Persons who are not U.S. citizens are either resident aliens or nonresident aliens for U.S. income tax purposes. Resident aliens – those who meet either the “green card” test or the substantial presence test – are subject to income tax the same way as U.S. citizens, that is, they are subject to U.S. income tax on their worldwide income. Nonresident aliens are subject to tax based on the source of their income, and whether their income is “effectively connected with a U.S. trade or business”.
For nonresidents, taxable income is separated into two categories:
1. Income that is effectively connected with a U.S. trade or business, after the deductions that are allowed, is subject to U.S. income tax at graduated rates – the same rates that apply to U.S. citizens and residents – or lower rates if the provisions of a tax treaty apply.
2. Income that is subject to U.S. income tax, for being U.S. source income, but that is not effectively connected with a U.S. trade or business, is subject to a flat 30% tax.
If a nonresident is considered to be engaged in a trade or business in the U.S., all income from sources within the U.S. that are connected with the conduct of that trade or business are “effectively connected income” (ECI). Therefore, to determine your tax liability, it is first necessary to determine whether you are considered to be engaged in a trade or business in the U.S.
Engaged in a Trade or Business in the U.S.
The nature of your activities determines whether you are engaged in a trade or business in the United States. Generally, for U.S. income tax purposes, you are considered to be engaged in a trade or business in the U.S. if:
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· You are a student or trainee temporarily present in the U.S. under a “F”, “J”, “M”, or “Q” visa. Any part of a scholarship or fellowship that you receive, that is considered U.S. source income and is taxable, is considered income effectively connected with a trade or business.
· You own and operate a business in the United States, whether the business involves rendering services or selling merchandise or other products. If you purchase products or merchandise outside the U.S. and sell them in the U.S., you are engaged in a U.S. trade or business.
· You are a partner in a partnership that is engaged in a U.S. trade or business at any time during the year.
· You are a beneficiary of an estate or trust that is engaged in a U.S. trade or business.
· You have a gain or loss from the sale or exchange of a U.S. real property interest.
· You have income from the rental of real property and you elect to treat it as income effectively connected with a U.S. trade or business.
Trading in Stocks, Securities, or Commodities
If you trade in stocks, securities, or commodities through a broker or agent who is a resident of the U.S. and that is your only U.S. business activity, you are not considered to be engaged in a U.S. trade or business. For transactions in stocks and securities, this applies even if you are a broker. For transactions in commodities, it applies to commodities that are normally traded on an organized commodities exchange.
But, if at any time during the tax year, you have a U.S. office or fixed place of business where you carry out transactions in stocks, securities, or commodities, you may be considered to be engaged in a U.S. trade or business.
Investment Income
Investment income from U.S. sources may or may not be considered effectively connected with a U.S. trade or business. There are two tests that apply in determining whether investment income is effectively connected:
· Asset-Use Test: If income is from assets used in, or held for use in a trade or business in the U.S., the income is effectively connected.
· Business Activities Test: The income is considered to be effectively connected if the conduct of a U.S. trade or business was a material factor in producing the income.
The asset-use test would normally apply to income that is not generated directly by the trade or business activity, but rather by the use of trade or business assets, for example, interest on accounts or notes receivable, or rental income from business property, when renting such property is not the normal line of business.
For purposes of the asset-use test, stock in a corporation is not considered an asset used in, or held for use in a U.S. trade or business. Therefore investment income from stock transactions would not necessarily be treated as effectively connected income.
The business activities test takes on importance, and usually applies when dividends or interest are received by a dealer in stocks or securities, royalties are received from licensing patents or other similar property, and when fees are earned by a service business.
Personal Service Income
Income you receive for personal services in a tax year in which you are considered to be engaged in a U.S. trade or business is considered to be effectively connected to that trade or business. If you receive the income in a year other than the year you performed the services (for example, you receive the income in January for services performed in December), that income will still be considered effectively connected.
If you are considered to be engaged in a U.S. trade or business only because you perform services in the U.S., other sources of income you may have, such as income (interest and dividends, rents and royalties) and gains and losses from the sale or exchange of capital assets are generally not considered to be effectively connected to a trade or business. But if there is a direct economic connection between your holding the asset and your trade or business of performing services, then any income, gain or loss from that asset would be considered effectively connected.
Pensions
If you are a nonresident who receives a pension or retirement pay for services you performed in the United States after 1986, your payments are considered to be effectively connected with a U.S. trade or business, even if you are no longer engaged in a U.S. trade or business when you receive these payments.
Transportation Income
Transportation income, for tax purposes, is income from the use of a vessel or aircraft, or from directly-related services. All the transportation income is considered U.S. source income if the transportation begins and ends in the U.S. If the transportation either begins or ends in the U.S., 50% of the income is considered U.S. source.
