When Is Interest Expense Subject to Withholding Tax?

Interest expense is subject to withholding tax in two situations: when you pay interest to a foreign person or foreign entity, in which case you generally withhold 30 percent, and when you pay interest to a domestic recipient who has not given you a valid taxpayer identification number, in which case you withhold 24 percent as backup withholding. Everything else in this area (exemptions, treaty rates, FATCA, documentation) is machinery for adjusting those two default rates or avoiding them entirely. Getting the answer wrong is costly: the payer is personally liable for tax that should have been withheld, plus interest and penalties.

Interest Paid to a Foreign Person

If you pay U.S.-source interest to a nonresident alien individual, you must withhold 30 percent of the gross payment before sending the rest.1Office of the Law Revision Counsel. 26 U.S. Code 1441 – Withholding of Tax on Nonresident Aliens A parallel provision applies the same 30 percent rate when the recipient is a foreign corporation.2Office of the Law Revision Counsel. 26 USC 1442 – Withholding of Tax on Foreign Corporations These are the IRS’s Chapter 3 rules, and they reach interest along with dividends, royalties, rents, and similar categories of U.S.-source income.3Internal Revenue Service. NRA Withholding

Anyone who controls, receives, or makes the payment counts as a “withholding agent” and carries the responsibility. That includes individuals, companies, partnerships, trusts, corporate officers, and financial intermediaries handling the transaction.4Internal Revenue Service. Withholding Agent You don’t get to opt out of the role because you’re not a bank.

Interest Paid to a Domestic Recipient Without a Valid TIN

Interest paid to a U.S. person normally carries no withholding obligation. The exception is backup withholding, which kicks in when the recipient has not given you a valid taxpayer identification number, the IRS has notified you that the number is wrong, or the recipient has a history of underreporting. In those situations you deduct 24 percent of the interest payment before sending it.5Internal Revenue Service. Backup Withholding The rate stays at 24 percent for 2026.6Internal Revenue Service. Publication 15 (2026), (Circular E), Employers Tax Guide

The safeguard is collecting a completed Form W-9 from every domestic payee before the first interest payment. If you have a valid W-9 on file and no IRS notice about that payee, backup withholding does not apply.

Exemptions That Eliminate the 30 Percent Rate

Several statutory carve-outs cancel Chapter 3 withholding on interest paid to foreign persons. Each has its own conditions and its own documentation.

Portfolio Interest

Interest paid on qualifying debt to a foreign lender is completely exempt from withholding under the portfolio interest rule. A parallel provision extends the same treatment to foreign corporate lenders.7Office of the Law Revision Counsel. 26 USC 881 – Tax on Income of Foreign Corporations Not Connected With United States Business Three conditions must be met. The debt has to be in registered form, meaning it’s recorded with the issuer or its agent rather than being a bearer instrument. The foreign lender must certify non-U.S. status, typically through Form W-8BEN or W-8BEN-E. And the lender cannot own 10 percent or more of the voting stock of a corporate borrower or 10 percent or more of the capital or profits interest in a partnership borrower.8Office of the Law Revision Counsel. 26 USC 871 – Tax on Nonresident Alien Individuals

That 10 percent threshold is where related-party loans often fail. The IRS applies ownership attribution rules, so indirect ownership through family members or affiliated entities can push a lender over the limit even when the direct stake is smaller. Bank loans also fall outside the exemption when the lending bank receives the interest in the ordinary course of its business.7Office of the Law Revision Counsel. 26 USC 881 – Tax on Income of Foreign Corporations Not Connected With United States Business

Bank Deposits and Short-Term Debt

Interest on deposits with U.S. banks, savings institutions, and credit unions is exempt from withholding when the foreign recipient has no connection to a U.S. trade or business.9Internal Revenue Service. Nonresident Aliens – Exclusions From Income That covers ordinary savings accounts, certificates of deposit, and similar arrangements. A separate exemption covers short-term original issue discount obligations that mature in 183 days or less from the date of issue.8Office of the Law Revision Counsel. 26 USC 871 – Tax on Nonresident Alien Individuals Both exemptions operate independently of any tax treaty, so they apply even when the lender’s home country has no treaty with the United States.

Interest Connected to a U.S. Business

When a foreign person earns interest through an active U.S. trade or business, the income is treated as effectively connected income (ECI). ECI is not subject to the flat 30 percent rate. The foreign person instead reports it on a U.S. income tax return and pays at graduated rates like a domestic taxpayer.10Internal Revenue Service. Effectively Connected Income (ECI) To skip withholding, the recipient files Form W-8ECI with the payer, certifying that the interest is connected to their U.S. business, that they are the beneficial owner, and that they will include the income on their U.S. return.11Internal Revenue Service. Withholding Exemption on Effectively Connected Income ECI is also excluded from FATCA withholding, so a valid W-8ECI clears both layers at once.

