold (or resold in connection with its original issuance) only to foreign persons or to foreign branches of U.S. FIs in accordance with procedures similar to those provided in Regulations section 1.163-5(c)(2)(i). However, the procedure that requires the obligation to be offered for sale (or resale) only outside the United States does not apply if the registered obligation is offered for sale through a public auction. Also, the procedure that requires the obligation to be delivered outside the United States does not apply if the obligation is considered registered because it may be transferred only through a book-entry system and the obligation is offered for sale through a public auction. The documentation needed depends on whether the interest is paid to an FI, a member of a clearing organization, or to some other foreign person. See Notice 2012-20 and Regulations section 1.871-14(e) for more information on foreign-targeted registered obligations.

Obligations not in registered form and obligations issued before March 19, 2012. For obligations issued before March 19, 2012, interest on an obligation that is not in registered form (bearer obligation) is portfolio interest if the obligation is foreign targeted. A bearer obligation is foreign targeted if:

• There are arrangements to ensure that the obligation will be sold, or resold in connection with the original issue, only to a person who is not a U.S. person;

• Interest on the obligation is payable only outside the United States and its territories; and

• The face of the obligation contains a statement that any U.S. person who holds the obligation will be subject to limits under the U.S. income tax laws.

Documentation is not required for interest on bearer obligations to qualify as portfolio interest. In some cases, however, you may need documentation for purposes of Form 1099 reporting and backup withholding.

Interest on such obligations is not a withholdable payment under chapter 4, except when the instrument is materially modified after March 18, 2012.

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Interest that does not qualify as portfolio interest. Payments to certain persons and payments of contingent interest do not qualify as portfolio interest. You must withhold at the statutory rate on such payments unless some other exception, such as a treaty provision, applies and withholding under chapter 4 does not apply.

Contingent interest. Portfolio interest generally does not include contingent interest. Contingent interest is interest that is determined by reference to any of the following.

• Any receipts, sales, or other cash flow of the debtor or a related person.

• Income or profits of the debtor or a related person.

• Any change in value of any property of the debtor or a related person.

• Any dividend, partnership distributions, or similar payments made by the debtor or a related person.

• Any amount that is a dividend equivalent.

The term “related person” is defined in section 871(h) (4)(B).

The contingent interest rule does not apply to any interest paid or accrued on any indebtedness with a fixed term that was issued:

• On or before April 7, 1993; or

• After April 7, 1993, pursuant to a written binding contract in effect on that date and at all times thereafter before that indebtedness was issued.

10% owners. Interest paid to a foreign person that owns 10% or more of the total combined voting power of all classes of stock of a corporation, or 10% or more of the capital or profits interest in a partnership, that issued the obligation on which the interest is paid is not portfolio interest. To determine 10% ownership, see Regulations section 1.871-14(g).

Banks. Except in the case of interest paid on an obligation of the United States, interest paid to a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of the bank’s trade or business does not qualify as portfolio interest.

Controlled foreign corporations. Interest paid to a controlled foreign corporation from a person related to the controlled foreign corporation is not portfolio interest.

Reduced rate or exemption from chapter 3 withhold- ing for interest on real property mortgages (income code 2). Certain treaties permit a reduced rate or exemption for interest paid or credited on real property mortgages. This is interest paid on any type of debt instrument that is secured by a mortgage or deed of trust on real property located in the United States, regardless of whether the mortgagor (or grantor) is a U.S. citizen or a U.S. business entity.

REMIC excess inclusions. A domestic partnership must separately state a partner’s allocable share of REMIC taxable income or net loss and the excess inclusion amount on Schedule K-1 (Form 1065). If the partnership

allocates all or some part of its allocable share of REMIC taxable income to a foreign partner, the partner must include the partner’s allocated amount in income as if that amount was received on the earlier of the following dates.

1. The date of distribution by the partnership.

2. The date the foreign partner disposed of its indirect interest in the REMIC residual interest.

3. The last day of the partnership’s tax year.

For purposes of item (2), the disposition may occur as a result of:

• A termination of the REMIC,

• A disposition of the partnership’s residual interest in the REMIC,

• A disposition of the foreign partner’s interest in the partnership, or

• Any other reduction in the foreign partner’s allocable share of the partnership’s part of the REMIC net income or deduction.

The partnership must withhold tax on the part of the REMIC amount that is an excess inclusion. Excess inclusion income is treated as income from sources in the United States and is not eligible for any reduction in withholding tax (by treaty or otherwise). It is also a withholdable payment for chapter 4 purposes.

An excess inclusion allocated to the following foreign persons must be included in that person’s income at the same time as other income from the entity is included in income.

