Foreign investors, including individuals and corporations, are subject to U.S. tax on their share of income derived from U.S. sources through various forms of investment vehicles. These sources of income can include income earned from a trade or business, income earned from passive sources, and capital gains from the interest on the sale of real property. As with all areas of taxation, there are exceptions to the general tax requirements and reduced tax rates available to qualifying investors; thus, foreign persons investing in the U.S. should seek tax planning advice to reduce tax exposure and the burden of compliance.
Determine Whether Income is U.S. or Foreign Source
First, foreign taxpayers should understand how different types of income should be sourced between U.S. and foreign jurisdictions as this would impact the taxability of the income. The U.S. has established rules that govern the sourcing of income. Generally, interest and dividends paid by a U.S. corporation are sourced to the U.S. On the other hand, the source of rent and royalty income for the use of property is determined based on where the property is located. The income from the sale of personal property by a foreign corporation is generally treated as deriving from a foreign source. However, if that same foreign corporation has an office or fixed place of business in the U.S. the income then becomes U.S. sourced income. Furthermore, if personal property, such as inventory, is purchased outside the U.S. and then sold within the U.S., the income is sourced to the U.S. Conversely, if that same inventory was purchased in the U.S. and sold outside the U.S. then the income is considered to be foreign-sourced. There are special rules regarding the production and sale of inventory property which makes it important to distinguish between inventory purchased versus inventory produced (manufactured). In cases where the inventory is produced, the income is sourced solely based on the place where production activities occur, i.e., on U.S. soil, overseas, or a combination of both.
Income from Regular Trade or Business
U.S. citizens and residents pay taxes on their worldwide source income. This means that U.S. persons are expected to report and pay taxes on income earned in any country in the world. Similarly, if a non-U.S. person receives income from a regular trade or business that is operated in the U.S., he or she will be subject to the U.S. taxation on that income which is referred to as “effectively connected income”. Regular trade or business is business that requires active participation, for example, having an ownership interest in a restaurant or gas station, and similar businesses. The foreign owner, individual or corporation, will be required to pay U.S. income taxes on this income and may be required to file a U.S. income tax return.
Furthermore, foreign partners who invest directly or indirectly in a U.S. partnership that has effectively connected income from a trade or business will be subject to withholding on the net effectively connected income at the highest marginal rates for individuals and corporations, respectively. The applicable tax rates in 2020 were 37% for individuals and 21% for corporations.
Income Earned from Passive Sources
Foreign investors are subject to taxation at a flat 30% tax rate on the gross income from passive U.S. sources. Passive income includes interest, dividends, rents, annuities, and other U.S. income that is fixed, determinable, annual, or periodic (FDAP) and which is not connected to a U.S. trade or business.
There are special tax rules for nonresident alien individuals renting U.S. real property for income. As mentioned above, rental payments on real property to foreign investors are also subject to withholding at the flat 30% rate on the gross rents. In this case, the withholding responsibility falls on the tenant, lessee, or property manager who is expected to withhold and pay over to the IRS a significant portion of the rent payments. Foreign investors can avoid this flat rate withholding by electing to treat the rental income as effectively connected income. This allows the foreign taxpayer to claim related rental expenses like property taxes, mortgage interest, and other rental expenses against the gross rental income, and thus only pay taxes on the net rental income from the property.
In addition, nonresident individuals and foreign corporations may be exempted from this 30% withholding tax on portfolio interest. Portfolio interest is interest paid on obligations that are in registered form which means that there is a record of ownership maintained by the issuer that identifies the owner, principal, and stated interest. Congress provided the portfolio interest exemption because they believed that imposing a withholding tax for debt obligations issued by U.S. persons could impair the ability of U.S. corporations to raise capital in the global markets.
Capital Gains on Sales or Transfer of U.S. Real Property
Non-U. S persons are exempt from capital gains from the sale of U.S. securities and other capital assets unless the gain is effectively connected to a U.S. trade or business. There are special rules when the foreign seller has interest in U.S. real property or owns stock in a U.S corporation that has significant holdings in U.S. real property interest. The capital gain from the sale or transfer of the U.S. real property by foreign investors would be treated as gains effectively connected to a U.S. trade or business and would be subject to tax and related withholding requirements. The buyer of the property is required to withhold 15% of the gross proceeds of the sale and remit that amount to the IRS under the Foreign Investment in Real Property Tax Act (FIRPTA). The purpose of this act is to provide an incentive for foreign sellers to file tax returns with the IRS in order to report income from the sale and claim tax credits which can lead to a refund for taxes already withheld and paid to the IRS by the U.S. withholding agent.
FIRPTA withholding rules also apply to foreign partners who have an indirect interest in a partnership, estate, or trust that holds U.S. real property interest. The foreign partner would be subject to U.S. tax on the capital gain from the sale of their partnership interest in the entity that holds the U.S. real property interest. In addition, the foreign partner will also recognize ordinary income on the portion of the gain that is attributable to unrealized receivables and inventory.
The taxation of foreign investors in the U.S. is a continually evolving area that provides a lot of planning considerations for foreign investors and withholding agents. It is imperative that both the U.S. withholding agent and the foreign person understand the sourcing of income and respective tax filing and payment obligations. A U.S. withholding agent, including a tenant, may be held liable for the payment of the tax and any penalties and interest if they fail to withhold the tax on payments to foreign investors, where applicable.
If you have questions about any aspects on how your income should be sourced or treated, please contact your Untracht Early tax advisor.