International Tax and Estate Planning Discussion Post 3

International Tax and Estate Planning Discussion Post 3

Project description
Please compose a response to the discussion prompt below.

Nancy and Richard had been married for 9 years. Richard recently passed away survived by Nancy and their two minor children. Richard and their two children are US citizens but Nancy kept her Canadian citizenship. The family has lived in the US for the last seven years.
Nancy sought your help to settle Richards estate. Earlier this year Richard gave Nancy a $35,000 diamond ring and necklace to celebrate their wedding anniversary. Nancy inherited a rental property from her parents last year. She decided to upgrade the property before renting it to another tenant. Richard loaned Nancy $50,000 to pay for the renovation. The rental property is Nancys separate property. Prior to the loan, they made sure to prepare a written loan contract for the renovation cost.
Last year, Richard and Nancy established a trust for their family. Nancy seeks your help to understand the potential tax consequences of Richards death to their family assets. In his will, Richard also gave a gift of $30,000 to her only sister, Michelle, to help her build her new medical practice. The trust was primarily intended to take care of Nancy and their children and she wants to make sure that the trust continues to meet this goal after Richards death.
Will your advice to Nancy change if she is a US citizen?
Limit your response to the discussion of issues relevant to the assigned material for this week (see attached).

International Estate Planning

Copyright 2012, Matthew Bender & Company, Inc., a member of the LexisNexis Group.

CHAPTER 1 U.S. Estate, Gift and Generation-Skipping Transfer Taxation of Nonresident Aliens

§ 2.01 Summary of this Chapter

§ 2.02 Basis for Income Taxation of Nonresident Aliens. Nonresident alien individuals are subject to U.S. income tax on U.S. source income and income effectively connected with a U.S. trade or business. Income effectively connected with a U.S. trade or business is taxed at graduated rates similar to tax on U.S. persons. Gross U.S. source income not effectively connected with a U.S. trade or business is taxed at a flat 30 percent, or lower, treaty rate.

§ 2.03 Determining Residency. Lawful permanent resident and substantial presence tests determine resident alien status for income tax purposes. The income tax rules are different from the estate and gift tax rules. An individual taxpayer is deemed U.S. resident for income tax purposes if either test is met or if the taxpayer elects resident status. U.S. tax treaties contain tie-breaker rules for determining residency. Code residency rule does not override these treaties. However, an alien protected by a treaty may be affected by the Code definition in situations not covered by the treaty.

§ 2.04 U.S. Trade or Business. A facts and circumstances test is applied in most cases to determine if an alien taxpayer is engaged in a U.S. trade or business. A nonresident alien performing personal services in the United States is generally engaged in a trade or business; there are exceptions. An alien maintaining an office to trade in securities or commodities for others is engaged in a trade or business. If an alien taxpayer’s agent or spouse conducts the taxpayer’s business or trade, the taxpayer may be found to be engaged in a trade or business.

§ 2.05 Alien Not Engaged in a U.S. Trade or Business. U.S. source income not effectively connected with the conduct of a U.S. trade or business is subject to a flat 30 percent tax unless reduced by a treaty. This includes (1) fixed or determinable annual or periodical income, (2) original issue discount, (3) portfolio interest income, and (4) gain on the sale of a capital asset. Interest on bank deposits is not subject to tax. Special rules apply to an alien who expatriates to avoid tax.

§ 2.06 Alien Engaged in U.S. Trade or Business–Effectively Connected Income. Nonresident aliens are taxed at the same rates applicable to U.S. citizens or residents on income effectively connected with the conduct of a trade or business. Interest or dividend income is subject to the asset use test to determine whether the asset is held in a direct relationship to a trade or business. Business activities test determines whether passive income, gain or loss is related to the conduct of a trade or business. Income from U.S. real property is subject to special rules.

§ 2.07 Foreign Source Income. Foreign source income is effectively connected with a U.S. trade or business if foreign income is attributable to a taxpayer’s U.S. office. To qualify, an office or fixed place of business must be a material factor in the realization of income and regularly carry on activities that produce income.