• Shareholder of a real estate investment trust (REIT).

• Shareholder of a regulated investment company (RIC).

• Participant in a common trust fund.

• Patron of a subchapter T cooperative organization.

The entity must withhold on the excess inclusion. For information on the taxation and reporting of excess inclusion income by REITs, RICs, and other pass-through entities, see Notice 2006-97, 2006-46 I.R.B. 904, available at IRS.gov/irb/2006-46_IRB#NOT-2006-97 .

Reduced rate or exemption from chapter 3 withhold- ing for interest paid to controlling foreign corpora- tions (income code 3). A treaty may permit a reduced rate or exemption for interest paid by a domestic corporation to a controlling foreign corporation. The interest may be on any type of debt, including open or unsecured accounts payable, notes, certificates, bonds, or other evidences of indebtedness.

Reduced rate or exemption from chapter 3 withhold- ing for interest paid by foreign corporations (income code 4). If a foreign corporation is engaged in a U.S. trade or business, any interest paid by the foreign corporation’s trade or business in the United States (branch interest) is subject to chapter 3 withholding as if paid by a domestic corporation (without considering the “payer having income from abroad” exception) and is a withholdable

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payment. As a result, the interest paid to foreign payees is generally subject to chapter 3 withholding and withholding may apply under chapter 4 absent an applicable withholding exception. In addition, if “allocable interest” exceeds the branch interest paid, the excess interest is also subject to tax and reported on the foreign corporation’s income tax return, Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. See the Instructions for Form 1120-F for more information.

If there is no treaty provision that reduces the rate of withholding on branch interest, you must withhold tax under chapter 3 at the statutory rate of 30% on the interest paid by a foreign corporation’s U.S. trade or business and you must withhold under chapter 4 when otherwise applicable and without regard to a treaty provision.

In general, payees of interest from a U.S. trade or business of a foreign corporation are entitled to reduced rates of, or exemption from, tax under a treaty in the same manner and subject to the same conditions as if they had received the interest from a domestic corporation. However, a foreign corporation that receives interest paid by a U.S. trade or business of a foreign corporation must also be a qualified resident of its country of residence to be entitled to benefits under that country’s tax treaty. If the payee foreign corporation is a resident of a country that has entered into an income tax treaty since 1987 that contains an LOB article, the foreign corporation need only satisfy the LOB article in that treaty to qualify for a reduced rate of tax.

Alternatively, a payee may be entitled to treaty benefits under the payer’s treaty if there is a provision in that treaty that applies specifically to interest paid by the payer foreign corporation. This provision may exempt all or a part of this interest. Some treaties provide for an exemption regardless of the payee’s residence or citizenship, while others provide for an exemption according to the payee’s status as a resident or citizen of the payer’s country.

A foreign corporation that pays interest must be a qualified resident (under section 884) of its country of residence for the payer’s treaty to exempt payments from tax by the foreign corporation. However, if the foreign corporation is a resident of a country that has entered into an income tax treaty since 1987 that contains an LOB article, the foreign corporation need only satisfy the LOB article in that treaty to qualify for the exemption.

Interest on deposits (income code 29). Foreign persons are not subject to chapter 3 withholding on interest that is not connected with a U.S. trade or business if it is from:

• Deposits with persons carrying on the banking business;

• Deposits or withdrawable accounts with savings institutions chartered and supervised under federal or state law as savings and loan or similar associations, such as credit unions, if the interest is or would be deductible by the institutions; or

• Amounts left with an insurance company under an agreement to pay interest on them.

Deposits include certificates of deposit, open account time deposits, Eurodollar certificates of deposit, and other deposit arrangements.

You may have to file Form 1042-S to report certain payments of interest on deposits. See Deposit interest paid to certain nonresident alien individuals under Returns Re- quired , later. You may also have to file Form 1042-S when the deposit interest is a withholdable payment to which withholding applies (or was applied) to chapter 4.

Obligations issued before August 10, 2010. Interest received from a resident alien individual or a domestic corporation is not subject to chapter 3 withholding and is not a withholdable payment if the interest meets all of the following requirements.

• At least 80% of the payer’s gross income from all sources has been from active foreign business for the 3 tax years of the payer before the year in which the interest is paid, or for the applicable part of those 3 years.

• The recipient is not a related person. Use rules similar to those in section 954(d)(3) to determine if the recipient is a related person.

• The interest is paid on an obligation issued before August 10, 2010.

• The obligation has not been significantly modified since August 10, 2010.

Interest from foreign business arrangements. In certain cases, interest received from a domestic payer, most of whose gross income is active foreign business income, is not subject to chapter 3 withholding and is not a withholdable payment.

