United States Taxation of Nonresident and Resident Aliens and Foreign Corporations
The United States (US), as most other countries, taxes income earned within its borders, even if it is earned by foreigners. Generally, only the US sourced income of nonresident aliens and foreign corporations is taxed by the United States. However, some foreign sourced income may be taxed by the US if the income was earned by a US trade or business that was effectively connected to the US. Resident aliens are subject to the same tax rules as US citizens, using the same tax forms. Nonresident aliens are subject to special rules and must file Form 1040 NR, U.S. Nonresident Alien Income Tax Return to report their income.
Resident or Nonresident Alien? Green Card or Substantial Presence Test
A nonresident alien (NRA) is an individual who is neither a citizen, which is determined either by birth in the US or through naturalization, nor a resident of the US. IRC §7701(b) stipulates that a person is a resident of the United States for income tax purposes if either the green card test or the substantial presence test is met for the calendar year. A foreign person is considered a US resident on the 1st day when the person is physically present in the US after the issuance of a green card. Green card status is maintained until it is either revoked or the person has abandoned lawful permanent resident status.
The substantial presence test (a.k.a. 183-day test) applies to an individual without a green card, but who has been present for at least 183 countable days in the current year and previous 2 years and at least 31 of those days were in the current year. A countable day equals a full day for the current tax year, 1/3 of a day for the previous year, and 1/6 of a day for the year before that.
Example: So the substantial presence test is satisfied if the alien was in the United States for 183 days in the current year, but it would not be satisfied if the alien was in the United States for 100 days in the current year, 120 days in the preceding year, and 180 days in the year before that since:
Number of Countable Days = 100 + 120 × 1/3 + 180 × 1/6 = 100 + 40 + 30 = 170 days
Both the 1st and last day of physical presence are counted. However, a nominal presence that does not exceed 10 days does not factor into whether the substantial presence test was met or not.
Exceptions to the Substantial Presence Test
Commuting days for people who work in the United States, but live in Mexico or Canada, are not counted as days of physical presence for the 183-day test.
People who plan to leave but could not because of a medical condition will be treated as a nonresident even if the 183-day test is satisfied, but only if the alien files Form 8843, Statement for Exempt Individuals and Individuals with a Medical Condition to claim the medical exception.
There may also be an exception under a tax treaty with the foreign country, where the alien will not be treated as a resident alien even if the green card test or 183-day test is satisfied.
An alien will not be treated as a resident alien if he was present in the US for fewer than 183 days, maintains a tax home in the foreign country, and has a closer connection to that country. A tax home is the place where the alien has a business or regularly lives there, but having a tax home outside the United States is not sufficient to be treated as a nonresident alien: a closer connection must also be demonstrated and reported by filing Form 8840, Closer Connection Exception Statement for Aliens report the basis of the claim. However, this exception will not apply if the alien was present in the US for more than 183 days in the current year or applied for a green card. Likewise, a foreign student will not be treated as a resident alien if the student complies with visa requirements, maintained a closer connection to a foreign country and has not taken any steps to become a lawful permanent resident of the United States.
There is an exception for counting the days under the 183-day test for the following people: teacher, student, trainee, foreign government related person, or professional athlete competing in a charitable sports event. A foreign government related person is:
- one who has diplomatic or consular status
- a full-time employee of an international organization; or
- an immediate family member of any thereof.
Teachers or trainees require a "J" or "Q" visa and a student must have either of those visas or an "F" or "M" visa, and compliance for those visas must be maintained.
However, these exceptions are time-limited. The visa exception will not apply if it was used in 2 years of the past 6 years, unless all compensation was received outside of the US and the exception has not been used for more than 3 years in the past 6 years. The exception will also not apply to students if the visa exception, including as a teacher or a trainee, was used for more than 5 calendar years unless the alien reports that there is no intention to stay within the US and that the requirements of the student visa were satisfied.
Taxation of Resident Aliens
Like a US citizen, a resident alien is taxed on all worldwide income, including a pension received from a foreign government and uses the same tax forms as US citizens. However, the resident alien can claim an exclusion for foreign earned income or a foreign tax credit if taxes are paid in the foreign country. A resident alien who works for a foreign government in the United States is not taxed if the foreign government allows a similar exemption for United States citizens working in the foreign country.
In the 1st year that the alien received a green card or the 183-day test applies, US residency begins on the earlier of when the alien was present in the United States as a lawful resident or on the 1st day of physical presence.
Taxation of Nonresident Aliens
A nonresident alien must pay taxes on income sourced from the US or from a US trade or business (taxable foreign income), using Form 1040 NR, U.S. Nonresident Alien Income Tax Return or Form 1040NR-EZ, U.S. Income Tax Return for Certain Nonresident Aliens with No Dependents. An NRA must file a tax return even if no US taxable income was earned, if the NRA engaged in a trade or business within the US during the tax year. US sourced income received by an NRA that is not effectively connected with the conduct of a US trade or business is subject to a 30% withholding tax on the following types of income: dividends, interest, rents, royalties, premiums, annuities, and any annual or periodic (FDAP) income that is fixed and determinable. The payers of this income are required to withhold 30% of the gross amounts. However, Canadians and Mexicans are permitted dependency exemptions.
An NRA does not have to pay tax on some types of income:
- some tax-exempt income, such as the interest received from certain debt instruments, even if US sourced;
- interest earned on deposits and banking institutions as long as the income was not effectively connected with US trade or business;
- likewise for capital gains not connected with a US trade or business, but only if the NRA was not present in the US during the taxable year for 183 days or more. Capital losses, however, cannot be carried forward.
