U.S. Source vs. Foreign Source Income

Under U.S. tax law, the source of service fees is where the services are performed. Thus, all payments for services rendered entirely outside the United States are foreign-source income. In fact, IRS guidance explicitly states that “services performed outside the United States is foreign source income”. Likewise, the IRS notes that wages paid to non‐U.S. persons for work done abroad are foreign-source and not subject to U.S. income. In our case (Chinese affiliate performing all services abroad), the $5 million fee is foreign-source FDAP income, not U.S.-source income. Consequently, the payment is not U.S.-source fixed, determinable, annual, or periodical income (FDAP) subject to Chapter 3 withholding under IRC 1441/1442.

Chapter 3 Withholding (1042/1042‑S)

• No 30% withholding required. Because the fee is foreign-source, the U.S. payer is not required to withhold the usual 30% tax under IRC 1441. Chapter 3 withholding only applies to U.S.-source FDAP paid to a foreign. Here, none of the income is U.S.-sourced, so no tax is withheld on the $5 M payment.

• Form 1042 and 1042‑S: Form 1042 (Annual Withholding Tax Return) and Form 1042‑S (Foreign Person’s U.S. Source Income) are used only when there is U.S.-source income to report. IRS instructions confirm that Form 1042‑S reports amounts paid to foreign persons that are subject to nonresident alien. Since this service fee is foreign-source and not subject to any U.S. tax, the U.S. corporation does not file Form 1042 or issue a Form 1042‑S for these payments. (By contrast, if any portion of the service had been performed in the U.S., that portion would be U.S.-source and subject to withholding at 30% or the treaty rate.)

• Reporting exception: IRS guidance (Notice 2001‑4) notes that a U.S. payor need not report payments for services performed outside the U.S. if the payee is foreign and a Form W-8. In short, the U.S. payor has no Chapter 3 withholding obligation on these payments, and correspondingly no 1042‑S reporting obligation.

Documentation Requirements

• Form W‑8BEN‑E: The U.S. corporation should obtain a valid IRS Form W‑8BEN‑E from the Chinese affiliate. This certifies that the payee is a foreign entity and helps substantiate that the payment is not subject to U.S. tax or withholding. Notice 2001‑4 advises that if the payor has a Form W-8 confirming the payee is not a U.S. person, the payor is relieved from withholding/reporting obligations on foreign-service. Without this documentation, the IRS could theoretically treat the payee as U.S. (requiring Forms 1099 or 1042‑S); with it, the foreign status and sourcing are clear.

• Agreements and records: Maintain the intercompany service agreement and evidence (invoices, work logs, locations) showing the services were provided in China. This documentation supports the source-of-income analysis. Even though no U.S. tax is being withheld, proper recordkeeping avoids uncertainty if the IRS ever questions the transaction.

U.S.–China Tax Treaty

The U.S.–China income tax treaty reinforces the domestic sourcing result. Article 7 (Business Profits) provides that “profits of an enterprise of a Contracting State shall be taxable only in that Contracting State” unless the enterprise has a U.S. permanent establishment. Here, the Chinese parent has no U.S. fixed base, and all work occurred abroad. Thus under Article 7, the service fee is taxable only in China and not subject to U.S. tax. In practice, the treaty and the source rules concur: there is no U.S. withholding on these fees. (If any portion of the payment were recharacterized as a royalty or other income, one would check the treaty’s royalty articles; but a genuine service fee under a valid service agreement generally falls under business profits.)

Other Considerations

• Transfer pricing: Large related‐party service fees must meet arm’s‐length standards (IRC §482). The IRS could reallocate income if the fee is unreasonably high. Any such recharacterization could affect the U.S. subsidiary’s taxable income (but would not itself create withholding on the original payment).

• Foreign tax: While U.S. withholding is not an issue, the Chinese affiliate must report and pay Chinese tax on this income. For example, China typically imposes VAT (≈6%) on imported services. These are Chinese domestic issues, separate from U.S. withholding rules.

• BEAT and other rules: For completeness, note that under BEAT (IRC §59A), deductible payments to foreign affiliates can trigger additional U.S. tax (depending on thresholds). If the $5 M fee is a deductible expense, the U.S. company should evaluate BEAT applicability. (However, BEAT is an income tax issue, not a withholding form issue.)

Summary: Because the services were performed entirely outside the U.S., the $5 million fee to the Chinese affiliate is foreign-source and falls outside U.S. withholding tax. The U.S. payor should collect a Form W‑8BEN‑E to document foreign status, but it will not withhold 30% nor file Form 1042/1042‑S for these payments. In short, IRS source rules and the U.S.–China treaty both exempt this foreign-service fee from U.S. withholding requirements.