Active foreign business income is gross income that is:

• Derived from sources outside the United States, and

• Attributable to the active conduct of a trade or business in a foreign country or territory of the United States by the domestic payer.

Corporations existing on January 1, 2011. Certain interest received from a domestic corporation that is an existing 80/20 company is not subject to withholding. An existing 80/20 company must meet all of the following requirements.

• It was in existence on January 1, 2011.

• For the 3 tax years beginning before January 1, 2011 (or for its years of existence if the corporation was in existence for less than 3 tax years), at least 80% of its gross income from all sources was active foreign business income.

• It continues to meet the 80% test for every tax year beginning after December 31, 2010.

• It has not added a substantial line of business after August 10, 2010.

Transitional rule for active foreign business income. In most cases, the domestic corporation determines its active foreign business income by combining its income and the income of any subsidiary in which it owns, directly

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or indirectly, 50% or more of the stock. However, if the testing period includes 1 or more tax years beginning before January 1, 2011, the corporation can use only its gross income for any tax year beginning before January 1, 2011, and will meet the 80% test if the weighted average percentage of active foreign business income is more than 80%. A foreign beneficial owner does not need to provide a Form W-8 or documentary evidence for this exception. However, documentation may be required for purposes of Form 1099 reporting and backup withholding.

Sales of bonds between interest dates. Amounts paid as part of the purchase price of an obligation sold or exchanged between interest payment dates is not subject to chapter 3 withholding. In addition, such a payment is not a withholdable payment. This does not apply if the sale or exchange is part of a plan the principal purpose of which is to avoid tax and you have actual knowledge or reason to know of the plan. The exemption from chapter 3 withholding and from withholdable payments applies even if you do not have any documentation from the payee. However, documentation may be required for purposes of Form 1099 reporting and backup withholding.

Short-term obligations. Interest and original issue discount paid on an obligation that is payable 183 days or less from the date of its original issue (without regard to the period held by the taxpayer) that satisfy other requirements intended to ensure that the debt is not held by a U.S. nonexempt person are not subject to chapter 3 withholding. In addition, such a payment is not a withholdable payment. These exemptions apply even if you do not have any documentation from the payee. However, documentation may be required for purposes of Form 1099 reporting and backup withholding.

Income from U.S. Savings Bonds of residents of the Ryukyu Islands or the Trust Territory of the Pacific Is- lands. Interest from a Series E, Series EE, Series H, or Series HH U.S. Savings Bond is not subject to chapter 3 withholding if the nonresident alien individual acquired the bond while a resident of the Ryukyu Islands or the Trust Territory of the Pacific Islands.

Dividends

The following types of dividends paid to foreign payees are generally subject to chapter 3 withholding and are generally withholdable payments such that withholding chapter 4 applies absent an exception available under chapter 4.

Dividends paid by U.S. corporations—general (in- come code 6). This category includes all distributions of domestic corporations (other than dividends qualifying for direct dividend rate—income code 7).

A corporation making a distribution with respect to its stock, or any intermediary making a payment of such a distribution, is required to withhold on the entire amount of the distribution at the rate applicable under chapter 3 when withholding under chapter 4 does not apply.

However, a distributing corporation or intermediary may elect to not withhold on the part of the distribution that:

1. Represents a nontaxable distribution payable in stock or stock rights;

2. Represents a distribution in part or full payment in exchange for stock;

3. Is not paid out of current or accumulated earnings and profits, based on a reasonable estimate of the anticipated amount of earnings and profits for the tax year of the distribution made at a time reasonably close to the date of the distribution;

4. Represents a capital gain distribution (use income code 36) or an exempt interest dividend by a RIC; or

5. Is subject to withholding under section 1445 (withholding of tax on dispositions of USRPIs) and the distributing corporation is a U.S. real property holding corporation (USRPHC) or a qualified investment entity (QIE).

The election is made by actually reducing the amount of withholding at the time the distribution is paid.

Dividends paid by a QIE (income code 24). A QIE is:

1. Any REIT, or

2. Any RIC that is a USRPHC.

A distribution by a QIE to a nonresident alien or a foreign corporation is treated as a dividend and is not subject to withholding under section 1445 as a gain from the sale or exchange of a USRPI if:

• The distribution is on stock regularly traded on a securities market in the United States, and

• The individual or corporation did not own more than 10% of such stock in the case of a REIT or 5% of such stock in the case of a RIC at any time during the 1-year period ending on the date of distribution.

Certain distributions by a REIT may be treated as a dividend and are not subject to withholding under section 1445 as a gain from the sale or exchange of a USRPI. See Qualified investment entities (QIEs) under U.S. Real Prop- erty Interest , later.

