Exemption codes on Form 1042-S explain why no withholding or a reduced withholding rate applies to a payment. These codes are predefined by the IRS and cover various situations, including exemptions for certain organizations, treaty benefits, and special exemptions under U.S. tax law.
What Are Form 1042-S Exemption Codes?
Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, is used to report certain U.S.-sourced income paid to foreign persons and the amount of tax withheld. Two important boxes on this form are Box 3a (Chapter 3 Exemption Code) and Box 4a (Chapter 4 Exemption Code). These boxes indicate whether the recipient qualifies for an exemption from withholding under Chapter 3 (Withholding on Payments to Foreign Persons) or Chapter 4 (FATCA Withholding).
When completing Form 1042-S, withholding agents must enter the correct exemption code if an exemption applies. If no exemption applies, the boxes are left blank or mentioned as “00.”
Chapter 3 Withholding on Payments to Foreign Persons
Chapter 3 withholding rules apply to U.S.-sourced income paid to non-U.S. persons (foreign individuals, corporations, partnerships, etc.). The standard withholding rate is 30%, unless an exemption or tax treaty reduction applies.
– Box 3a is used to report why the payment is exempt from Chapter 3 withholding
Code 01: Effectively Connected Income (ECI)
If the income is effectively connected with a U.S. trade or business, it is subject to taxation at regular U.S. income tax rates instead of being withheld at source. If this exemption code is used, the recipient’s U.S. Taxpayer Identification Number (TIN) must be entered in Box 13e to confirm that the income will be reported on a U.S. tax return. The recipient must also provide Form W-8ECI to the withholding agent.
Code 02: Exempt Under Internal Revenue Code (IRC)
This exemption code applies when a payment is exempt from withholding under a specific section of the Internal Revenue Code (IRC), but does not qualify under any of the other Chapter 3 exemption codes. It is a general exemption code that should only be used if no other more specific exemption applies.
Code 03: Income Is Not From U.S. Sources
A payment is subject to Chapter 3 withholding only if it is from a U.S. source. If the income is from a foreign source, it is not subject to U.S. withholding tax. In such cases, this exemption code should be used to indicate that the income does not originate from the U.S. and is therefore not subject to Chapter 3 withholding.
Code 04: Exempt Under Tax Treaty
If the recipient is eligible for a reduced withholding rate or an exemption under a tax treaty between their home country and the United States, this exemption code is used. To claim a tax treaty exemption, the recipient must provide a valid Form W-8BEN or W-8BEN-E, and the withholding agent must verify that the tax treaty applies.
Code 05: Portfolio Interest Exempt Under IRC
Certain interest payments made to foreign persons qualify for the portfolio interest exemption under the Internal Revenue Code. This exemption generally applies to interest on certain U.S. corporate or government bonds that meet specific requirements, including being registered obligations. If the interest qualifies for this exemption, withholding is not required, and this exemption code should be used.
Code 06: Qualified Intermediary (QI) That Assumes Primary Withholding Responsibility
A Qualified Intermediary (QI) is a foreign financial institution that has entered into an agreement with the IRS to handle withholding and reporting responsibilities on behalf of its account holders. If the QI has agreed to take full responsibility for withholding under Chapters 3 and 4, this exemption code should be used. The recipient must provide Form W-8IMY, indicating that it is acting as a QI with primary withholding responsibility.
Code 07: Withholding Foreign Partnership (WFP) or Withholding Foreign Trust (WFT)
A Withholding Foreign Partnership (WFP) or a Withholding Foreign Trust (WFT) is a foreign entity that has been approved by the IRS to act as a withholding agent for its partners or beneficiaries. If a payment is made to a WFP or WFT that has represented its status on Form W-8IMY, this exemption code should be used.
Code 08: U.S. Branch Treated as a U.S. Person
If a foreign financial institution’s U.S. branch or a U.S. territory financial institution (FI) elects to be treated as a U.S. person for withholding tax purposes, it is not subject to Chapter 3 withholding. This election is made on Form W-8IMY, and this exemption code should be used when making payments to such branches.
Code 10: Qualified Intermediary (QI) Represents That Income Is Exempt
This code applies when a Qualified Intermediary (QI) does not assume primary withholding responsibility but represents that the income is exempt from withholding. The QI must indicate the exemption status on a withholding statement associated with Form W-8IMY.
Code 11: Qualified Securities Lender (QSL) That Assumes Primary Withholding Responsibility
A Qualified Securities Lender (QSL) is a financial institution that engages in securities lending transactions and takes responsibility for withholding on substitute dividend payments. If a payment is made to a QSL that has assumed primary withholding responsibility, this exemption code should be used. The QSL must provide Form W-8IMY stating its role.
Code 12: Payee Subject to Chapter 4 Withholding
If a recipient is already subject to withholding under Chapter 4 (FATCA withholding), it is not subject to additional Chapter 3 withholding. This exemption code is used when a payment has already been withheld under FATCA (30% withholding on withholdable payments to noncompliant entities). The withholding agent must ensure that the correct Chapter 4 withholding amount is remitted to the IRS and properly reported on Form 1042-S.