§ 2.08 Treaties. U.S. tax treaties generally contain specific provisions on benefits, source and character for common types of income and taxpayers. They generally give primary right of taxation to the nation of the taxpayer’s domicile, and reduce or eliminate tax by the non-domiciliary nation on most passive income arising in that nation. Even where income is effectively connected to active conduct of a U.S. trade or business, a taxpayer who is entitled to treaty benefits may avoid taxation if he does not have a permanent establishment, i.e., a fixed place of business, in the U.S. through which business of foreign enterprise is carried on. Most treaties also contain provisions on exchanges of information about taxpayers by the taxing authorities.

§ 2.09 Determination of the Source of Income. Subject to treaty provisions, the source of income determines whether a foreign person’s income is subject to U.S. taxation. U.S. interest is treated as U.S. source income no matter where or how paid. The source of dividend payments is generally wherever the paying corporation is created or incorporated. Source of rental, royalty and real property sales income depends on the location of the property. Personal services income is U.S. source if performed in the United States. Personal property income is sourced to the seller’s residence. Trust or estate income is subject to conduit treatment. Sourcing rules also apply to partnership income, international transportation and communications activities, ocean and space activities and insurance underwriting income.

§ 2.10 Deductions and Credits. Business costs, losses and expenses may be deducted from a nonresident alien’s income effectively connected with a U.S. trade or business. A deduction or credit for foreign taxes paid on this income is also allowed. Generally, no deductions are allowed for income not effectively connected with a U.S. trade or business. Exceptions include theft or casualty losses, charitable contributions and personal exemptions.

§ 2.11 Return Requirements. Generally a nonresident alien individual with income which is effectively connected with the conduct of a U.S. trade or business must file an income tax return on Form 1040-NR and pay the tax.

§ 2.12 Withholding Requirements. A nonresident alien’s U.S. source income not effectively connected with a U.S. trade or business is subject to 30 percent withholding tax at its source. Normal graduated withholding rates apply to foreign taxpayer’s U.S. source compensation for personal services (other than self-employment income). A withholding agent withholds and pays over the tax. Taxpayers eligible for benefits of a tax treaty may be subject to partial or full exemption from withholding on income specified in the treaty.

§ 2.02 Basis for Income Taxation of Nonresident Aliens

Nonresident alien individuals are subject to U.S. income tax on U.S. source income and income effectively connected with a U.S. trade or business. Income effectively connected with a U.S. trade or business is taxed at graduated rates similar to tax on U.S. persons. Gross U.S. source income not effectively connected with a U.S. trade or business is taxed at a flat 30 percent, or lower, treaty rate.

The United States is now the only nation which subjects its citizens to income taxation of their worldwide income even if they are nonresidents of the United States. 1 Thus, residence or non-residence is not relevant to a United States citizen for income tax purposes, and the discussion below of residence is relevant only to aliens, that is, non-citizens, of the United States.

Nonresident aliens of the United States must include in gross income for U.S. income tax purposes all income that is effectively connected with the conduct of a trade or business in the United States (see § 2.04, below), 2 as well as any income from U.S. sources even if it is not so connected. See § 2.05, below. 3 For purposes of our discussion of the income tax, nonresident alien individuals are divided into two classes: (1) nonresident alien individuals who at no time during the taxable year are engaged in a trade or business in the United States, and (2) nonresident alien individuals who at any time during the taxable year are engaged in a trade or business in the United States. 4

While status as a nonresident alien for U.S. estate and gift tax purposes is based upon a factual determination of domicile (see Chapter 1, § 1.03), status as a nonresident alien for U.S. income tax purposes has since January 1, 1985 been based upon the clear statutory tests of I.R.C. Section 7701(b). See § 2.03, below.

For discussion of income tax return filing and other reporting requirements for nonresident aliens, see Chapter 10.

An alien benefits from a finding of nonresidency. The Code’s definition of residence gives foreign persons leeway to conduct business and personal matters in the United States without jeopardizing nonresident status. See § 2.03, below. Treaty residence tie-breakers provide some protection, but their application is too imprecise to rely upon other than as a last resort. Even if the alien maintains nonresident standing, he may fall prey to withholding and graduated rate taxes depending upon the type of income. See § 2.03[1], below. Treaties can be particularly helpful in mitigating withholding, but are less so if the income is effectively connected because the concept of a permanent establishment is so similar to that of “engaging in a trade or business.” See § 2.08, below.