Dividends paid by a domestic corporation (an ex- isting “80/20” company). The active foreign business percentage of any dividend paid by a domestic corporation that is an existing 80/20 company is not subject to withholding. A domestic corporation is an existing 80/20 company if it satisfies all of the following.

1. It was in existence on January 1, 2011.

2. For the 3 tax years beginning before January 1, 2011 (or for all years of existence if it was in existence for less than 3 tax years), at least 80% of its gross income from all sources was active foreign business income. Active foreign business income is gross income that is:

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a. Derived from sources outside the United States,

and

b. Attributable to the active conduct of a trade or

business in a foreign country or territory of the United States by the corporation.

3. It continues to meet the 80% test for every tax year beginning after December 31, 2010.

4. It has not added a substantial line of business after August 10, 2010.

Transitional rule for item (2). In most cases, the domestic corporation determines its active foreign business income by combining its income and the income of any subsidiary in which it owns, directly or indirectly, 50% or more of the stock. However, if the testing period includes 1 or more tax years beginning before January 1, 2011, the corporation can use only its gross income for any tax year beginning before January 1, 2011, and will meet the 80% test if the weighted average percentage of active foreign business income is more than 80%.

The active foreign business percentage is found by dividing the corporation’s active foreign business income for the testing period by the corporation’s total gross income for that period. The testing period is the 3 tax years before the year in which the dividends are declared (or shorter period if the corporation was not in existence for 3 years). If the corporation has no gross income for that 3-year period, the testing period is the tax year in which the dividend is paid.

Consent dividends. If you receive a Form 972, Consent of Shareholder To Include Specific Amount in Gross Income, from a nonresident alien individual or other foreign shareholder who agrees to treat the amount as a taxable dividend, you must pay and report on Form 1042 and Form 1042-S any withholding tax you would have withheld if the dividend actually had been paid.

Interest-related dividends and short-term capital gain dividends received from mutual funds. Certain interest-related dividends and short-term capital gain dividends paid by a mutual fund or other RIC are exempt from chapter 3 withholding.

Dividends qualifying for direct dividend rate (income code 7). A treaty may reduce the rate of withholding on dividends from that which generally applies under the treaty if the shareholder owns a certain percentage of the voting stock of the corporation when withholding under chapter 4 does not apply. In most cases, this preferential rate applies only if the shareholder directly owns the required percentage, although some treaties permit the percentage to be met by direct or indirect ownership. The preferential rate may apply to the payment of a deemed dividend under section 304(a)(1). Under some treaties, the preferential rate for dividends qualifying for the direct dividend rate applies only if no more than a certain percentage of the paying corporation’s gross income for a certain period consists of dividends and interest other than dividends and interest from subsidiaries or from the active conduct of a banking, financing, or insurance busi

ness. A foreign person should claim the direct dividend rate by filing the appropriate Form W-8.

Consent dividends. If you receive a Form 972 from a foreign shareholder qualifying for the direct dividend rate, you must pay and report on Form 1042 and Form 1042-S any withholding tax you would have withheld if the dividend actually had been paid.

Dividends paid by foreign corporations (income code 8). Dividends paid by a foreign corporation are generally not subject to chapter 3 withholding and are not withholdable payments. This exception does not require a Form W-8. However, a Form W-8 may be required for purposes of Form 1099 reporting and backup withholding.

The payment to a foreign corporation by a foreign corporation of a deemed dividend under section 304(a)(1) is subject to chapter 3 withholding and may be a withholdable payment except to the extent it can be clearly determined to be from foreign sources.

Corporation subject to branch profits tax. If a foreign corporation is subject to branch profits tax for any tax year, withholding is not required on any dividends paid by the corporation out of its earnings and profits for that tax year. Dividends may be subject to withholding if they are attributable to any earnings and profits when the branch profits tax is prohibited by a tax treaty.

A foreign person may claim a treaty benefit on dividends paid by a foreign corporation to the extent the dividends are paid out of earnings and profits in a year in which the foreign corporation was not subject to the branch profits tax. However, you may apply a reduced rate of withholding under an income tax treaty only under rules similar to the rules that apply to treaty benefits claimed on branch interest paid by a foreign corporation. You should check the specific treaty provision.

Dividends paid to Puerto Rican corporation. For chapter 3 purposes, the tax rate on dividends paid to a corporation created or organized in, or under the law of, the Commonwealth of Puerto Rico is 10%, rather than 30%, if:

• At all times during the tax year less than 25% in value of the Puerto Rican corporation’s stock is owned, directly or indirectly, by foreign persons;

• At least 65% of the Puerto Rican corporation’s gross income is effectively connected with the conduct of a trade or business in Puerto Rico or the United States for the 3-year period ending with the close of the tax year of that corporation (or the period the corporation or any predecessor has been in existence, if less); and

• No substantial part of the income of the Puerto Rican corporation is used, directly or indirectly, to satisfy obligations to a person who is not a bona fide resident of Puerto Rico or the United States.

