Steven Weiser is a tax lawyer with a practice focusing on international tax matters. His contact information and information on his practice can be found on his web site at http://www.lw-law.com/.
Last month we began our review of the U.S. income tax laws with an analysis of the various tests used to determine whether an individual is considered a resident alien or nonresident alien of the U.S. The distinction between a resident alien and nonresident alien is important, as the latter are subject to U.S. income tax on their worldwide income, and the former are generally only subject to U.S. income taxes on income earned from U.S. sources.
To summarize last month’s conclusions, aliens holding a green card are treated as residents of the U.S. (unless treaty benefits are claimed). Additionally, those physically present in the U.S. for at least 183 days over the current and prior two tax years (with at least 31 days of presence occurring during the current year) are also treated as residents unless one of several exceptions apply. The first exception applies for those individuals with a “closer connection” to another country. Other exceptions allow certain “exempt individuals” to exclude certain days of presence from determining whether the 183 day test is satisfied, or to exclude certain days of presence due to medical conditions, commuting between Canada or Mexico and employment within the U.S., or days in transit between points outside the U.S. Lastly, an alien otherwise treated as a nonresident may elect to be treated as a resident provided certain conditions are satisfied.
This month our attention will shift from determining who is a resident alien, to the taxation of nonresident aliens.
Nonresident aliens may find themselves subject to two separate U.S. income tax regimes. The first regime applies to certain limited types of U.S. source income that are not effectively connected with a trade or business operated within the U.S. The second regime applies to income that is effectively connected with the conduct of a U.S. trade or business. The rules regarding the taxation of nonresidents are often confusing, complex and subject to many exceptions. Therefore, we will only review the general rules and most significant exceptions to those rules.
Nonbusiness Income from U.S. Sources
Income of a nonresident alien that is not effectively connected with the conduct of a U.S. trade or business is generally exempt from U.S. income tax unless it is from sources within the U.S. and falls within the definition of “fixed or determinable annual or periodical gains, profits, and income” (otherwise known as “FDAP”). FDAP includes wages and compensation, interest, dividends, rents and royalties received from U.S. sources, but does not include capital gains and other income realized from the sale of property. The tax on FDAP is applied at a flat rate of 30 percent and is usually collected by the payor of income who withholds this tax from the nonresident alien and remits the tax to the Internal Revenue Service (“IRS”). The tax is applied against the gross amount of income, meaning that no deductions are allowed in arriving at the taxable amount. The withholding tax reflects the difficulty of collecting taxes from nonresident aliens who are often neither physically present in the U.S. nor tied to this country by residence or business operations.
By disallowing the deduction of expenses the withholding tax is often confiscatory. For example, the disallowance of a depreciation expense often causes the 30 percent withholding tax on gross rental receipts to exceed 30 percent of net income. In certain instances the withholding tax may even apply despite the fact that the nonresident alien recognizes no net income at all!
The U.S. has enacted a number of exceptions to the above rules. For instance, exemptions for certain types of interest income exist, and nonresident aliens may, in limited circumstances, pay a flat 30 percent tax on U.S. source capital gains, despite the general rule that such gains are generally exempt from the withholding tax.
Taxation of FDAP – Salaries, Wages, and Compensation
Salaries, wages and compensation from U.S. sources are included in FDAP and payments of such to nonresident aliens are subject to either (1) the 30 percent withholding tax, or (2) wage withholding on the same basis as U.S. citizens and residents. Wages, salaries and compensation are U.S. source if such payments relate to services performed in the U.S. If compensation paid to a nonresident does not exceed $3,000 for a tax year such income is treated as foreign source, and not subject to withholding, if (1) the nonresident is temporarily present in the U.S.; (2) the nonresident is not present in the U.S. for more than 90 days during the tax year; and (3) the employer is either a foreign person not engaged in business in the U.S., or is a foreign office of a U.S. employer. Note, that because the performance of services in the U.S. generally gives rise to the existence of a U.S. trade or business, payments for such services are often not subject to the withholding tax and are instead taxed under the effectively connected income rules (see below).
Taxation of FDAP – Scholarships and Grants to Foreign Students and Researchers
Taxable scholarships and grants received by nonresident aliens temporarily present in the U.S. under nonimmigrant F, J, M or Q visas are subject to the withholding tax; however, the rate of tax is reduced to 14 percent. Generally, scholarships and grants are nontaxable to the extent used for qualified expenses, including tuition and fees, but amounts used for living expenses are taxable.
