Archive for April, 2014

Foreign Individuals Subject to U.S. Taxationby kyoffelaw

by Katya Yoffe

Nonresident Alien or Resident Alien? Foreign Individuals and the “Substantial Presence” Test

Residents and non residents are taxed differently in the United States. Foreigners should be aware that the definition of a “resident alien” under the Internal Revenue Code is not the same as the definition used for purposes of immigration. Section 7701(b) of the IRC defines a resident alien under two tests, known as the “green card test” and the “substantial presence test”. The green card test identifies a resident alien as an individual who is a permanent resident of the United States under immigration laws. The substantial presence test identifies foreign individuals who spend substantial periods of time within the United States as resident aliens. This test is met if the foreign individual was present within the U.S. at least 31 days during the current year and 183 days during the 3 year period that includes the current year and the 2 preceding years, determined as follows:

-all days present in the current year

-1/3 of the days present in the first preceding year

-1/6 of the days present in the second preceding year

It is quite common for foreign individuals traveling to the United States for work or other purposes to be unaware of the substantial presence test. The only exemptions provided under the substantial presence test for the purpose of counting days of presence are individuals temporarily present in the U.S. on behalf of foreign governments, teachers and trainees under J or Q visas, students under F, J, M or Q visas, professional athletes competing in charitable sports events, and certain individuals with medical conditions.

Foreign individuals who travel frequently to the United States and do not file U.S. tax returns should be aware of the substantial presence test and be sure to keep track of their travel records. Individuals who travel to the United States on a regular basis frequently for professional or recreational purposes find themselves unwittingly falling within the definition of U.S. resident under the Tax Code.

Aliens deemed U.S. residents under the substantial presence test may still be treated as nonresidents by establishing a closer connection to a foreign country. The closer connection test is met if the individual is present in the U.S. for less than 183 days out of the year, maintains a tax home in a foreign country during the year, and can demonstrate a closer connection to that foreign country via the location of residence designated by the individual on forms and documents, permanent home, family, business activities, etc.

It is important to note that the closer connection test may only be met by filing a U.S. tax return and making a closer connection exception claim.

Source Rules: Income of Nonresident Aliens

U.S. residents are taxed on their worldwide income. This includes interest, dividends, wages or other compensation, royalties and rental income from both within and outside the United States. Nonresidents, however, are generally taxed only on U.S. source income. Income is generally considered U.S. source if the location of the activity or the sale of property for which the payment is being made is in the United States. This may include interest, dividends, rents and royalties, employment income, compensation for personal services and sale of real and personal property.

U.S. source rules for nonresident aliens can be complex. Heavily nuanced rules exist to address many  issues involving the nature of the income-generating activity, the amount of time the nonresident alien has spent in the U.S. and the type of income received. These rules address numerous matters such as the sale of intellectual property, interest income, scholarships and grants, inventory and so forth. Nonresident individuals who work both within and outside the United States will need to prorate their compensation to figure out how much is U.S. source.

Foreign Persons: U.S. Trade or Business Income

When a foreign person engages in a U.S. trade or business, all U.S. source income connected with the activity of the trade or business is considered Effectively Connected Income (ECI). ECI is taxed at the same graduated rates applicable to U.S. citizens and resident aliens (or lesser rate if permitted by treaty). Deductions are permitted against ECI.

Foreign Persons: Nonbusiness U.S. Source Income

Most of the forms of U.S. source income received by foreign persons that are not ECI are subject to a flat withholding tax of 30 percent (or lower treaty rate). These types of income are referred to as Fixed, Determinable, Annual, or Periodical (FDAP) income and includes interest, dividends, rents, salaries, wages, fixed or determinable annual or periodical gains, profits and income. The obligation is imposed on the payor to withhold the tax in order so as to ensure its collection. Deductions are not permitted against FDAP income. If FDAP income is also classified as ECI in a given situation, however, it will be subject to the ECI rules explained above.

Certain types of investments such as the sale or exchange of capital assets or real property are subject to special rules and will be investigated later in this blog.

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