No special rules apply to Puerto Rican corporations for chapter 4 purposes, but special withholding rules do apply for withholdable payments made to territory financial institutions and nonfinancial entities. See the chapter 4 regulations for information on these special requirements.

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Dividend Equivalents

Dividend equivalent payments are treated as U.S. source dividends such that withholding under chapter 3 may apply. Dividend equivalent payments are withholdable payments except when an exception applies for chapter 4 purposes. Dividend equivalent payments are divided into three income code reporting categories.

1. Substitute dividends that are dividend equivalents (income code 34 or 53).

2. Dividend equivalents with respect to transactions that are section 871(m) transactions as a result of combining transactions under Regulations section 1.871-15(n) (income code 56).

3. All other dividend equivalents (income code 40).

Note: Because a dividend equivalent is determined on a gross basis, there may be a payment for reporting purposes even when there is no transfer of funds. See Regulations section 1.871-15(i).

Amounts Paid to Qualified Securities Lenders (QSLs)

A withholding agent that makes substitute dividend payments to a QSL may apply the transition rules described in Notice 2010-46, Part III, C, D and E, for payments made before January 1, 2027, which do not include the credit forward provisions. See Notice 2024-44, 2024-25 I.R.B. 1737, available at IRS.gov/irb2024-25_IRB#NOT-2024-44 .

Amounts Paid to QDDs

A withholding agent that makes a payment to a QI that is acting as a QDD is not required to withhold on the following payments if the withholding agent can reliably associate the payment with a valid QI withholding certification that satisfies the documentation requirements.

1. A payment with respect to a potential section 871(m) transaction that is not an underlying security (see Regulations section 1.871-15(a)(12) and (15) for the definitions of potential section 871(m) transaction and underlying security).

2. A payment of a dividend equivalent.

3. A payment of a dividend received by the QDD in its equity derivatives dealer capacity prior to January 1,

All other payments to a QDD, including dividends not received in its equity derivatives dealer capacity and any other U.S. source FDAP payments in any capacity, remain subject to withholding to the extent required under the general withholding rules.

For more information on amounts paid to QDDs, see Regulations section 1.1441-1(b)(4)(xxii) and Notice 2024-44 .

Gains

You generally do not need to withhold under chapter 3 or 4 on any gain from the sale of real or personal property because it is not FDAP income. However, see U.S. Real Property Interest, later.

Capital gains (income code 9). You must withhold at 30%, or if applicable, a reduced treaty rate, on the gross amount of the following items.

• Gains on the disposal of timber, coal, or domestic iron ore with a retained economic interest, unless an election is made to treat those gains as income effectively connected with a U.S. trade or business.

• Gains on contingent payments received from the sale or exchange after October 4, 1966, of patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property.

• Gains on certain transfers of all substantial rights to, or an undivided interest in, patents if the transfers were made before October 5, 1966.

• Certain gains from the sale or exchange of original issue discount obligations issued after March 31, 1972. For more on withholding on original issue discount obligations, see Interest, earlier.

If you do not know the amount of the gain, you must withhold an amount necessary to ensure that the tax withheld will not be less than 30% of the recognized gain. The amount to be withheld, however, must not be more than 30% of the amount payable because of the transaction. Unless you have reason to believe otherwise, you may rely upon the written statement of the person entitled to the income as to the amount of gain. The Form W-8 or documentary evidence must show the beneficial owner’s basis in the property giving rise to the gain.

Tax treaties. Many tax treaties exempt certain types of gains from U.S. income tax. Be sure to carefully check the provision of the treaty that applies before allowing an exemption from withholding.

Royalties

In general, you must withhold tax under chapter 3 on the payment of royalties from sources in the United States. However, certain types of royalties are given reduced rates or exemptions under some tax treaties. Accordingly, these different types of royalties are treated as separate categories for withholding purposes. For chapter 4 purposes, royalties are nonfinancial payments and are therefore excluded as withholdable payments.

Caution: Most treaties have more than one withholding rate on royalties, which varies by the classification of the payment in that treaty. Be sure to check your particular treaty for the specific rate that applies to you.

Industrial royalties (income code 10). This category of income includes royalties for the use of, or the right to use,

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patents, trademarks, secret processes and formulas, goodwill, franchises, “know-how,” and similar rights. It may also include payments for the use of, or right to use, industrial, commercial, and scientific equipment, when this is included in the treaty definition of royalties.