In most instances, whether a nonresident alien is engaged in a U.S. trade or business is determined by a “facts and circumstances” test. See § 2.04, below. Aliens not engaged in a trade or business are usually taxed at a flat rate of 30 percent on fixed determinable income derived from sources within the United States. Other income, such as gain from the sale or exchange of property and portfolio interest, usually remains tax-free. See § 2.05, below. Certain foreign source income is taxed if effectively connected to a U.S. trade or business.

The nonresident alien’s income from a U.S. trade or business must be effectively connected in order to be taxed. Several tests are applied under the Code. See § 2.06, below.

Deductions and credits available to nonresident aliens are discussed in § 2.10, below. See § 2.11, below, for withholding requirements.

FOOTNOTES:
Footnote 1. The Philippines formerly subjected its citizens to worldwide income tax, regardless of their residence, but ceased to do so in 1995. Most countries subject their citizens to taxation of their worldwide income only if they remain resident in their home country, or have emigrated to a tax haven and retain ties to their home country. For example, (1) Germany subjects to an income tax those German citizens who emigrate to a tax-haven country or do not assume residence in any country and who maintain substantial economic ties with Germany as measured in terms of the individual’s German-source income or assets; (2) Italian citizens who remove themselves from the residents’ Civil Registry and move to a tax haven continue to be subject to an income tax; and (3) a Swedish citizen may continue to be taxed on his or her worldwide income if he or she maintains essential ties with Sweden after ceasing to be its resident. See a nonexhaustive, but broad, survey of other countries’ taxation of citizens and residents by the Joint Committee on Taxation in theReview of the Present-law Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-term Residency (JCS-2-3), February 2003, 140-176. See also Reuven S. Avi-Yonah, The Case Against Taxing Citizens, draft paper published 3/22/10 by the Berkeley Electronic Press.

§ 2.03 Determining Residency

Lawful permanent resident and substantial presence tests determine resident alien status for income tax purposes. The income tax rules are different from the estate and gift tax rules. An individual taxpayer is deemed U.S. resident for income tax purposes if either test is met or if the taxpayer elects resident status. U.S. tax treaties contain tie-breaker rules for determining residency. Code residency rule does not override these treaties. However, an alien protected by a treaty may be affected by Code definition in situations not covered by the treaty.

The determination of residence can have significant impact upon the tax liability of an individual since U.S. residents pay U.S. tax on worldwide income 1 while nonresidents generally are taxed only on U.S. source income and certain foreign source income effectively connected to a U.S. trade or business. 2

[1] Statutory Rules

Since January 1, 1985, an alien individual is by statute treated as a resident alien for U.S. income tax purposes if he satisfies either one of two tests: (1) the lawful permanent resident test, 3 or (2) the substantial presence test. 4 A nonresident alien can also elect resident status under certain circumstances. 5

A lawful permanent resident is an individual who has been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws (that is, he holds a green card, discussed below) and whose status has not been revoked or judicially or administratively determined to have been abandoned. 6 A lawful permanent resident under U.S. immigration law is a resident alien for tax purposes, regardless of the length of time he spends in the United States in any particular year. 7

The lawful permanent resident test is commonly referred to as the green card test. A green card is the alien registration receipt card (Immigration Form I-551) given to an alien individual who has been granted under the U.S. immigration laws the privilege of residing permanently in the United States. The term derives from the fact that the card was once green in color, though it is now blue and white. Resident alien status under the green card test terminates only when green card status has been revoked or administratively or judicially determined to have been abandoned. 8 For immigration purposes, an alien’s green card status may change by abandonment which occurs when the alien leaves the United States for other than temporary purposes. The intention to abandon permanent resident status may be inferred from the length and purpose of the alien’s absence, the retention of ties to the United States, and other factors that a given case may present. For purposes of the immigration law, a formal determination of abandonment may not take place until many years after the actual abandoning act, because the Immigration and Naturalization Service does not need to know the alien’s status until he or she tries to return to the United States. For tax purposes, however, a green card holder permanently living abroad is to be treated as a lawful permanent resident of the United States under the green card test until there has been a formal determination that his or her status had been abandoned. 9 Note that the Service took a contrary position, and lost to taxpayer’s estate (which claimed continued U.S. domicile for a green card holder who had left the United States to return to his native Pakistan five years prior to his death in 1991) in Estate of Kahn v. Commissioner. 10

[a] Substantial Presence Test

The substantial presence test is entirely independent of and makes no inquiry into the immigration status of the alien taxpayer. Instead it simply looks to the number of days that an alien has spent in the United States during the current calendar year and the two preceding calendar years. 11 If an alien has spent enough time in the United States such individual is deemed to have a “substantial presence” and is a U.S. resident for income tax purposes in the year for which the calculation is being made. A new determination of residence for U.S. income tax purposes is made annually.

