For U.S. income taxation purposes, the IRC (Internal Revenue Code wikipedia entry) provides that an alien individual is treated as a resident of the U.S. with respect to any calendar year if (and only if):
- Such individual meets the substantial presence test2
- Is a lawful permanent resident of the US. at any time during such calendar year,3 or
- Makes a ﬁrst-year election4
U.S. resident aliens are taxed on worldwide income5 while non-resident aliens are taxed only on their taxable U.S. source income.6
Under most U.S. income tax treaties, green card holders are generally considered U.S. residents for income tax purposes as well.7
There are, however, instances where an individual may be deemed an income tax resident of both the US. and another treaty country for a given tax year.
In such cases, the tax residence is determined by the tiebreaker rules of the governing treaty, so that the individual would be taxed by only one of the two countries.8
Thus, an analysis of the applicable U.S. income tax treaty is necessary to determine the individual’s income tax residence for the given year.9
Income tax treaties do not eliminate, only modify, taxation of income derived from U.S. situs property, an issue addressed later in this article.
The federal government taxes foreign investors under one of two tax regimes:
- U.S. trade or business income tax regime.
- Passive income tax regime.
U.S. trade or business income tax regime
When a foreign investor is engaged in a U.S. trade or business, any income effectively connected with such will be taxed on a net10 basis at the regular graduated tax rates (in the same manner U.S. persons are taxed).11
Although the IRC and Treasury Regulations provide no comprehensive deﬁnition for the term “trade or business,” the determination of what activities give rise to such classiﬁcation has developed through case law and IRS rulings and depends heavily on the facts and circumstances of each case.12
The courts apply a qualitative (the nature of activity) and quantitative (the amount of activity) analysis for determining whether the U.S. activities constitute engagement in a US trade or business.13
Generally, a US. trade or business exists when the taxpayer is engaged in “considerable, continuous and regular” economic activities within the United States.14
However, a single or isolated transaction will not rise to the level of being deemed “engaged in a US. trade or business.”15
Passive income tax regime
When the foreign investor’s U.S. activities do not rise to the level of a U.S. trade or business, the income is deemed “passive” (also known as: ﬁxed, determinable, annual, or periodic income, or FDAP income).
FDAP income that is paid to the foreign investor is generally subject to a 30% tax on the gross amount of such income.16
Taxation of FDAP income, which is based on gross income, is to be distinguished from taxation of trade or business income, which is based on net amount.
If the foreign investor is engaged in a U.S. trade or business at any time during the taxable year, it is possible for the net-basis tax to apply.17
Furthermore, in the case of any income of a foreign investor which is taken into account for any taxable year but is attributable to a sale or exchange of property or the performance of services or any other transaction in any other taxable year, the determination of whether such income or gain is taxable under the net-basis tax regime shall be made as if such income or gain were taken into account in such other taxable year and without regard to the requirement that the taxpayer be engaged in a trade or business within the U.S. during the taxable year.18