Foreign Investment into the U.S. – Part III: What is the Basis for Taxation?
NRAs are not taxed on worldwide income and assets. Therefore, there needs to be a system in place to determine what is taxable.
Step one for calculating U.S. taxable income is the most important. NRAs will only pay tax on U.S. source income. Similar to U.S. persons v. NRAs, there are only two types of sources – U.S. source and foreign source. Every type of income has a specific set of rules to determine its source. Payments for services are sourced based on where they are performed, payments for goods are sourced where the title changes hands, dividends are sourced based on the location of the corporation paying the dividend, royalties are sourced based on where the legal protection is given and continuing on each type of income has its own rule. This is where the best planning can happen. If you can shift income from U.S. source to foreign source the analysis is complete because NRAs do not pay tax on foreign source income.
Once we have determined we have U.S. source income, the next breakdown is between active income and passive income. Passive income, such as dividends and interest, does not require further analysis, and will be taxable barring some exception. On the other hand, active business income requires a closer look. First, the income must result from a U.S. trade or business. This is an extremely low threshold and nearly any U.S. activity will satisfy the requirement. Next, the income must be effectively connected to the U.S. trade or business. While this is a higher threshold than U.S. trade or business, it is still relatively easy to meet assuming the business is undertaking profit generating activities in the U.S. The best exception comes from U.S. tax treaties which offer the final step and require the effectively connected income to be attributable to a permanent establishment. Under the treaties, generally there are a lot of activities that can be allowed in the U.S. and not be deemed to meet the requirement. Therefore, if the NRA is from a treaty country, there is a lot of potential planning to avoid taxation on active business income earned in the U.S. Overall, the rules on how to calculate the taxable income are very detailed and specific, but this also means there are well defined and clear ways to minimize taxation.
NRAs determine estate and gift tax based on a standard principle. In general, the tax will only apply on U.S. situs assets. The definition of what is a U.S. situs asset is dependent on the type of asset. For example, for personal property, such as cash or a painting, the test would be based on physical location. However, corporate stock would be based on the place of incorporation rather than the physical location of the shares, which means that stock in a U.S. corporation will be deemed U.S. situs. Not all assets are as straightforward, such as a U.S. investment account may not be considered U.S. situs if it only holds foreign assets. There are some notable differences though between application of the estate tax and the gift tax. Most importantly, a gift of stock of a U.S. corporation or a partnership interest in a U.S. partnership will not trigger the gift tax even though they are considered U.S. situs assets. Therefore, all these scenarios present possible planning opportunities and require strict attention to detail on the law and classifications. What is very clear is that before making an investment in the U.S. the future wealth transfer strategy should be considered to limit exposure to U.S. estate and gift taxes.