Treaty Rates That Reduce the 30 Percent

The United States has income tax treaties with dozens of countries, and most of them reduce or eliminate the 30 percent rate on interest. Treaties with the United Kingdom, Canada, Germany, Japan, France, and the Netherlands bring the interest rate to zero. Others set reduced rates at 10 or 15 percent. The IRS publishes a table listing the interest rate for every treaty country.12Internal Revenue Service. Tax Treaty Tables

You cannot apply a reduced rate simply because the recipient says they’re from a treaty country. Modern treaties include a Limitation on Benefits provision meant to stop companies from routing payments through treaty jurisdictions where they have no real presence.12Internal Revenue Service. Tax Treaty Tables The recipient must be a genuine resident with meaningful business activity or ownership ties in the treaty country, and they certify eligibility on Form W-8BEN or W-8BEN-E. If the form is incomplete or the Limitation on Benefits test is not clearly satisfied, withhold at 30 percent. Treaty benefits also generally drop away when the foreign recipient has a permanent establishment in the United States and the interest-bearing asset is connected to it; that income is typically ECI instead.

FATCA: A Second Withholding Layer

The Foreign Account Tax Compliance Act (FATCA), codified as Chapter 4 of the Internal Revenue Code, imposes its own 30 percent withholding on U.S.-source interest paid to certain foreign entities. This layer targets foreign financial institutions that have not agreed to report their U.S. account holders to the IRS, along with non-financial foreign entities that refuse to identify substantial U.S. owners.13Internal Revenue Service. Withholding and Reporting Obligations

When a payment triggers both Chapter 3 and Chapter 4, you do not withhold twice. Amounts withheld under Chapter 4 count toward your Chapter 3 obligation on the same payment.13Internal Revenue Service. Withholding and Reporting Obligations In practice you apply Chapter 4 first. If the foreign recipient is a participating financial institution or a deemed-compliant entity under an intergovernmental agreement, FATCA withholding falls away and only Chapter 3 remains. Form W-8BEN-E documents the entity’s FATCA status.

Documentation Determines the Rate You Apply

The withholding rate you apply depends on what documentation you have on file. Without a valid form, you must withhold at the full default rate.

A Form W-8BEN generally remains valid from the date it is signed through the last day of the third following calendar year. A form signed in March 2026 expires on December 31, 2029.15Internal Revenue Service. Instructions for Form W-8BEN Any change in the recipient’s circumstances (new address, change in treaty country, shift in ownership) invalidates the form immediately and requires a new one. Stale forms are one of the most common audit findings in this area.

Reporting the Payments You Made

For domestic recipients, file Form 1099-INT whenever you pay at least $10 in interest during the calendar year, and file it regardless of amount if you applied backup withholding.16Internal Revenue Service. About Form 1099-INT, Interest Income

For foreign recipients, file Form 1042 (an annual return summarizing all amounts withheld on payments to foreign persons) along with a Form 1042-S for each recipient.17Internal Revenue Service. Instructions for Form 1042 Both are due by March 15 of the year following payment.18Internal Revenue Service. Instructions for Form 1042-S Withheld funds are deposited through the Electronic Federal Tax Payment System (EFTPS) during the year, with deposit frequency depending on the total amount withheld.

What Happens If You Get It Wrong

If you were required to withhold and failed to, you are personally liable for the full amount of tax you should have collected. The statute is blunt: every person required to withhold is “made liable for such tax.”19Office of the Law Revision Counsel. 26 USC 1461 – Liability for Withheld Tax That liability exists independently of the foreign recipient’s own tax obligation. Even if the recipient later files a U.S. return and pays what’s owed, you may still be on the hook for interest and penalties from your failure to withhold on time.4Internal Revenue Service. Withholding Agent

The failure-to-pay penalty starts at 0.5 percent of the unpaid tax for each month or partial month the tax remains unpaid, climbing to a maximum of 25 percent.20Office of the Law Revision Counsel. 26 U.S. Code 6651 – Failure to File Tax Return or to Pay Tax Separate per-form penalties apply for failing to file or for furnishing incorrect Forms 1042-S, and if the IRS finds intentional disregard the penalty per form increases substantially with no aggregate cap.21Internal Revenue Service. Penalties Related to Form 1042-S The definition of “withholding agent” is broad enough to reach corporate officers, trustees, partnership managers, and employees who handle payments; if you have control, custody, or disposal of interest income owed to a foreign person, you qualify.4Internal Revenue Service. Withholding Agent