Code 22: Qualified Derivatives Dealer (QDD) That Assumes Primary Withholding Responsibility
A QDD is a financial institution that acts as a dealer in equity derivatives and assumes responsibility for withholding on dividend-equivalent payments. If a payment is made to a QI that is acting as a QDD and has assumed primary withholding responsibility, this exemption code should be used.
Code 23: Exempt Under Section 897(l) (Qualified Foreign Pension Fund)
Under Section 897(l) of the tax code, certain distributions made by a Qualified Investment Entity (QIE) to a qualified foreign pension fund (or an entity entirely owned by a qualified foreign pension fund) are exempt from withholding. If this exemption applies, this code should be used.
Code 24: Exempt Under Section 892 (Foreign Governments and International Organizations)
Foreign governments and certain international organizations are exempt from U.S. taxation on specific types of income under Section 892 of the tax code. This exemption applies primarily to investment income (e.g., interest and dividends) received by foreign governments or government-controlled entities. If the payment qualifies for this exemption, this code should be used.
Chapter 4 FATCA (Foreign Account Tax Compliance Act) Withholding
Chapter 4 withholding applies under FATCA (Foreign Account Tax Compliance Act) and primarily targets foreign financial institutions (FFIs) and certain non-financial foreign entities (NFFEs) that do not comply with FATCA reporting requirements. The standard FATCA withholding rate is 30% on withhold payments.
– Box 4a is used to report why the payment is exempt from Chapter 4 withholding.
List of Chapter 4 Exemption Codes:
Code 13: Grandfathered Payment
This exemption code applies to payments made under a grandfathered obligation. Under FATCA, certain financial agreements executed before July 1, 2014, are exempt from Chapter 4 withholding. This exemption is used only if the payment falls within the IRS-defined grandfathered obligations category.
Code 14: Effectively Connected Income (ECI)
If the income is effectively connected with a U.S. trade or business, it is taxed at regular U.S. income tax rates rather than being subject to FATCA withholding. If this exemption code is used, the recipient’s U.S. Taxpayer Identification Number (TIN) must be entered in Box 13e. The recipient must also provide Form W-8ECI to certify that the income will be reported on a U.S. tax return instead of being withheld at source.
Code 15: Payee Not Subject to Chapter 4 Withholding
This exemption applies when a payment meets the definition of a withholdable payment under Chapter 4 but is not withheld due to the payee’s FATCA classification. It can also be used if the withholding agent is applying the 90-day grace period for FATCA compliance, meaning the withholdable payment is temporarily exempt from withholding while the payee’s FATCA status is being determined.
Code 16: Excluded Nonfinancial Payment
Certain nonfinancial payments are not subject to FATCA withholding. According to Regulations Section 1.1473-1(a)(4)(iii), this includes payments for wages, services, purchases of goods, leases, and real estate transactions. If a payment qualifies as an excluded nonfinancial payment, this exemption code should be used. However, if another exemption code applies, use the most specific code instead.
Code 17 – Foreign Entity That Assumes Primary Withholding Responsibility
This exemption applies when a foreign entity, such as a Qualified Intermediary (QI), a Withholding Foreign Partnership (WP), or a Withholding Foreign Trust (WT), has agreed to assume primary withholding responsibility under FATCA. If a payment is made to such an entity, this exemption code should be used. The recipient must provide Form W-8IMY certifying its FATCA compliance.
Code 18 – U.S. Payees of a Participating FFI or Registered Deemed-Compliant FFI
This exemption code is used when a payment is made to a U.S. payee that is an account holder of a participating Foreign Financial Institution (FFI) or a registered deemed-compliant FFI under FATCA. Since the recipient is a U.S. taxpayer, the payment is not subject to FATCA withholding, but it must still be reported as taxable income under U.S. tax laws.
Code 19 – Exempt from Withholding Under an Intergovernmental Agreement (IGA)
Many countries have signed Intergovernmental Agreements (IGAs) with the U.S. to facilitate FATCA compliance and modify certain withholding requirements. If a payment is exempt from FATCA withholding under an IGA, this exemption code should be used. The recipient’s FATCA status must align with the terms of the IGA between their country and the U.S.
Code 20 – Dormant Account
A dormant account refers to a financial account that has been inactive for an extended period. FATCA regulations provide that payments allocable to dormant accounts are not subject to immediate withholding, but they must follow specific escrow and reporting rules under Regulations Section 1.1471-4(b)(6). If a participating FFI or a registered deemed-compliant FFI reports that a payment is allocable to a dormant account holder, this exemption code should be used.
Code 21 – Other Payment Not Subject to Chapter 4 Withholding
This is a general exemption code used for payments that are not subject to Chapter 4 withholding but do not fit into any of the other specific exemption categories. It is also used when reporting Income Code 37 (Return of Capital), which refers to non-dividend payments that are excluded from FATCA withholding.
Learn more about the 1042 Filing Instructions.
File Form 1042-S Online with Tax1099
Tax1099, an IRS-authorized e-file provider, simplifies the 1042-S filing process by offering features like bulk e-filing, USPS address validation, and instant status updates. The platform ensures compliance with IRS regulations and provides a user-friendly interface for quick and accurate reporting.
The deadline to File Form 1042-S is March 17, 2025
