Non-U.S. citizens who conduct business, invest, or live in the U.S. often wonder to what extent they will be impacted by U.S. taxation. The effect of U.S. tax law on any person can vary greatly depending on the nature of the activities they are conducting, whether their income is from U.S. sources, and whether they are considered a U.S. person for tax purposes.
For tax purposes, a U.S. person includes more than just U.S. citizens. A U.S. person also includes domestic corporations and “resident aliens.” A resident alien is a person who either meets the green card test or the substantial presence test. The green card test is simply whether the person has been issued a permanent resident card, commonly known as a green card.
The substantial presence test involves a calculation based on the number of days that a person was present in the U.S. during the last 3 years. If a person meets the substantial presence test, they will be treated as a U.S. person for tax purposes. This is significant because a non-U.S. citizen might meet the substantial presence test unknowingly which could lead to adverse tax consequences or could cause them to be noncompliant with their U.S. tax obligations.
U.S. persons are taxed on their worldwide income whereas foreign persons are only taxed on their income from sources within the U.S. Additionally, U.S. persons have informational reporting requirements for certain foreign financial assets and activities. Fulfilling reporting obligations related to international tax items can be complex and time consuming. Some common foreign reporting includes the Report of Foreign bank and Financial Accounts (FBAR); Statement of Specified Foreign Financial Assets (Form 8938); and Information Return of U.S. Persons with Respect to Certain Foreign Corporations (Form 5471). All U.S. persons must comply with any relevant informational reporting, even if they only meet substantial presence, or they could face significant penalties from the IRS.
Anyone who does not fit the definition of a U.S. person is considered a nonresident alien (NRA) for U.S. tax purposes. NRAs are only taxed on their income that is from sources within the U.S. The rules for determining the source of income are complex and riddled with special rules and exceptions. In general, the source rules look to where services were performed; where property is located, sold, or produced; and the residence of the payer of the income to determine the source.
If income is determined to be from a U.S. source, an NRA can be taxed on the income through two tax regimes based on two types of income: (1) active income effectively connected with a trade or business in the U.S. (ECI); and (2) fixed, determinable, annual, or periodical income from sources within the U.S. (FDAP). FDAP income generally includes passive investment income, such as interest, dividends, rents, royalties, etc. ECI generally consists of income from active trade or business activities.
ECI is taxed on a net basis. This means that the total amount of income can be reduced by certain deductions and expenses; the net income remaining after deductions and expenses is then subject to tax at the same rate that applies to U.S. persons.
In contrast, FDAP is taxed on a gross basis at 30%. Because FDAP is taxed on a gross basis, no deductions or expenses can be used to reduce the taxable income. Another distinction is the FDAP income tax is withheld at the source. The payer of the FDAP income must withhold 30% and pay the tax to the IRS. Fortunately for some taxpayers, the amount of tax and withholding on FDAP income can be reduced or potentially eliminated by a relevant tax treaty or other exception.
As shown above, the extent to which a non-U.S. citizen is taxed by the U.S. can vary dramatically based on the nature of the activities they are conducting, whether their income is from U.S. sources, and whether they are considered a U.S. person for tax purposes. Foreign persons who are conducting business, performing services, investing, or spending time living in the U.S. should carefully consider how their activities can be impacted by U.S. tax.