Motion picture or television copyright royalties (in- come code 11). This category refers to royalties paid for the use of motion picture and television copyrights.

Other royalties (for example, copyright, software, broadcasting, endorsement payments) (income code 12). This category refers to the royalties paid for the use of copyrights on books, periodicals, articles, etc., except motion picture and television copyrights.

Real Property Income and Natural Resources Royalties (Income Code 14)

You must withhold tax under chapter 3 on income (such as rents and royalties) from real property located in the United States and held for the production of income, unless the foreign payee elects to treat this income as effectively connected with a U.S. trade or business. If the foreign payee chooses to treat this income as effectively connected, the payee must give you Form W-8ECI (discussed earlier). This real property income includes royalties from mines, wells, or other natural deposits, as well as ordinary rents for the use of real property. For chapter 4 purposes, income from real property is either a nonfinancial payment (and therefore not a withholdable payment) or is excluded as a withholdable payment because it is ECI. For withholding that applies to the disposition of USRPI, see U.S. Real Property Interest , later.

Pensions, Annuities, and Alimony (Income Code 15)

The following rules apply to withholding on pensions, annuities, and alimony of foreign payees.

Pensions and annuities. In most cases, you must withhold tax on the gross amount of pensions and annuities that you pay that are from sources within the United States. This includes amounts paid under an annuity contract issued by a foreign branch of a U.S. life insurance company.

Most tax treaties provide an exemption from tax on non-government pensions and annuities. See the specific treaty rules for government pensions. The exemption may not apply to lump-sum payments. See, for example, Article 17(2) of the United States–United Kingdom income tax treaty. In addition, it does not apply to payments treated as deferred compensation, which is often treated as income from employment.

For purposes of chapter 3 withholding, in the absence of a treaty exemption, you must withhold at the statutory rate of 30% on the entire distribution that is from sources within the United States. You may, however, apply withholding at graduated rates to the part of a distribution that arises from the performance of services in the United States after December 31, 1986.

Employer contributions to a defined benefit plan covering more than one individual are not made for the benefit of a specific participant, but are made based on the total liabilities to all participants. All funds held under the plan are available to provide benefits to any participant. If the distribution is from such a plan, you can use the method in Revenue Procedure 2004-37 to allocate the distribution to sources in the United States.

The withholding rules that apply to payments to foreign persons generally take precedence over any other withholding rules that would apply to distributions from qualified plans and other qualified retirement arrangements.

Foreign pension plans are exempt from applying withholding under chapter 4 when they are exempt beneficial owners under Regulations section 1.1471-6(f). A payment from a U.S. pension plan to a foreign individual beneficiary in the plan is not subject to withholding under chapter 4.

No withholding. Do not withhold tax on an annuity payment to a nonresident alien if, at the time of the first payment from the plan, 90% or more of the employees eligible for benefits under the plan are citizens or residents of the United States and the payment is:

1. For the nonresident’s personal services performed outside the United States; or

2. For personal services by a nonresident individual present in the United States for 90 days or less during each tax year, whose pay for those services did not exceed $3,000, and the personal services were performed for:

a. A nonresident alien individual, foreign partnership,

or foreign corporation not engaged in a trade or business in the United States; or

b. An office or place of business of a U.S. resident or

citizen that was maintained outside the United States.

If the payment otherwise qualifies under these rules, but less than 90% of the employees eligible for benefits are citizens or residents of the United States, you still need not withhold tax on the payment if:

• The recipient is a resident of a country that gives a substantially equal exclusion to U.S. citizens and residents, or

• The recipient is a resident of a beneficiary developing country under the Trade Act of 1974.

The foreign person entitled to the payments must provide you with a Form W-8BEN that contains the TIN of the foreign person.

Alimony payments. In most cases, alimony payments made by U.S. resident aliens to nonresident aliens are taxable and subject to chapter 3 withholding whether the recipients are residing abroad or are temporarily present in the United States.

Many tax treaties, however, provide for an exemption from withholding for alimony payments. See Tax Treaties , later, for information about treaty benefits.

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Alimony payments made to a nonresident alien by a U.S. ancillary administrator of a nonresident alien estate are from foreign sources and are not subject to withholding. Alimony payments are not subject to chapter 4 withholding.

Note: Under section 11051 of P.L. 115-97 (TCJA), alimony is no longer considered income if the divorce or separation agreement is executed after December 31, 2018, or if executed before January 1, 2019, but modified after December 31, 2018, the modification must state that section 11051 of P.L. 115-97 applies to the modification.

