Foreign Recipients of U.S. Income, and Tax Withheld, 1985 By Margaret P. Lewis* Total income paid to foreign persons (including individ- foreign recipients did not file a U.S. income tax return be- uals, corporations and other organizations) from U.S. cause their tax liability had thus been satisfied at its source. sources increased 2 percent in 1985 to $17.5 billion; at the The responsibility for withholding this tax belonged to the same time, U.S. tax withheld on this income fell to $940 payer or a representative of the payer (usually a financial insti- million, a 3 percent decrease [1]. U.S. source income in- tution). Income connected with a foreign recipient's U.S. trade cluded such items as interest and dividend payments, rents or business was exempt from such withholding. The United and royalties, but not income "effectively connected" with a States taxed this income separately, the same as though it U.S. trade or business, or interest paid on bank deposits. were received by a U.S. citizen or corporation. Amounts of The total income figure included $748 million in social secu- such "effectively connected" income are not included in the rity and railroad retirement payments which became sub- statistics for U.S. source income presented here. ject to tax withholding beginning in 1984 and were included for the first time in the statistics for 1985. Nearly $80 million U.S. source income was taxed at a flat rate (generally 30 in tax was withheld on these payments in 1985. The de- percent) rather than being subject to graduated tax rates as crease in total tax withheld resulted partially from the re- was the income of U.S. individuals and organizations (and 11 moval of the withholding tax on most interest payments to effectively connected" income of foreign persons). Be- foreign persons when the Deficit Reduction Act of 1984 took cause most foreign persons receiving income from U.S. effect in mid-1984. This income is generally still subject to sources were not required to file U.S. income tax returns reporting and therefore, is included in these statistics [2]. (which would require that they consolidate all of their U.S. income), the flat rate provided for equitable taxation in situa- U.S. source income paid to residents of the Netherlands tions where foreign individuals or organizations received Antilles increased 12 percent in 1985 surpassing the United income from more than one U.S. source. Kingdom as the largest recipient of this income. Residents of the Netherlands Antilles received 18 percent ($3.1 billion) RECENT LEGISLATION AND ITS IMPACT of the total $17.5 billion of U.S. source income paid to for- eign persons, while income paid to residents of the United The Deficit Reduction Act of 1984 removed the U.S. with- Kingdom fell by $257 million to $2.8 billion, an 8 percent holding tax on most interest payments made to foreigners. decrease. This exemption was effective for all qualified debt issues made after July 18, 1984 [3]. The Act was intended to re- BACKGROUND duce U.S. borrowing through tax haven countries (which are discussed later in this article) and to encourage U.S. A U.S. individual or organization paying income to a for- corporations to borrow foreign funds through direct Euro- eign individual (who, for tax purposes, was not a resident or bond placements [4]. The interest paid on these new issues citizen of the United States) or to a corporation or other was exempted from tax withholding regardless of the recipi- organization that was not incorporated or organized in the ent's country of residence. United States reported this income and the U.S. tax with- held on Form 1042S, Foreign Persons' U.S. Source Income The Social Security Amendment Act of 1983 required Subject to Withholding. While the basic tax rate was 30 U.S. tax withholding on certain benefits paid to foreign per- percent, certain types of income were taxed at lower rates. sons beginning in 1984. At the same time, the Railroad Moreover, income paid to residents of countries that entered Retirement Act of 1937 was also revised to require withhold- into tax treaty agreements with the United States was also ing on certain payments to foreigners. Almost $80 million in usually taxed at lower rates. The tax withheld represented taxes was withheld in 1985 on social security and railroad final payment of the actual tax liability in most instances; the retirement payments of $748 million. * Foreign Returns Analysis Section. Prepared under the direction of James Hobbs, Chief. 