A taxpayer’s residency classification is a threshold issue for determining the applicability of U.S. taxation in international tax issues. We will consider the U.S. tax jurisdiction on “domestic” taxpayers. Generally, United States citizens, United States residents, and domestic corporations are subject to tax on their worldwide income. Nonresident alien individuals and foreign corporations are typically subject to U.S. taxation only on specified items or types of income.
How are U.S. Citizens Taxed Internationally?
The U.S. imposes taxation on the worldwide income of U.S. citizens, whether they reside in the United States or abroad. This can come as a surprise to a U.S. citizen that is a resident in Mexico and earns a salary in Mexico, for example. That income, although taxed by Mexico, will also be taxed by the U.S. However, they may receive favorable taxation of that income earned outside the U.S. through the use of foreign tax credits and treaties. Nonetheless, the individual is required to report all income, even if no tax is owed on that income in the U.S. The validity of worldwide taxation was upheld by the Supreme Court in Cook v. Tate. 265 U.S. 47 (1924). This worldwide taxation is the price one pays for the protection and benefits of being a U.S. citizen or resident.
How are “U.S. Residents” Taxed Internationally?
Residency is considered for any foreign national residing in the U.S. Besides being a U.S. citizen, one may be liable for tax on worldwide income if considered a U.S. resident. Residency is defined in I.R.C. §7701(b) and provides a “bright line” test. The two most common ways an individual is considered to be a resident of the U.S. is if the individual meets one of these tests: lawful admission to the United States (“green card” test); “substantial presence” in the United States.
Green Card Test:
The “green card” test applies to a foreign national who is a “lawful permanent resident of the United States”. Like a U.S. citizen, a green card holder cannot avoid worldwide taxation. This is a simple test based on the immigration status of the individual.
Substantial Presence Test:
An individual is considered a U.S. resident for U.S tax purposes if that individual is present in the United States for at least 31 days during the current year and at least 183 days for the three-year period ending on the last day of the current year using a weighted average. I.R.C. §7701(b)(3). The weighted average works as follows: days present in the current year are multiplied by 1; days in the immediate preceding year are multiplied by 1/3; days in the next preceding year are multiplied by 1/6. An individual is present in the U.S. on any day the individual is physically present at any time during the day (except for commuters from Mexico and Canada). I.R.C. §7701(b)(7).
The substantial presence test is for individuals. The residency test for corporations is much simpler. A U.S. corporation is taxable on its worldwide income if the corporation was created or organized in the United States, regardless of where the income was earned.
Inbound vs. Outbound Taxable Transactions
Transactions involving international tax are categorized as either “inbound” or “outbound.” Outbound transactions can be simple in a sense because there is always a U.S. taxpayer and that taxpayer is sending money abroad. However, the taxation of inbound transactions can be more complicated because it deals with nonresident aliens and foreign corporations that are doing business in the U.S. They are not taxed on their worldwide income – like is the case in outbound transactions – so special rules are made to decide which income will be taxed in the U.S. These rules are what we call “source rules” wherein the U.S. will only tax nonresidents on their income that is somehow connected to the U.S. Even if income is considered sourced in the U.S., foreigners can potentially minimize U.S. tax exposure through the use of U.S. tax treaties with their home country. These treaties override U.S. tax law as it relates to taxation of a foreigner.
Which Kinds of Income of a Foreign Person Can be Taxed by the U.S.?
There are two main types of income that will be taxed by the U.S. if one is a foreign person (nonresident alien or foreign corporation) and the income is sourced in the United States. There is passive income earned in the U.S. and there are business profits attributable to U.S. activity. Although there are some differences in how a nonresident alien and a foreign corporation are taxed on U.S. sourced income, we will consider the areas where the taxation is the same for both.
What is considered Passive Income and how is it taxed if I am Foreign?
Passive income is known as “fixed, determinable, annual, and periodical income” also known as FDAP. This income will be subject to a 30% withholding tax on the gross amount of the payment (§§1441-1445). The payor of the income is the party who must withhold the 30% and remit it to the IRS. In addition, §1461 states that every person required to withhold tax is made primarily liable if the tax is not paid. This is because of the difficulty for the U.S. to go after foreign citizens that do not file U.S. tax returns. Examples of FDAP include passive income such as interest, dividends, royalties, and rents. Exceptions to FDAP include gains from the sale of property (including gains from sale of stock in U.S. corporations), interest paid on bank deposits, certain dividends from U.S. companies earning most of their income from an active foreign business, and portfolio interest income.
How do I know if I have Business Income that will be taxed?
The U.S. taxes U.S. sourced business income of a foreign person that is “effectively connected” with a U.S. trade or business, also know as “ECI”. Unlike the tax on FDAP that taxes gross amounts, effectively connected income is taxed on the net amount of the business income at graduated rates. A “U.S. trade or business” is a threshold question. Basically, performing services in the U.S. is a U.S. trade or business. It also includes any other “regular, continuous, substantial” economic activity in the U.S. There are many details regarding what is considered a U.S. trade or business that can be found in § 864(b). Mere ownership of U.S. property, however, is not enough – like owning shares of stock or real estate. In those cases, there must be some sort of active, continuous, and regular managing of the assets for it to be considered a U.S. trade or business. If a foreign person is deemed to have a U.S. trade or business, then any U.S. source income that is not FDAP or capital gain is automatically considered to be “effectively connected” with that U.S. trade or business.
Seeking The Help Of A Qualified Tax Attorney For Assistance In International Tax Cases
US tax law is complex and complicated. Those complications are significantly increased when compounded with the tax laws of foreign countries. It is critically important for anyone dealing with international tax issues to seek the help of an experienced tax attorney.
The Tax Lawyer - William D Hartsock has been resolving international tax issues for clients since the mid 1980's. Mr. Hartsock offers free consultations with the full benefit and protections of attorney client privilege. Call for your free consultation today.