Assuming the individual is not lawfully admitted for residence, the alien is a nonresident if the weighted number of days spent in the United States in the current and two preceding years combined is less than 183 days or the individual spent less than thirty-one days in the United States during the current year. The weighted number is determined by adding, to the total number of days the alien is present in the current year, one-third the number of days he was present in the preceding year and one-sixth of the number of days he was present during the second preceding year. 12 Fractions of days are treated as such and not rounded, so that if, under the formula, the alien is determined to have spent 182.5 days in the United States over a three-year period, she will be treated as a nonresident alien. 13

Example 1:
A is an alien who was present in the United States on 140 days during 1991, 90 days in 1990 and 120 days in 1989. The sum of days is calculated as follows to determine her status:

1991    140    x    1    =    140
1990    90    x    1/3    =    30
1989    120    x    1/6    =    20

140    +    30    +    20 = 190
Since the total number of days on which A was present in the United States for the last three calendar years is (equal to or) greater than 183, she is a resident alien under the substantial presence test.

Example 2:
B is an alien who spent 360 days in the United States in 1989, 300 days in the United States in 1990 and 23 days in 1991. B is a resident alien of the United States in each of 1989 and 1990, but is a nonresident alien under the substantial presence test for 1991. Even though the sum of the number of days present (using the applicable multipliers) in the last three years equals 183, B spent less than 31 days in the United States during the current year.

Example 3:
C is an alien who was present in the United States on 182 days during 1991. She was never in the United States before. Since the total number of days she was present in the United States between 1989 and 1991 is less than 183, she is a nonresident alien under the substantial presence test.

The provisions of I.R.C. Section 7701(b) are an absolute test for income tax purposes, so that an alien is a resident only if he meets the requirements of one or both of the tests. 14If the individual fails either test, he may look to exceptions for:
(1) foreign government-related individuals, teachers, teacher-trainees, and students; 15

(2) those with medical conditions arising while the individual is in the United States and that prevent departure; 16 and

(3) those who spend less than half the year in the United States and who have a closer connection to a foreign country (the “closer connection” test). 17

Resort also may be made to treaties. See § 2.03[1], below.

[b] Exceptions

[i] Closer Connection Test

Under the closer connection test, an individual whose presence over three years equals or exceeds 183 days on the weighted presence test of I.R.C. Section 7701(b)(3) is still deemed a nonresident alien if he is present in the United States for less than 183 days in the year in question and can demonstrate that his “tax home” is in another country. 18 The definition of tax home, under I.R.C. Section 911(d)(3), is by reference to the statute 19 and case law defining “tax home” for purposes of allowing a deduction for traveling expenses while away from home, 20 which the Service and most Circuit Courts have interpreted to mean the place of the taxpayer’s regular or principal place of business or employment, and not where the taxpayer’s personal residence is located. 21 The inquiry under I.R.C. Section 911(d)(3), which governs the ability of U.S. citizens living abroad to exclude amounts of earned income from United States income tax (see discussion in Chapter 12, § 12.03, below), begins with whether the taxpayer’s “regular or principal place of business is in a foreign country.” 22 The inquiry under the I.R.C. Section 7701(b) regulations is more comprehensive, however, and the various facts and circumstances relevant to determining a “closer connection” include the location of a permanent home, membership in social and religious organizations, bank accounts, personal belongings, family ties and voting records. 23 These factors are similar to those the Service previously considered when residency for income tax purposes involved a case-by-case inquiry.