Taxation of FDAP – Interest Income
The taxation of interest income is perhaps the most confusing area of FDAP. Generally, the 30% withholding tax applies to the gross amount of interest income received by a nonresident alien. However, the U.S. is in fact a “tax haven” when it comes to interest income. The general rules concerning the taxation of interest income do not apply to several types of interest that the U.S. Congress has chosen to exempt from taxation, including: (1) portfolio interest and (2) interest on U.S. bank deposits. These exemptions allow nonresidents to lend massive amounts of capital to U.S. persons without paying any U.S. taxes on the resulting interest income.
Portfolio Interest Exemption
The portfolio interest exemption was originally enacted to permit U.S. corporations to participate directly in the Eurobond market. If not for this exemption, U.S. corporations would find it difficult to trade U.S. obligations in international markets, since international holders of these obligations want assurances that they will not be subject to U.S. income or withholding taxes.
If the obligation on which interest is paid is in registered form, the portfolio interest exemption only applies if a statement is given declaring that the beneficial owner of the instrument is not a U.S. resident. The statement (often given as IRS Form W-8) must be filed with the person who would otherwise be required to withhold tax from the interest. If the instrument is not in registered form, no statement to the withholding agent is required, but the exemption is denied unless the instrument was issued under guidelines designed to prevent the obligation from coming into the hands of U.S. persons. Compliance with the portfolio interest exemption rules insures that a U.S. resident is not able to avoiding the regular income tax on interest income. To determine if an obligation is in registered form consult your investment advisor.
The portfolio interest exemption is also not available for interest received by a 10 percent shareholder or 10 percent partner. Thus, a major owner of an entity cannot receive tax-free income under the portfolio interest exemption.
Interest on Bank Deposits
Interest on U.S. bank deposits is generally exempt from the withholding tax. The purpose of this exemption is to encourage foreign persons to deposit funds in the U.S. The exemption may also be applied with respect to deposits with domestic savings and loan associations, and amounts held by insurance companies under agreements to pay interest thereon.
Taxation of FDAP – Dividend Income
The 30 percent withholding rate also applies to the payment of U.S. source dividends, regardless of whether dividends are paid in cash or property. Generally, dividends are from U.S. sources if they are paid by a U.S. corporation. Dividends are foreign source if paid by foreign corporations. A dividend from a U.S. corporation may be partially or wholly exempt from withholding taxes if at least 80 percent of the corporation’s gross income from all sources was derived from the active conduct of a trade or business in a foreign country or U.S. possession. In determining whether the 80 percent test is met, the three years preceding the tax year in which the dividend is paid are considered.
Dividends received from a foreign corporation are treated as U.S. source and subject to withholding taxes if 25 percent or more of the foreign corporation’s gross income during the preceding three years was effectively connected with the active conduct of a U.S. trade or business.
Taxation of FDAP – Rental Income
Rents are from U.S. sources and subject to withholding taxes whenever paid for the use of property that is located in the U.S. However, the withholding tax on rents is seldom paid. Often, the activities of managing leased property rises to the level of conducting a U.S. trade or business (see below), thus exempting such income from the FDAP regime. Additionally, a foreign investor may elect to treat real property income from U.S. sources as effectively connected with a trade or business. The election is advantageous because it allows foreign investors otherwise subject to the FDAP withholding tax regime the ability to deduct expenses associated with the management of such real property.
Taxation of FDAP – Royalties
U.S. source royalties are also subject to the withholding tax. Contrary to the phrase “annual or periodical,” royalties are taxable whether received in installments over time or in a lump sum. Gains on the sale of intellectual property are also subject to withholding taxes if they are recognized from the receipt of payments that are contingent on the productivity, use or subsequent disposition of the property.
Other Types of FDAP
The following is a brief list of other types of U.S. source income that are considered FDAP and subject to U.S. withholding taxes:
2. Certain gambling winnings
3. Social security benefits
Effect of Tax Treaties
Tax treaties between the U.S. and the country in which the recipient of FDAP resides often reduce or eliminate the withholding rates applicable to many of the types of income discussed above.
