Withholding on prizes and awards to US nonresidents

Prizes and awards to US nonresidents may be subject to US income tax withholding!

The long arm of the US tax law can reach unexpected places. 

Did you know that awarding prizes (cash or otherwise) to non-US persons might require you to withhold US federal income taxes and pay them over to the US Treasury?  Moreover, failure to do so may result in the person who should have withheld those taxes being responsible for the unpaid tax!

If that weren’t enough, that requirement can also apply to those who simply administer the prize/award program for someone else (even if they aren’t the one choosing the winners).

Example

• COMPANY (based in the US) runs an entertainment website.
• The website has visitors from around the world.
• COMPANY periodically runs promotions on its website where visitors can win cash prizes by solving puzzles and being randomly chosen from correct entries. 
• Entrants are not required to make purchases to enter/win, nor are they required to perform any services to receive their prize.
• ALEX (age 15, a nonresident alien individual) wins a $1000 prize.

Issue 

• How much must COMPANY withhold in US income taxes from its $1000 prize payment to ALEX?

Short Answer

• COMPANY must withhold $300 in US taxes from ALEX's prize and send the remaining $700 to ALEX.

Brief Discussion

• Answer above is not intuitive.  ALEX does not have any obvious taxable connection to the US and solved the puzzle in his own home.
• COMPANY must determine the nature of the transaction taking place because it controls the “source” (i.e., US source vs. foreign source) of the income, which often dictates whether US income taxes must be withheld by the payor.
• Quick synopsis of US income tax withholding requirements (to the extent applicable here):
• Section 1441 applies to withholding of tax on nonresident aliens. It requires (among other things) that those having control over most types of income being paid to nonresidents withhold tax from those payments.
• Section 871 sets the tax rate (and thus the section 1441 withholding rate) at 30% on US source income of nonresident alien individuals.
• Source of income is mostly covered by sections 861 - 865. Key authorities relevant here:
• Section 861 – Compensation for services performed in the US are US source.
• Section 862 – Compensation for services performed outside of the US are foreign source.
• Section 863 – Permits Treasury to promulgate regulations as to source for items of income not specified in section 861 and 862.
• Treas. Reg. section 1.863-1(d)(2) provides that the source of income from prizes and awards is determined by the residence of the payor.
• ALEX winning the prize was not a direct result of solving the puzzle, it was a result of being chosen from all correct entries received by COMPANY.  As such, ALEX was not being compensated for services performed by him for COMPANY's benefit.  Thus, sections 861 and 862 do not apply to this issue.
• As a result, Treas. Reg. section 1.863-1(d)(2) treats ALEX’s prize as US source income because COMPANY (the payor) is a US person.
• Section 871 thus requires 30% withholding on the $1000 prize.
• If the person administering prize payments has (per section 1441) control over the payments, that person is a considered a “withholding agent” (defined under section 7701(a)(16)) and may be held responsible for the failure to withhold.

 Full text of Internal Revenue Code available at https://www.law.cornell.edu/uscode/text/26