Chapter 3 vs Chapter 4 on Form 1042-S: Key IRS Withholding Differences
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- IRS Form 1042-S
Introduction
IRS Form 1042-S is used to report certain U.S.-source income paid to foreign persons, along with any U.S. federal tax withheld. The form covers two major sets of rules: Chapter 3 and Chapter 4 of the Internal Revenue Code. While both involve withholding and reporting for non-U.S. persons, they serve different purposes. This guide explains the key differences between Chapter 3 vs Chapter 4 on Form 1042-S, who they apply to, withholding rates, FATCA compliance, and reporting requirements.
What Is Chapter 3?
Chapter 3 governs the withholding of U.S.-source income paid to foreign persons, such as nonresident aliens and foreign corporations. The primary goal is to ensure the correct amount of U.S. tax is withheld on payments like interest, dividends, royalties, and certain wages.
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Purpose: Apply U.S. withholding tax rules to payments made to foreign recipients.
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Who Is Affected: Foreign individuals and entities receiving U.S.-source income.
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Withholding Tax: 30% (unless reduced by a tax treaty).
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Tax Treaty Benefits: Eligible recipients may claim reduced rates under applicable treaties.
What Is Chapter 4 (FATCA)?
Chapter 4 is part of the Foreign Account Tax Compliance Act (FATCA). Its purpose is to prevent offshore tax evasion by requiring foreign financial institutions (FFIs) and certain entities to report U.S. account holders or face withholding penalties.
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Purpose: Enforce FATCA compliance.
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Who Is Affected: Non-compliant FFIs and foreign entities.
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Withholding Tax: 30% on U.S.-source income if FATCA requirements are not met.
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Tax Treaty Benefits: FATCA compliance is required—treaty benefits do not apply to avoid withholding.
Side-by-Side Comparison
| Aspect | Chapter 3 | Chapter 4 (FATCA) |
|---|---|---|
| Purpose | Withholding on U.S.-source income paid to foreign persons | FATCA compliance to prevent offshore tax evasion |
| Who Is Affected | Foreign individuals/entities receiving U.S.-source income | Foreign financial institutions/entities not FATCA-compliant |
| Withholding Tax | 30% (unless reduced by treaty) | 30% if FATCA compliance not met |
| Tax Treaty Benefits | May reduce or eliminate withholding | Not applicable for FATCA non-compliance |
| Income Reported | Interest, dividends, royalties, wages | U.S.-source income to non-compliant foreign entities |
| Form 1042-S Reporting | Reports income paid and tax withheld | Reports non-compliant entities and related withholding |
Why This Matters
Correctly identifying whether a payment falls under Chapter 3 or Chapter 4 is essential to avoid IRS penalties, ensure proper withholding, and maintain compliance with both tax treaties and FATCA rules.
Example:
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Chapter 3: A U.S. company pays royalties to a foreign author living in Canada. Withholding is reduced to 10% under the U.S.-Canada tax treaty.
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Chapter 4: A non-compliant foreign bank receives U.S.-source dividends. The full 30% withholding applies until FATCA reporting is met.
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