For example, treaties often offer generous exemptions from U.S. taxation for compensation and wages received by nonresidents located in the U.S. for short periods of time. Employee compensation is usually exempt from U.S. taxes if (1) the nonresident is present in the U.S. for not more than 183 days during the tax year; (2) the employer is not a resident of the U.S.; and (3) the compensation is not borne by a fixed place of business of the foreign employer in the U.S.
Gains from the Disposition of Property
As stated above, capital gains (gains from the sale of property) are generally exempt from FDAP; however, some exceptions exist.
One such exception concerns net capital gains from U.S. sources realized by nonresident aliens present in the U.S. for 183 days or more. At first glance this rule seems obvious since noncitizens present in the U.S. for 183 days or more are generally treated as resident aliens and thus, subject to U.S. taxation on their worldwide income. The 183-day test under the FDAP rules generally only has significance where an alien’s days of presence in the U.S. do not count for purposes of determining whether the alien is a resident or nonresident (see last month’s article). For example, days in the U.S. because of a medical condition may count as FDAP days of presence, but are exempt days for purposes of establishing resident or nonresident status.
Withholding Occurs at the Source
The 30 percent withholding tax is almost entirely enforced by the withholding of tax at the source of payment. The tax must be withheld and remitted to the IRS by any payor (the “withholding agent”) including a lessee, mortgagee, employer, or fiduciary having control over the payment of the income. Withholding agents are personally liable for the amount required to be withheld.
Because partnerships are not taxpaying entities under U.S. tax laws the withholding tax is imposed on a foreign partner’s share of FDAP. In the case of a U.S. partnership, the partnership must withhold tax from payments to the foreign partner. In the case of a foreign partnership the payor of income must withhold tax on payments made to a foreign partnership.
Often a withholding agent may not be able to determine whether a payment is one of the above described types of FDAP, because the item’s characterization as income may depend on the payee’s individual circumstances. For instance, the payor of a scholarship may not know if those funds are being used for qualified expenses. Treasury regulations generally require that tax be withheld on the entire payment, leaving it to the payee to straighten matters out by applying for a tax refund.
In certain instances a withholding agent is exempt from withholding any tax. For example, the withholding agent may rely on the payee’s statement that the payee is a U.S. citizen, resident, or a domestic corporation or partnership.
Income Effectively Connected With A U.S. Trade or Business
Income of a nonresident alien that is effectively connected with the conduct of a U.S. trade or business (otherwise known as “effectively connected income” or “ECI”) is subject to taxation on a “net basis,” meaning that the nonresident may take into consideration certain allowable deductions when computing taxable income. Additionally, tax is payable following the close of the tax year at normal, graduated tax rates, as opposed to having it withheld at the time of payment at a flat 30 percent rate.
A U.S. trade or business exists if profit oriented activities are carried on directly or through agents, on a regular, substantial and continuous basis in the U.S. The performance of personal services in the U.S. at any time during a tax year is a U.S. trade or business. This concept has been applied to a single performance by a visiting entertainer or athlete. A limited exception identical to that under the FDAP rules above, applies for nonresident aliens in the U.S. for short periods of time that provide limited services ($3,000 or less).
Determining whether income is ECI can be a complicated process. Items ordinarily included in FDAP are treated as ECI if one of two tests are satisfied. The first test is satisfied if the FDAP type income arises from assets used or held in the conduct of the U.S. business. The second test is satisfied if the activities of the U.S. trade or business were a material factor in producing such income. Items not ordinarily included in FDAP, such as gains from the sale of physical inventory, are connected with a U.S. trade or business if such income arises from sources within the U.S. (regardless of whether or not such income is actually connected with the U.S. trade or business). For example, a foreign corporation maintains a U.S. business through which it sells office furniture, and a foreign office through which it sells computer equipment. The sale of computer equipment to customers in the U.S. is considered ECI.
Effect of Tax Treaties
Under most U.S. tax treaties, business profits of a resident of the other country may be taxed in the U.S. only if the nonresident has a “permanent establishment” in the U.S. and the profits are attributable to such permanent establishment. A permanent establishment (“PE”) is a fixed place of business through which the activities of the enterprise are wholly or partially carried on. Examples of PEs are offices and places of management. Certain facilities are exempt from the definition of a PE, thereby exempting profits attributable from such facilities from U.S. income taxation.