In 1987, the IRS released Notice 87-7 providing guidance on whether certain recipients of payments from employer deferred compensation plans, individual retirement plans, and commercial annuities are subject to federal income tax withholding under section 3405.  The notice provided that:

  • payors must withhold on periodic and nonperiodic payments under section 3405(a) or 3405(b), respectively, to payees that provide a residence address outside the United States;
  • payors must withhold on periodic and nonperiodic payments under section 3405(a) or 3405(b), respectively, to payees that provide a residence address inside the United States, unless the payee has elected no withholding in accordance with section 3405; and
  • payors must withhold on periodic and nonperiodic payments under section 3405(a) or 3405(b), respectively, to payees that provide a residence address outside the United States.

However, if the payee certifies under penalties of perjury that he or she is not a U.S. citizen, is a bona fide resident of a foreign country, and is not a person subject to the tax on expatriates under section 877 of the Code, withholding under section 3405 is not required even if the residence address provided is outside of the United States.  Notice 87-7 indicates that regulations will be promulgated setting forth these rules and will be effective as of January 1, 1987, with any changes to be effective prospectively.  The notice warns that regulations could include a limitation on the payor’s ability to rely on a residence address within the United States as a basis for not withholding.

Some 32 years later, the Treasury has promulgated the promised rules, largely incorporating the framework laid out in the notice with some clarifications and a limitation as foreshadowed by the notice.  The proposed regulations provided that payors must withhold on periodic and nonperiodic payments under section 3405(a) or 3405(b), respectively, even if a payee provides a residence address inside the United States and elects no withholding in accordance with section 3405, provided that the payee instructs the payor to:

  • send the distribution to a financial institution or other person located outside of the United States;
  • send the distribution to a financial institution or other person located within the United States with further instructions (such as “for further credit to” instructions) directing that the funds be forwarded to a financial institution or other person located outside of the United States; or
  • send the distribution to a financial institution or other person pursuant to payment instructions that reference an International Automated Clearing House Transaction (IAT), International Bank Account Number (IBAN), or Society for Worldwide Interbank Financial Telecommunication (SWIFT) Business Identifier Code (BIC), linked to a financial institution or other person located outside of the United States.

In addition, the proposed regulations would clarify that APO/FPO/DPO addresses are treated as addresses within the United States for purposes of section 3405.  The proposed regulations also make clear that if the payee is known or presumed to be a nonresident alien individual subject to Chapter 3 withholding, those rules trump the rules under section 3405.  Accordingly, nonresident alien individuals that are not subject to withholding under section 3405 may alternatively be subject to 30% withholding unless treaty relief is appropriate.