US Federal Income Taxation of Non-US Citizens

By Paul Bercovici  |  November 7, 2018

US CITIZENS ARE SUBJECT TO US FEDERAL INCOME TAX ON THEIR WORLDWIDE INCOME

For US federal income tax purposes, an “alien” is an individual who is not a US citizen. As a general rule, “resident aliens” are subject to US federal income tax on their worldwide income. In contrast, “nonresident aliens” are generally subject to US federal income tax only on their US source “passive” income and on income effectively connected with the conduct of a trade or business in the US.

RESIDENT ALIEN OR NONRESIDENT ALIEN?

Aliens are treated as nonresident aliens for US federal income tax purposes unless:

1. They are “lawful permanent residents” of the US (i.e., holders of an “alien registration card”, commonly referred to as a “green card”); or
2. They meet the “substantial presence test”.

Therefore, a non-citizen and non-green card holder will be treated as a resident alien for US federal income tax purposes only if he or she meets the substantial presence test. However, even if an individual meets the substantial presence test they will be treated as a nonresident alien if they also meet the “closer connection test”.

SUBSTANTIAL PRESENCE TEST

In determining whether or not an individual meets the substantial presence test for the 2018 tax year, the individual must be physically present in the US on at least:

1. 31 days during 2018, and
2. 183 days during the 3- year period that includes 2018, 2017 and 2016, counting:
   a. All of the days that the individual was physically present in the US in 2018;
   b. 1/3 of the days that the individual was physically present in the US in 2017; and
   c. 1/6 of the days that the individual was physically present in the US in 2016

The substantial presence test is to be applied on an annual basis. A particular individual’s status under the substantial presence test can change from year to year. For the purposes of the substantial presence test, an individual is treated as being physically present in the US on any day that the individual is physically present in the country at any time during the day.

There are certain exceptions to the above-noted rule that an individual is treated as being physically present in the US on any day that the individual is physically present in the country at any time during the day, including the exception for regular commuters to the US from Canada and Mexico, days that an individual is in the US for less than 24 hours when they are in transit between two places outside of the US and days that an individual is unable to leave the US due to a medical condition that arose while they were in the US.

The most important exception is the one for days that an individual was an “exempt individual”. That is, days that the individual was physically present in the US but for which he or she was an exempt individual do not count in the determination of whether or not the individual meets the 183 day threshold for the purposes of the substantial presence test. The term exempt individual includes individuals temporarily present in the US as foreign government related individuals, certain teachers and trainees and certain students.

CLOSER CONNECTION TO A FOREIGN COUNTRY

As noted above, an individual who meets the substantial presence test will nevertheless be treated as a nonresident alien if he or she also meets the closer connection test.

In order to meet the closer connection test, an individual must:

• Be present in the US for less than 183 days during the year,
• Maintain a “tax home” in a foreign country during the year, and
• Have a “closer connection” during the year to one foreign country in which the individual has a tax home than to the US.

An individual’s tax home is the general area of the individual’s main place of business, employment or post of duty, regardless of where he or she maintains their family home. An individual’s “tax home” is the place where they permanently or indefinitely work as an employee or as a self-employed individual.

As a general rule, an individual will be considered to have a closer connection to another country than to the US if it is established that the individual has maintained more significant contracts with the foreign country than with the US. Some of the factors that are evaluated in making the determination include the location of the individual’s permanent home, where the individual’s family resides, he location of the individual’s business activities and the country of residence that the individual designates on forms and documents.

POSSIBLE APPLICATION OF INCOME TAX TREATIES

In general, where an individual is considered to be a resident of both the US and a foreign country under the domestic laws of each country, the individual’s residency status for income tax treaty purposes is determined by the successive application of a series of residency “tie-breaker” rules. Most (if not all) bilateral income tax treaties entered into between the US and other countries include residency tie-breaker rules. For example, under the Canada-US Income Tax Treaty, the first test prong of the residency tie-breaker tests is the location of the individual’s “permanent home”. If the individual has a permanent home in both jurisdictions (or in neither jurisdiction), the next test is where is the individual’s “centre of vital interests”. As a general rule, a taxpayer’s centre of vital interests is considered to be where his or her personal and economic relations are closer. The location of an individual’s centre of vital interests is determined by examining his or her family and social relations, occupation, political, cultural and other activities, place of business, and the place from which his or her property is administered.

In almost all cases, the determination of a single state of residency is made by applying the centre of vital interests prong of the residency tie-breaker tests. In those cases where an individual’s single state of residency still cannot be determined by applying the centre of vital interests test, factors such as “habitual abode” and citizenship are considered. Where application of all the residency tiebreaker tests does not give rise to the conclusion that a particular individual is a resident of one Contracting State and not the other, the determination is to be made by mutual agreement of the competent authorities of the two Contracting States.

An individual who is determined to be a resident of a foreign country (and not the US) by application of treaty residency tie-breaker rules is treated as a nonresident of the US for the purposes of determining his or her US federal income tax liability.

US FEDERAL INCOME TAXATION OF NONRESIDENT ALIENS

Nonresident aliens are subject to US federal income tax on two separate and distinct categories of income:

(i.)    income that is effectively connected with the conduct of a trade or business in the US (referred to as “ECI”); and

(ii.)   income that is not ECI.

Taxation of Effectively Connected Income

ECI is taxed at the same graduated income tax rates that apply to citizens and resident aliens. The most common type of income of a nonresident alien that is considered to be ECI is income derived from the provision of personal services in the US. Other examples of types of income of a nonresident alien that are considered to be ECI include scholarship or fellowship income received by a student or trainee, income derived from the ownership and operation of a business in the US and income allocated to a nonresident partner by a partnership that is engaged in a trade or business in the US.

Taxation of Non-Effectively Connected Income

Nonresident aliens who are not actively engaged in the conduct of a US trade or business (i.e., passive investors) are subject to US federal withholding tax on Fixed or Determinable, Annual or Periodical (“FDAP”) income which they receive from US sources.

FIXED OR DETERMINABLE, ANNUAL OR PERIODICAL INCOME

FDAP income is generally passive investment income and includes dividends, interest, rents and royalties. The US federal withholding tax rate on US source FDAP income is 30%. However, the 30% domestic withholding rate on FDAP income may be reduced under the provisions of an applicable income tax treaty entered into between the US and the nonresident alien recipient’s country of residence. For example, under the terms of the Canada-US Income Tax Treaty, the general withholding tax rate on dividends that can be imposed by the country of source is 15% and the withholding tax rate on interest that can be imposed by the country of source is zero percent.

Under US tax principles, interest and dividend income received by a non-resident payee are considered US source income if the payer of the income is resident in the US. Rents are US source income if the rental producing property is located in the US. Similarly, royalties paid for the use of intellectual property are US source income if the intellectual property is used in the US.

Non-resident recipients of US source income are able to establish their right to treaty-reduced withholding rates by timely submitting certain Internal Revenue Service (“IRS”) forms to the payer of the income. The withholding forms do not have to be filed with the IRS. Payers of the income are generally entitled to rely on such withholding forms to withhold at the applicable treaty reduced rate, and not at the otherwise applicable US domestic withholding tax rate of 30%.

This article originally appeared in the October 2018 issue of the Taxes & Wealth Management publication by Thompson Reuters.

About Paul Bercovici