How To: taxation

With this second and final part we will be concluding our tax chapters. However, we will certainly return to other aspects of this important issue in the future.

Taxation of non-immigrants Reminder: in our last newsletter we had a look at how US tax law classifies people as immigrants (resident alien) and non-immigrants. This differentiation is important because for the first category, the worldwide income will be subject to taxation, while non-immigrants only have to pay taxes on the money they are earning from US sources.

Let us briefly summarize last months' results again:

Foreigners with a green card status who have spent at least 183 days of the past year and the two years prior to it in the US (and at least 31 days of the current year) will be classified as RESIDENT2 under fiscal law. There are exceptions to this rule: the first is for people who have closer ties to another country than they have to the US. Other exceptions allow some individuals to exclude certain days from the 183-days rule. Others can state days of medical treatment for health reasons and transit times between two points outside the US for this. Last but not least, under certain circumstances a non-immigrant can also ask to be classified as an immigrant.

In this newsletter, we want to look at it from a different angle. This time, we will be looking at the taxes for NON-IMMIGRANTS. Under immigration law this includes all people who are in the US on a student, internship and tourist visa. Others are those who are in the US with a temporary work permit. The first group of people is a defined group not bound to a specific company in the US. The other group are people who have a business/company in the US themselves. Especially the regulations for non-immigrants tend to be a little confusing, so that we are going to focus on the general rules and a few exceptions.

Income from non-business transactions Income that is not directly related to trade or business activities is generally exempt from taxation. Unless it is form US sources and included in the definition of the so-called fixed or determinable annual or periodical gains, profits, and income (FDAP). This term includes wages and salaries, interest, dividends, rental and license income from US sources, but does not include capital income or other forms of income from property sales. Taxes are a lump sum of 30% and to be paid by the person who deducts taxes from the non-immigrants income and pays them to internal revenue. The taxes are already deducted form the total income, this means that no further tax credits are available on income tax. The system of withholding tax reflects the problem of taxing non-immigrants who often aren't physically present in the US, have no close ties such as a place of residence there or are not employed if the US.

Since the expenditure tax is not allowed, the withholding tax takes on a confiscating character. For example, the prohibition of value decreasing expenditure for lump-sum taxation often causes a 30% tax on net income. In some cases the withholding tax even applies if the non-immigrant doesn't even have taxable income in the US. Therefore, the US have created a number of exceptions, e.g. for different forms of income from interest. Within a limited frame the non-immigrant can pay a lump-sum tax on capital income, even though income like that is usually excluded from tax at source.

Taxation of FDAP

WAGES, SALARIES AND SEVERANCE PAY

Wages, salaries and severance payments are included in the FDAP regulations. For non-immigrants they will be taxed either a) with 30% withholding tax or b) same as for US citizens and immigrants taxed at source. Wages, salaries and severance payments will be seen as coming from US sources if the income has been earned in the US. If compensation payments do not exceed a maximum of $3,000 a year, they will not be treated as US sources and not be subject to US taxation at source. The requirement is that the non-immigrant a) is in the US for a limited time only and b) for no more than 90 days and c) the employer himself is an alien with no business activities in the US or is working in a foreign subsidiary of a US company. Please not that while income such as this is not subject to taxation at source, it s still subject to other tax regulations described below.

SCHOLARSHIPS AND FINANCIAL AID FOR STUDENTS AND RESEARCHERS

Also scholarships and financial aid for students or researchers at US institutions who are in the US for a limited time only are subject to taxation (Visa types F,J, M or Q). Tax rates are limited to 14%, however. The taxation does not include expenditures that are directly related to the purpose of the stay (specialist literature etc). However, expenditures for regular costs of living are taxable at source.

INTEREST INCOME

Taxation of interest income is probably the most difficult part of the FDAP. In general, taxes will be raised on the gross value of the non-immigrant's interest income. However, the US can be a tax haven, because US Congress has left quite a few loopholes in the respective law. For example the exception for portfolio interest income and interest from bank balances. These exceptions allow non-immigrants massive capital flow to US persons without having to pay taxes on interest.

