U.S. Income Taxation of Foreign Nationals

any foreign nationals could find themselves subject to U.S. tax because either they spend time in this country or they have investments here. Without proper planning, these people may be considered resident aliens (see “ From The Tax Adviser ,” JofA, Oct.01, page 106), with significant income tax ramifications and requirements.

The first factor that must be determined is whether the foreign national’s income is connected to a U.S. trade or business.

NO U.S. TRADE OR BUSINESS

A foreign national who does not spend much time in the United States should qualify as a nonresident alien and be taxed at a 30% rate on investment income from U.S. sources not connected to a U.S. trade or business. This tax is generally withheld at the source and is assessed on interest, dividends, rents, royalties and other, similar types of income.

Interest. There is an exception to the withholding requirement for interest on the most common types of debt obligations. In addition, there may be exemptions from withholding for interest from bank deposits, deposits with domestic savings and loan associations and amounts held by insurance companies under agreements to pay interest.

Dividends. U.S.-source dividends are generally subject to the 30% withholding tax. However, there is an exception for dividends paid by domestic companies that derive at least 80% of their income from business transacted overseas.

Capital gains. Capital gains are generally exempt from withholding, unless they are the proceeds from sales of intellectual property, the price of which is contingent on the property’s productivity, use or disposition.

Compensation. Payments for a foreign national’s services will be treated as though it were from foreign sources (and therefore not subject to U.S. taxation) if

The foreign national is present in the United States for no more than 90 days during the tax year.

The total compensation for such services does not exceed $3,000.

The individual’s employer is either a foreign person not engaged in a U.S. trade or business or a foreign office of a U.S. person.

Generally, if the compensation does not meet these criteria, it would be subject to wage withholding (rather than the 30% otherwise applicable).

Real property. Rental income may be subject to the 30% withholding. Taxpayers may make a special election to treat a passive rental real estate investment as a U.S. trade or business, allowing the foreign national to deduct mortgage interest, real estate taxes and repair and maintenance costs.

U.S. real property sales. In general, for individual investors, gains from the sales of interests in U.S. real property will be taxed at capital gain rates.

U.S. TRADE OR BUSINESS

If a foreign national has a U.S. trade or business, he or she will be taxed as a U.S. citizen would be and the income derived from this trade or business will be taxed at marginal tax rates. To qualify, income items must meet either an asset-use test or a business-activities test. A nonresident alien will meet this test if he or she derives income from assets used (or held for use) in the conduct of a U.S. trade or business or if the activities of the U.S. business were a material factor in the realization of income, gain or loss. Assets held to meet the present (as opposed to future) needs of a U.S. trade or business (for example, bank accounts, securities or other investments) may satisfy these tests.

For a detailed discussion of these issues, see “A Guide to U.S. Income Taxation of Foreign Nationals,” by Barbara Raasch and Anthony Armitrano, in the April 2002 issue of The Tax Adviser.

—Nicholas Fiore, editor
The Tax Adviser