U.S has following two systems for taxing the U.S source income of non-resident aliens and foreign corporations.
- If a non-resident alien individual or foreign corporation derives investment type income from sources within the United States, the gross amount of that income is taxed at a flat rate of 30%.
- If a non-resident alien individual or foreign corporation is engaged in a trade or business within the United States, the net amount of income effectively connected with the conduct of that U.S trade or business is taxed at the regular graduated rates.
Capital gains are generally exempt from U.S taxation, except for gains on the sale of U.S real property interest, which are taxed in the same manner as income effectively connected with the conduct of a U.S trade or business.
FATCA (Foreign Account Tax Compliance Act of 2010)
FATCA deals with the failure of U.S persons that beneficially own foreign entities to report income earned from those foreign entities.
FATCA combats this failure via a 30% withholding when foreign payees do ot provide information about U.S persons.
The FATCA regime uses the threat of withholding as leverage against the foreign payee to provide information about the U.S persons that beneficially receive the income.
The threat of withholding induces the foreign payee to provide information to the IRS. The FATCA regime financial institutions and foreign non-financial institutions. Both are subject to withholding on payments like interest, dividends, rents, royalties and compensation.
FDAP (Fixed, determinable, annual or periodic income)
FDAP regime applies only if the FATCA regime does not impose withholding.
The United States taxes the gross amount of a foreign person’s U.S source investment type income, known as FDAP at a flat rate of 30%.
FDAP includes dividends, interest, royalties, and compensation for personal service and excludes gains from the sale of income producing assets.
Under the FDAP regime, the person controlling the payment of the income must deduct and withhold U.S tax at the 30% rate.
Persons subject to withholding
Nonresident alien individuals.
Foreign corporations.
Foreign partnerships.
Foreign estates and trusts.
Income subject to withholding
- Fixed, determinable, annual or periodic income.
- Income is derived from sources within the United Sates.
Allowable Deductions
No deductions are allowed for purposes of computing the amount of a foreign person’s U.S source investment income subject to U.S withholding taxes.
Applicable tax rate
Special statutory rates apply to the following types of income:
A 10% withholding rate applies to the amount realized on the disposition of a U.S real property interest.
The applicable withholding rate on a foreign partner’s distributive share of a partnership’s effectively connected taxable income is the maximum U.S tax rate applicable to the type of taxpayer in question.
A 14% withholding rate applies to scholarships and fellowships received by a non-resident alien individual.
Withholding Agent Responsibilities
Any person having control, receipt, custody, disposal or payment of an item of U.S source FDAP income to a foreign person is obligated to withhold U.S taxes.
A withholding agent must deposit any taxes withheld with a federal reserve bank or an authorized financial institution using a federal tax deposit coupon or through electronic funds transfer.
The federal agent must file an annual information return, form 1042, annual withholding tax return for U.S source income of foreign persons.
Effectively connected income
Withholding is not required on any U.S source income that is effectively connected income with the conduct of a U.S trade or business.
ECI is subject to U.S taxes at the regular graduated rates.
Interest, dividends, rents and royalties are treated as effectively connected income if the income is derived from assets used in or held for use in the conduct of a U.S trade or business or if the activities of the U.S trade or business are a material factor in the realization of income.
Effectively connected personal service income
The withholding exemption for effectively connected income does not apply to the personal services income of a nonresident alien.
Withholding on income allocable to a foreign partner
Partnerships with foreign partners must withhold on income received even if there is never a cash distribution.
Gains from the sale or exchange of property
Income derived from the sale in the United States of personal property is not subject to withholding under the FDAP regime because it is not FDAP income.
Withholding is required on the following types of gains:
Gains from the disposition of timber, coal or domestic iron ore with a retained economic interest.
Gains from the sale or exchange of original issue discount obligations attributable to certain accrued amounts.
Gains from disposition of U.S real property interest.
Gains from the sale or exchange of intangibles to the extent such gains are derived from payments which are contingent on the productivity, use of disposition of the property.
Portfolio interest exemption
Portfolio interest received by foreign persons is exempt from U.S withholding tax.
Following types of interest and dividend income are also exempt from 30% withholding tax:
The active foreign business percentage of any dividend or interest paid by an 80 / 20 company that existed prior to 2011.
The income derived by a foreign central bank of issue from banker’s acceptance.
The interest on bank deposits or amounts held by an insurance company under an agreement to pay interest thereon.
Treaty reductions for dividends, interest and royalties
Tax treaties usually reduce the 30% statutory withholding tax rate on dividend, interest and royalty income to 15% or less.
Treaty reductions for personal services income
Under the U.S model tax treaty, income derived by a nonresident alien individual from employment in the United States is exempt from U.S taxation if the following conditions are met:
The employee is present in the United States for 183 days or less.
The employee’s compensation is paid by, or on behalf of, an employer which is not a U.S resident.
The compensation is not borne by a permanent establishment or a fixed base that the employer maintains in the United States.
Election to treat real property income as effectively connected income
A foreign corporation or non-resident alien individual who is a passive investor in a U.S real property interest may elect to have the U.S source income derived from the investment taxed as if it were effectively connected income. This election allows foreign persons to offset the gross income from investments in U.S. real property with related deductions to compute effectively connected income.
Foreign governments and international organizations
Income derived by a foreign government from investments in the United States in stocks, bonds, or other domestic securities, financial instruments held in the execution of governmental financial or monetary policy, or interest on deposits in U.S banks is exempt from U.S tax.
Foreign tax-exempt organizations
A foreign tax-exempt organization is subject to withholding on any receipts of unrelated business taxable income, unless such income is effectively connected with the conduct of a U.S trade or business.
Social security benefits
Eighty five percent of the social security benefits received by a non-resident alien individual are subject to the 30% withholding tax.
Gambling winnings
Withholding is not required on proceeds from a wager placed by a non-resident alien individual in gambling on blackjack, baccarat, craps, roulette, or big-6 wheel, withholding is required on proceeds from horse or dog races occurring in the United States, unless the wager is place outside the United States. Other gambling winnings are subject to withholding tax if the amount of the winning exceeds certain dollar threshold.
Tax on gross transportation income
The U.S source gross transportation income of a foreign person is subject to a special 4% tax.
References:
Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.