EXCEPTIONS

PORTFOLIO INTEREST

The exception for income from portfolio interests has originally been introduced to allow US (stock) corporations to participate directly in the European Eurobond market. If this exception hadn't been created, US corporations would have been hardly interested in participating in the international market with US obligations. Apparently, international investors always want to make sure that their global activities cannot be subject to US taxation.

In case the investment income is registered by name, the exception only applies if the investor is not a US immigrant. The person who would have to pay taxes on the interest income has to submit form W-8 of the internal revenue service.

At this point, a few further pieces of information should follow. However, we have decided against this since even the simplified form of US legal terminology is difficult to understand even for investment experts. Better leave that to a US tax consultant, who, in turn, will probably not explain the process in too much detail.

INCOME FROM BANK DEPOSITS

Interest income from bank deposits is generally exempt from withholding tax in order to give aliens an incentive to invest their capital in the US. This exception can also be used for savings in the home country.

Taxation of:

DIVIDENDS

The 30% withholding tax also applies to income from dividends of US sources, it is irrelevant whether they are paid in movable or immovable property. Money from US (stock) corporations always qualifies as US source. Payments from foreign corporations are generally foreign sources. A dividend can be partially or completely exempt from taxation if at least 80% of the gross income from all US sources is derived from trade or business transactions abroad or if is US property. In order to determine this, the three years preceding the dividend payments will be used as a basis for calculation. Dividends from foreign stock corporations will be treated as US sources and taxed with 25% or more withholding tax. Requirement is that the foreign corporation's gross income within the last three years has been directly related to trade or business transactions.

RENTAL INCOME

Rental income from US sources will be taxed where it was created, meaning in the US. However, cases like this are very rare. This is because property management often turns out to be quite similar to trade and business activities under tax law. This would mean, however, that income from sources like these could qualify for the FDAP exceptions. The foreign investor can have his activities classified according to the above mentioned regulations anyway. This option has a great advantage in this case: the foreign investor who would usually have to pay the FDAP withholding tax can have fixed expenditures related to the property management deducted from taxes.

LICENSES

Income from licenses on US soil are also subject to withholding tax. Under certain circumstances this also applies to selling intellectual property.

Effects of the double taxation agreements The double taxation agreements in many cases mean that less or no withholding tax needs to be paid on the above mentioned kinds of income. The agreements, for example, offer generous regulations for tax exemption or reduction in tax for non-immigrants who have income in the form of wages and are only temporarily in the US, for example on a temporary work visa. This may apply if the non-immigrant is in the US for less than 183 days during one fiscal year, and if the employer is not a US resident and the compensation is not in the form of a steady place of employment for the alien in the US.

Income from US trade or business relations Effectively connected income (ECI) will be taxed on a net basis. This means that the non-immigrant should consider stating all possible deductions in his tax return. Furthermore, there is the option of paying taxes after the end of the actual fiscal year or to be granted the option of paying the taxes in single increments instead of the entire lump sum of 30%.

Classifying whether the income qualifies as ECI can be a tedious process. Usually, the methods are similar as those of the FDAP regulations. The first classification applies if the capital in question is capital used for managing a US business. The second classification applies if the business activities of the US business are a material factor of realized income. The elements that are usually not included in the FDAP, meaning profits from selling office inventory, will be seen as connection to a US business if the source is inside the US. One example: a foreign (stock) corporation has a US subsidiary selling office inventory and a foreign subsidiary selling computer equipment. In this case, the selling of computer equipment would be classified as ECI.

Results of the double taxation agreements In most double taxation agreements, business profits of a resident made in another country will only be taxed if the resident has a permanent establishment and the profits are derived from it. Such a permanent establishment (PE) exists if the business operations are conducted from there partly or entirely. Examples for PEs are office rooms. However, certain office environments can again be exempt from taxation and thus also the profits made from there.

Postscript: We are aware of the fact that tax law in the US is a very complex topic. We tried to make it as simple as possible here. However, if you need specific advice, please ask a US tax consultant. We will be glad to get you in touch with one.