27 28 Foreign Recipients of U.S. Income, 1985 DATA HIGHLIGHTS AND TRENDS Tax of $193 million was withheld on interest payments to foreign persons in 1985. As Figure A shows, this repre- As previously mentioned, U.S. source income paid to sented only 21 percent of the total tax withheld, although foreigners totaled $17.5 billion in 1985, a 2-percent increase interest payments represented more than half'of all U.S. over 1984. By contrast, U.S. source income paid jumped 57 source income. By contrast, dividends (Which are rarely percent in 1984, an increase largely attributable to contin- exempt from the withholding tax), accounted for 60 percent ued high U.S. interest rates and the exemption from tax of total tax withheld but represented less than 30 percent of withholding of interest paid on,debt issued after July 18, all income paid. [Figure A shows the percentage of total 1984. Interest paid in 1984 rose by 70 percent over 1983, income paid and the percentage of total tax withheld for and dropped only 2 percentage points in 1985. The 2- several income types.] percent increase in total U.S. source income paid in 1985 reflected continued high interest payments (dropping only During periods of high U.S. interest rates (and relatively slightly from the record 1984 level with a slowing down of low foreign interest rates), foreign persons tend,to take ad- new debt issues) and"a significant drop in direct foreign vantage of these rates by increasing their lending to the investment in the United States, affecting dividends, rents United States. The Eurobond rate is based primarily on U.S. and royalties'and other types of income [5]. interest rates and thus these affect the Eurobond issues which are a major source of foreign lending to the United The average income payment fell by 14 percent in 1985, States. Figures B and C show the relationship, between the to less than $19,000, which was indicated by a 2 percent U.S. prime interest rate, the Eurodollar rate, and'the amount increase in total income paid and an almost 20 percent of interest paid. Figure B charts the interrelationship of these increase in the number of Forms 1042S filed which grew to factors for the 10-year period 1976 through 1985 [6]. nearly 934,000 forms for 1985. The increase in the number of forms filed was due in large part to the inclusion of social The amount of interest paid appears to be influenced by the - security and railroad-retirement payments -to foreign-per- prime rate and the Eurodollar rate, in addition to other influenc- sons. These payments, while large in number, were com- ing factors such as the removal of withholding on most interest paratively small in size and, therefore, led to a decrease in payments to foreigners due to the Deficit Reduction Act of the average payment. 1984 (discussed elsewhere in this article). However, -this influ- ence can sometimes appear after a 2-3-year lag period. Thus, The average amount of tax withheld per payment fell by the sharp rise in the prime rate which peaked in 1981 is re- 19 percent to $1,000, which again reflected the large num- flected in a sharp increase (60 percent) in interest paid in 1984. ber of social security and railroad retirement payments with This lag may reflect the various pay schedules corporations small amounts of tax withheld. The average effective tax rate may arrange for their outstanding debt. (tax withheld as a percentage of total income paid by U.S. sources to foreign recipients) for all countries for 1985 fell to I Figure C, which examines this interrelationship more 5.4 percent, only a small change from the effective tax rate closely, shows that the percentage changes year-to-year in of 5.7 percent in 1984 (the reasons for this low tax rate,^ as the amou'nt of interest paid are again affected by the pattern compared to the 30 percent basic tax rate, are discussed of changes in the U.S. prime interest rate and the Eurodollar below under "Tax Withheld and Effective Tax Rates by rate. Country"). Interest payments constituted the largest category of U.S. TYPES OF INCOME source income paid to all types of foreign recipients in seven of the nine countries shown in Figure D (which in- The proportion of total U.S. source income,paid to for- cludes only those countries whose residents received a total eign persons that was attributable to interest payments fell of more than $700 million in U.S.,source income). The two slightly in 1985. Interest payments totaling nearly $10 billion exceptions were the United Kingdom and France, both of accounted for 56 percent of income paid in' 1985 (a de- which received more U.S. 'source income in the form of crease of 3 percentage points from 1984), while dividends dividends than interest. totaling just over $5 billion represented 29 percent of in- come paid in 1985 (a 4 percentage-point drop from 1984).