Chapter 3 Withholding

What is Chapter 3 Withholding?

Chapter 3 withholding refers to U.S. tax withholding rules and requirements (under sections 1441-1443 of the Internal Revenue Code) that apply to payments made to foreign persons (non-U.S. residents or entities) such as interest, dividends, rents, and royalties.

It was designed to ensure that the U.S. government collects tax on income paid from U.S. sources to foreign persons. It mandates that a 30% tax must be withheld. Since these foreign recipients may not be fully subject to U.S. tax laws or filing requirements, withholding acts as a pre-tax collection mechanism. This withholding is applied unless a tax treaty between the U.S. and the foreign person’s country provides for a reduced rate or exemption.

Chapter 3 Withholding Regimes

Chapter 3 withholding encompasses three main withholding regimes:

Fixed or Determinable Annual or Periodical (FDAP) withholding

FDAP withholding applies to payments such as interest, dividends, rents, salaries, annuities, and other types of periodic income. Recipients of this withholding regime are generally taxed at a flat 30% unless they belong to a country that has a trade treaty with the U.S. The person or company making the payment must withhold the tax and send it to the IRS on behalf of the foreign recipient.

Foreign Investment in Real Property Tax Act (FIRPTA) withholding

FIRPTA withholding addresses gains from the sale of U.S. real property by foreign individuals or entities. Since the U.S. treats those profits like business income, the IRS requires the buyer to withhold 15% of the sale price and send it to the IRS. It applies to items like homes, buildings, land, or even shares in certain U.S. companies that own real estate.

Foreign partner withholding

Foreign partner withholding occurs when a U.S. partnership makes money from doing business in the U.S. and shares some of that income with a foreign partner (someone who isn’t a U.S. citizen or company). The partnership must withhold taxes based on the partner’s share of the income. The withholding rate is 37% for individual foreign partners and 21% for foreign corporate partners. These rates can sometimes be lower if there’s a tax treaty between the U.S. and the partner’s country.

What happens if there’s no withholding?

If a person is required to withhold a payment to a foreign person under Chapter 3 but does not do so, that person may become liable for the tax that was required to be withheld. On the plus side, if a person does properly withhold, they’re indemnified against any claims and demands of any person for the amounts withheld. So, at least that’s somet