Scholarships and Fellowship Grants Subject to Chapter 3 Withholding (Income Code 16)

A scholarship or fellowship grant is an amount given to an individual for study, training, or research, and which does not constitute compensation for personal services. For information about withholding on scholarship and fellowship grants that is treated as compensation for services, see Pay for services rendered , later. Whether a fellowship grant from U.S. sources is subject to chapter 3 withholding depends on the nature of the payments and whether the recipient is a candidate for a degree. These amounts are not subject to chapter 4 withholding. See Scholarships, fellowships, and grants under Source of Income, earlier.

Candidate for a degree. Do not withhold on a qualified scholarship from U.S. sources granted and paid to a candidate for a degree. A qualified scholarship means any amount paid to an individual as a scholarship or fellowship grant to the extent that, in accordance with the conditions of the grant, the amount is to be used for the following expenses.

• Tuition and fees required for enrollment or attendance at an educational organization.

• Fees, books, supplies, and equipment required for courses of instruction at the educational organization.

The payment of a qualified scholarship to a nonresident alien is not reportable and is not subject to withholding. However, the part of a scholarship or fellowship paid to a nonresident alien that does not constitute a qualified scholarship is reportable on Form 1042-S and is subject to withholding. For example, those parts of a scholarship devoted to travel, room, and board are subject to withholding and are reported on Form 1042-S. The withholding rate is 14% on taxable scholarship and fellowship grants paid to nonresident aliens temporarily present in the United States in “F,” “J,” “M,” or “Q” nonimmigrant status. Payments made to nonresident alien individuals in any other immigration status are subject to 30% withholding.

Nondegree candidate. If the person receiving the scholarship or fellowship grant is not a candidate for a degree, and is present in the United States in “F,” “J,” “M,” or “Q” nonimmigrant status, you must withhold tax at 14% on the total amount of the grant that is from U.S. sources if the following requirements are met.

1. The grant must be for study, training, or research in the United States.

2. The grant must be made by:

a. A tax-exempt organization operated for charitable,

religious, educational, etc. purposes;

b. A foreign government;

c. A federal, state, or local government agency; or

d. An international organization, or a binational or

multinational educational or cultural organization created or continued by the Mutual Educational and Cultural Exchange Act of 1961 (known as the Fulbright-Hays Act).

If the grant does not meet both (1) and (2) above, you must withhold at 30% on the amount of the grant that is from U.S. sources.

Alternate withholding procedure. You may choose to treat the taxable part of a U.S. source grant or scholarship as wages. The student or grantee must have been admitted into the United States on an “F,” “J,” “M,” or “Q” visa. The student or grantee will know that you are using this alternate withholding procedure when you ask for a Form W-4.

The student or grantee must complete Form W-4 annually following the instructions given here and forward it to you, the payer of the scholarship, or your designated withholding agent. You may rely on the information on Form W-4 unless you know or have reason to know it is incorrect. You must file a Form 1042-S (discussed later) for each student or grantee who gives you, or your withholding agent, a Form W-4.

Each student or grantee who files a Form W-4 must file an annual U.S. income tax return to take the deductions claimed on that form. If the individual is in the United States during more than 1 tax year, they must attach a statement to the annual Form W-4 indicating that the individual has filed a U.S. income tax return for the previous year. If they have not been in the United States long enough to have to file a return, the individual must attach a statement to the Form W-4 saying that a timely U.S. income tax return will be filed.

The payer of the grant or scholarship must review the Form W-4 to make sure all the necessary and required information is provided. If the withholding agent knows or has reason to know that the amounts shown on the Form W-4 may be false, the withholding agent must reject the Form W-4 and withhold at the appropriate statutory rate (14% or 30%).

After receipt and acceptance of the Form W-4, the payer must withhold at the graduated rates in Pub. 15-T as if the grant or scholarship income were wages. The gross amount of the income is reduced by the total amount of any deductions on the Form W-4 and the withholding tax is figured on the rest.

Pay for services rendered. Pay for services rendered as an employee by an alien who is also the recipient of a scholarship or fellowship grant is usually subject to graduated withholding under chapter 3 according to the

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rules discussed later in Wages Paid to Employees . This includes taxable amounts an individual who is a candidate for a degree receives for teaching, doing research, and carrying out other part-time employment required as a condition for receiving the scholarship or fellowship grant (that is, compensatory scholarship or fellowship income).

Grants given to students, trainees, or researchers that require the performance of personal services as a necessary condition for disbursing the grant do not qualify as scholarship or fellowship grants. Instead, they are compensation for personal services considered to be wages. It does not matter what term is used to describe the grant (for example, stipend, scholarship, fellowship, etc.).