Nonresident Aliens Engaged in a US Trade or Business
The United States taxes US sourced income that is effectively connected to a US trade or business operated by an NRA. Effectively connected means that the business conducts any management, production, distribution, or other major business functions within the borders of the US that is regular, substantial, and continuous. Another strong determinant is if the NRA has an office in the US or some other place of business.
If an NRA has a US trade or business, then any income that is US sourced becomes effectively connected income, which is taxed. For instance, suppose a French wine producer exports wine to unrelated parties in the US. Although the income is US sourced, it is not subject to taxation, since the wine exporter has no place of business within the US nor does he conduct any activities related to business specifically in the US. But if the exporter then also opens a restaurant in the US, then all income earned from both the restaurant and the wine exports – in other words, all US sourced income – becomes taxable.
On the other hand, capital gain and FDAP income will only be considered effectively connected income either if the asset satisfied the asset-use test, where the assets are either used or held for use in a US business or if the activities satisfy the business-activities test, meaning that they were a material factor in producing the income.
So, for instance, if a business owner accumulates excess funds from a US business and invests that money in the short-term debt of a foreign country so that it is available for business, then the income generated is effectively connected income and therefore taxable.
FDAP income is generally subjected to a 30% withholding tax by the US, so that the US can easily collect the money without trying to collect it from foreign jurisdictions. However, the withholding provisions may be modified by US tax treaties, which can be found in IRS Publication 901, US Tax Treaties.
Dual Status Tax Year
Unless an NRA becomes a lawful permanent resident at the beginning of the year, the resident alien will have a dual status tax year, where part of the year was spent as an NRA and the remaining part was spent as a permanent resident, in which case, both the regular tax forms and the NRA form must be filed. The Form 1040 for US citizens and residents should be marked at the top with "Dual-Status Return" and the NRA form should be marked as "Dual-Status Statement". As an NRA, tax must be paid on US taxable foreign income; as a permanent resident, taxes must be paid on all worldwide income, including income received that would not have been taxable to an NRA.
If an NRA is married to a US citizen or resident alien, then the NRA can be treated as a resident alien for the entire year if both spouses report their worldwide income, file jointly, and attach a statement signed by both spouses that the NRA wants to be treated as a full-year resident.
An NRA also has a choice to be treated as a US resident since the time of his arrival to the US, but failed to qualify as a US resident under the green card test or the 183-day test in that year, but qualifies in the following year. The NRA must have been present in the US in the year of the arrival at least 31 consecutive days and for 75% of those days from the beginning of the consecutive period until the end of the year, although an absence of up to 5 days can be treated as a presence in the US for this rule.
If the taxpayer ends permanent resident status, then the final year of residency will also be a dual status tax year. However, if residency is being terminated to avoid the payment of US taxes, then the taxpayer may be subject to expatriation taxes.
Certificate of Tax Compliance for Alien Leaving the United States
An alien who plans on leaving the United States permanently must obtain a sailing or departure permit, otherwise known as a certificate of tax compliance. Diplomats, students, and employees of international organizations and foreign governments are exempt from the permit requirement. Form 1040-C, U.S. Departing Alien Income Tax Return, or, the shorter Form 2063, U.S. Departing Alien Income Tax Statement, must be filed. Form 2063 can be filed if there is no income from US taxable sources or if a residency termination assessment has not been made. If the IRS determines that the tax collection for the year will not be in jeopardy, then no prepayment of tax or the posting of a bond will be required before leaving the country.
Section 7701(a)(5) defines a foreign corporation as one that is not domestic, meaning that the corporation was incorporated or organized outside of the United States. Foreign corporations are taxed on their US-sourced income at the same rate as domestic corporations.
US-sourced FDAP income earned by a foreign corporation is taxed by the US at 30%. They also qualify for the same exemptions for investment income as NRA's. Capital gains are exempt if they are not effectively connected with a US business. As with individual NRA's, foreign corporations with effectively connected US income are taxed. FDAP or capital gain income is also taxable if it meets either the asset-use or business-activities tests.
Branch Profits Tax
If not modified by a tax treaty, then IRC §882 imposes a 30% tax on effectively connected income of the dividend equivalent amount (DEA) on top of the United States corporate tax on a foreign subsidiary operating within the US. The DEA is any income that is effectively connected to a US business minus any amount reinvested in the US business.
US Net Equity Increase = US Equity at End of Tax Year - US Equity at Start of Tax Year
Dividend Equivalent Amount = Income Effectively Connected to a US Business – US Net Equity Increase
Note that the branch profits tax is applied to any earnings effectively connected with a US business that is remitted outside of the United States.
Example: Branch Profits Tax
A foreign corporation has a US branch, described by the following:
|Pretax earnings effectively connected with a US trade or business||$20,000,000|
|US Corporate Tax Rate||35%|
|US Corporate Tax||$7,000,000||= Pretax Effectively Connected Earnings × US Corporate Tax Rate|
|Remittance to Foreign Home Office||$4,000,000|
|Branch Profits Tax Computation|
|Income Effectively Connected with a US Business||$13,000,000||= Pretax Effectively Connected Earnings – US Corporate Tax|
|US Net Equity Increase||$9,000,000||= Effectively Connected Income – Remittance to Home Office|
|Dividend Equivalent Amount||$4,000,000||= Effectively Connected Income – US Net Equity Increase|
|Branch Profits Tax Rate||30%|
|Branch Profits Tax||$1,200,000||= Dividend Equivalent Amount × Branch Profits Tax Rate|
Note that the branch profits tax is proportional to the amount of money sent back to the foreign home-office, for if the US business keeps all the pretax earnings within the US, not remitting any money to the home office, then it will not be subject to the additional branch profits tax, since the effectively connected income will equal the increase in US net equity, yielding a dividend equivalent amount equal to 0.