Inbound Transactions – Non-Business Income
Now that we’ve distinguished between US persons and non-US persons we will focus strictly on non-US persons and how their activities in the US cause them to be subject to US taxation.
From the reading you will note that when we are looking at the activities of non-US persons, we distinguish between Business Income and Non-Business Income (or Investment Income):
Business Income will be taxed according the usual tax regime where we start with Gross Income, reduce it by Deductions and tax the Net Income at graduated tax rates (this is called a Net Tax).
Non-Business/Investment Income will be subject to a withholding tax of 30% on the Gross amount. In this case there is only one tax rate, 30%, and no deductions are offered (this is called a Gross Tax).
Non-Business/Investment Income is basically passive income such as interest, dividends, royalties, rents and capital gain. In other words, it is the type of income that one earns strictly from ownership of property. This income is also referred to as Fixed, Determinable, Annual & Periodic income (FDAP income), although it need not be fixed, determinable, annual or periodic.
The primary reason that the Tax Code makes a distinction between tax regimes for Business Income and Non-Business Income is because of the practicality of collecting the income. Since Investment Income merely requires ownership, it is possible for a foreign individual to own US debt, equities, intangibles or other property without having any physical presence or activities in the US. It would therefore be very difficult to collect this tax from the foreign person since they would be beyond the jurisdiction of the US. As a result, the Tax Code imposes a fixed withholding rate of 30% on this type of income. The payor of the income is responsible for withholding the amount and since the payor is within the jurisdiction of the US, they have an incentive to make these payments of the payee’s behalf.
If Investment Income is US source income it may be subject to the withholding tax. Note however, that sometimes Investment Income may be US source income but it will not be subject to the withholding tax because it falls under one of the exceptions to FDAP Income.
A Note on Tax Treaties
The US has entered into a number of Income Tax Treaties with other foreign countries. These treaties have a number of provisions that we will be discussing throughout the course. There are provisions that operate to reduce or eliminate the withholding tax on FDAP Income. Instead of requiring a 30% withholding tax, many Tax Treaties override the Code and allow for a reduced rate such as 10% withholding for dividends or no withholding for interest income (the specific reductions vary from treaty to treaty).
A Note on Capital Gain
Capital Gain is earned from the disposition or exchange of a capital asset. Capital Assets may be Personal Property or Real Property. Stocks and other securities are examples of Personal Property that generate Capital Gain. Generally, Capital Gain from Personal Property is not subject to withholding tax. Hence, a non-US person who earns Capital Gain on the disposition or exchange of Personal Property will not be subject to any US withholding tax on that gain.
Capital Gain from Real Property is taxed under a different tax regime under FIRPTA (Foreign Investment in Real Property Tax Act) which we will be discussing in two weeks. Unlike personal property, Capital Gain from the sale of US real property by a non-US person will be subject to US tax.
Summary
To recap, when you are dealing with a non-US person conduct the following analysis:
– Distinguish between business and non-business/investment income,
– Identify the non-business/investment income that is US source income,
– Determine if the income falls under one of the exceptions to FDAP,
– Apply the withholding tax of 30%, or a lower rate provided by a tax treaty.
Next week we will focus on the tax consequences of Non-US persons earning Business Income in the US.