Caution: Withholding agents who pay grants that are in fact wages must report such grants on Forms 941 and W-2 and withhold income tax on them at the graduated rates. Withholding agents may not allow tax treaty exemptions that apply to scholarships and fellowships to be applied to grants that are really wages. It is the responsibility of the withholding agent to determine whether a grant is “wages” or a “scholarship or fellowship,” and to report and withhold on the grant accordingly. An alien student, trainee, or researcher may not claim a scholarship or fellowship treaty exemption against income that has been reported to them on Form W-2 as wages.

Per diem paid by the U.S. Government. Per diem for subsistence paid by the U.S. Government (directly or by contract) to a nonresident alien engaged in a training program in the United States funded by the U.S. Agency for International Development are not subject to 14% or 30% withholding. This is true even if the alien is subject to income tax on those amounts.

Tax treaties. Many treaties contain exemptions from U.S. taxation for scholarships and fellowships. Although usually found in the student articles of the tax treaties, many of these exemptions also apply to research grants received by researchers who are not students. See Tax Treaties, later, for information about treaty benefits. The treaty provision usually exempts the entire scholarship or fellowship amount, regardless of whether the grant is a “qualified scholarship” under U.S. law.

An alien student, trainee, or researcher may claim a treaty exemption for a scholarship or fellowship by submitting Form W-8BEN to the payer of the grant. However, a scholarship or fellowship recipient who receives both wages and a scholarship or fellowship from the same institution can claim treaty exemptions on both kinds of income on Form 8233.

The scholarship or fellowship recipient who is claiming a treaty exemption must provide you with a foreign TIN on Form W-8BEN or, in the case of a recipient who also received wages from the same institution, a U.S. TIN on Form 8233, or you cannot allow the treaty exemption. A copy of a completed Form W-7, showing that a TIN has been applied for, can be given to you with a Form 8233. See Form 8233, later, under Pay for Personal Services Performed.

Nonresident alien who becomes a resident alien. In most cases, only a nonresident alien individual may use the terms of a tax treaty to reduce or eliminate U.S. tax on income from a scholarship or fellowship grant. A student (including a trainee or business apprentice) or researcher who has become a resident alien for U.S. tax purposes may not use the terms of a tax treaty due to a provision known as a “saving clause.” However, an exception to the saving clause may permit an exemption from tax to continue for scholarship or fellowship grant income even after the recipient has otherwise become a U.S. resident alien for tax purposes. In this situation, the individual must give you a Form W-9 and an attachment that includes all the following information.

• The treaty country.

• The treaty article addressing the income.

• The article number (or location) in the tax treaty that contains the saving clause and its exceptions.

• The type and amount of income that qualifies for the exemption from tax.

• Sufficient facts to justify the exemption from tax under the terms of the treaty article.

Example. Article 20 of the U.S.–China income tax treaty allows an exemption from tax for scholarship income received by a Chinese student temporarily present in the United States. Under the Internal Revenue Code, a student may become a resident alien for tax purposes if their stay in the United States exceeds 5 calendar years. However, the treaty allows the provisions of Article 20 to continue to apply even after the Chinese student becomes a resident alien of the United States.

Other Grants, Prizes, and Awards Subject to Chapter 3 Withholding

Other grants, prizes, and awards made by grantors that reside in the United States are treated as income from sources within the United States. Those made for activities conducted outside the United States by a foreign person or by grantors that reside outside the United States are treated as income from foreign sources. These provisions do not apply to salaries or other pay for services.

Grant. The purpose of a grant must be to achieve a specific objective, produce a report or other similar product, or improve or enhance a literary, artistic, musical, scientific, teaching, or other similar capacity, skill, or talent of the grantee. A grant must also be an amount that does not qualify as a scholarship or fellowship. The grantor must not intend the amount to be given to the grantee for the purpose of aiding the grantee to perform study, training, or research.

Prizes and awards. Prizes and awards are amounts received primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, or are received as the result of entering a contest. A prize

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or award is taxable to the recipient unless all of the following conditions are met.

• The recipient was selected without any action on their part to enter the contest or proceeding.

• The recipient is not required to render substantial future services as a condition to receive the prize or award.

• The prize or award is transferred by the payer to a governmental unit or tax-exempt charitable organization as designated by the recipient.

Targeted grants and achievement awards. Targeted grants and achievement awards received by nonresident aliens for activities conducted outside the United States are treated as income from foreign sources. Targeted grants and achievement awards are issued by exempt organizations or by the United States (or one of its instruments or agencies), a state (or a political subdivision of a state), or the District of Columbia for an activity (or past activity in the case of an achievement award) undertaken in the public interest.