Transportation income is considered to be effectively connected with a U.S. trade or business if you had a fixed place of business in the U.S. where you earned the income, and at least 90% of your U.S. source transportation income is attributable to regularly scheduled transportation, that is, a ship or aircraft that follows a published schedule with repeated sailings or flights at regular intervals, that begin or end in the U.S. If these two conditions (“fixed place of business”, and “regularly scheduled transportation”) are not met, your transportation is not effectively connected with a U.S. trade or business and is subject to a 4% tax.
Real Property
Gains or losses from the sale or exchange of U.S. real property interests are considered effectively connected income. This includes direct interests in real property located in the United States or the Virgin Islands, and interests in a U.S. real property holding corporation.
Real property includes the land and natural resources attached to the land, such as growing crops and timber, and mineral and other deposits; buildings, permanent structures and their components; and personal property associated with the use of the real property. This personal property includes farming, mining, forestry, or construction equipment, and property used in lodging facilities or rented office space.
If you own shares in a U.S. real property holding corporation, any gain or loss on the sale of those shares would be taxed as if you were engaged in a U.S. trade or business yourself. In order to be considered a U.S. real property holding corporation, the fair market value of the corporation’s U.S. real property interests must be at least 50% of the total fair market value of all its real property interests, both in and outside the U.S., plus its other assets that are used in, or held for use in its trade or business.
Stock in a corporation that is traded on an established securities market is not considered a U.S. real property interest, unless you own more than 5% of the fair market value of all that class of the corporation’s stock. And, an interest in a foreign corporation that owns real property in the United States is generally not considered a U.S. real property interest.
Fixed Place of Business
There are certain circumstances in which foreign source income must be considered effectively connected with a U.S. trade or business. If you have an office or other fixed place of business in the United States, that office is a material factor in producing the income, and the income is produced in the ordinary course of the trade or business that you carry out through that office or fixed place of business, then the income is effectively connected.
There are three types of foreign income that could be considered effectively connected according to this rule:
1. Rents and royalties for the use of, or the privilege of using intangible property located outside the U.S. Intangible property includes patents, copyrights, processes and formulas, goodwill, trademarks, trade names, and franchises.
2. Dividends and interest from the active conduct of a banking, financing, or similar business in the U.S. This does not include dividends and interest from investments.
3. Income, gain, or loss on the sale of stock in trade, property includible in inventory, or property held primarily for sale to customers in the ordinary course of business. This does not apply if the property was sold outside the U.S. and a foreign office or place of business was a material factor in the sale.
Reporting
Income effectively connected with a U.S. trade or business is reported on lines 8 through 23 of Form 1040NR, U.S. Nonresident Alien Income Tax Return, which is filed annually.
Nonresidents are generally subject to a 30% Withholding Tax on income they receive from U.S. sources. Personal service income, as an employee, would be considered effectively connected income and would be subject to the same withholding tax that applies to U.S. citizens and residents. Gains from the sale or disposal of U.S. real property interests are subject to withholding according to section 1445 of the Internal Revenue Code, and a foreign partner’s share of effectively connected partnership income is subject to withholding according to section 1446.
Other income effectively connected with a trade or business in the U.S. is not subject to withholding, but you will need to file Form W-8ECI, to establish that you are not a U.S. person, that you are the beneficial owner of the income, and that the income is effectively connected with the conduct of a trade or business in the U.S. If you also have income that is not effectively connected, you will also need to file Form W-8BEN, Form W-8EXP or Form W-8IMY:
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· Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding, is used when you are an intermediary, acting as an agent, nominee, or custodian for the account of others, and not for your own account.
If you perform personal services as an employee in the U.S., you would complete Form W-4, Employee’s Withholding Allowance Certificate. If you are an independent contractor, you can claim exemption from withholding by filing Form 8233, Exemption from Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien.
The above-referenced withholding tax forms are not filed with the Internal Revenue Service, but rather with the withholding agent, or payer of the income. All of these forms are available for downloading from the Internal Revenue Service website at www.irs.gov.
Reference:
Deloitte – “Taxation of Foreign Nationals by the United States”: www.deloitte.com Internal Revenue Service – Businesses – “Taxation of Nonresident Aliens”: www.irs.gov Internal Revenue Service Publication 519, Tax Guide for Aliens: www.irs.gov The Investment FAQ – “Non-Resident Aliens and U.S. Holdings”: invest-faq.com University of Minnesota – Office of Human Resources – “Scholarships, Fellowships, and Grants Paid to Nonresident Aliens”: www1.umn.edu