This exception from the substantial presence test is the most important way in which an alien who spends extended time in the United States can retain nonresident status. An individual claiming “closer connection” status must file a full disclosure statement with the Service on Form 8840 no later than the due date for filing an income tax return as a nonresident for the year with respect to which a closer connection is claimed. 24 Taxpayers who file Form 8840 are also instructed to keep this information on file and readily available in the event of an examination. The closer connection exception cannot apply if the individual had applied for an adjustment of his alien status or taken other steps toward gaining lawful permanent residency in the United States. 25

[ii] Other Exceptions

The day count toward an individual’s substantial presence is also subject to modification. An individual will not be treated as being present in the United States on any day if the individual is an “exempt individual” for that day 26 or if the individual was unable to leave the United States on such day due to a medical condition that arose while the person was present in the United States. 27

A person is an exempt individual for any day if, for that day, the person is:
(1) a foreign government-related individual;

(2) a teacher or trainee;

(3) a student; or

(4) a professional athlete in the United States temporarily to compete in a charitable sports event. 28

To be treated as absent from the United States on a given day under one of these exemptions, it is important that the alien individual not be conducting activities in the United States which would be barred under the exempt visa classifications. 29 The primary visa classifications under which a taxpayer is not “present” in the United States for income tax purposes are the A visa, for accredited diplomats from foreign countries and their families, the F visa, for students and their families, the G visa, for foreign government representatives and foreign staff members and their families to U.S. postings for many non-government international organizations, like the World Bank but including many organizations, and the J visa, for teachers or trainers, but in common use of the visa, approved by the State Department in issuing the visas, used by foreign businessmen as well as full-time teachers in teaching at and assisting U.S. universities which sponsor them. Teachers or trainers in the United States under a J visa are limited in the number of years they may exclude their presence in the United States under a J visa to two of any six years or, if they were employed and received compensation described in I.R.C. Section 872(b)(3), to four of the six preceding calendar years. 30

An individual’s U.S. residence “day count,” apart from special visas, is also reduced in some cases by the medical condition exception. The simple rule, which may be difficult to apply on the facts of an individual case, is that if a nonresident alien enters the United States for medical treatment, he cannot exclude any of his days of presence here for treatment for that condition, but if he enters the United States for personal or business reasons not related to his medical condition, and while here suffers some medical event–a stroke, a heart attack–or, while here, is diagnosed with a medical issue unknown to him before, and the doctor certifies that the individual is not able to travel, not able to leave the United States while undergoing treatment or recuperating, then the days of extended presence will not be covered. 31

The mere application for a green card can have serious consequences even though residency does not date to the time of application. The exception to the substantial presence test for those who spend less than half a year in the United States and have a closer connection to a foreign country is not available to those who have applied for a change to permanent status. 32 Legislative history indicates that an application filed by a relative (as allowed under current immigration law) does not have the same adverse effect. 33

Planning Note

Delay Green Card Application to Maintain Nonresident Status. If one desires to maintain nonresident status for an additional year, it may be appropriate to delay slightly an end-of-year application or have a relative file the application. Filing by the alien of INS Form I-508 (Waiver of Immunities), INS Form I-485 (Application for Status as Permanent Resident), and Department of State Form OF-230 (Application for Immigrant Visa and Alien Registration) are considered affirmative steps to change status that preclude use of the closer connection exception. 34

[2] Effect of Treaties

The United States has numerous income tax treaties with foreign countries. These treaties do not define residence within either the United States or the foreign country. Instead, they allow each country to determine resident status under its own laws. This creates the possibility for more than one country to claim an individual as a resident. To deal with this possibility, many treaties contain tie-breaker rules to determine residence. 35

If a nonresident alien finds himself categorized as a resident by both the United States and another country, he should examine the definition of residence contained in any treaty between the two countries. 36 Such definitions, found in most treaties, articulate subjective criteria for determining which of two states may claim the individual as a resident (though the priority given to each criterion varies by treaty). 37 Typical are the conventions signed with Canada, Japan and the United Kingdom which set forth the factors for consideration in the following order:
(1) One is a resident where there is a permanent home, and if there is one in both states or in neither state, then home is where the center of vital interests is located (that is, where personal and economic relations are closer);

(2) If the center of vital interests is not ascertainable, then residence is where there is an habitual abode;

(3) If there is an abode in both or neither state, then where he is a national; and

(4) If he is a national of both or neither, then residence is decided by material agreement of the competent authorities of the two states. 38

This tracks the Treasury’s Model Treaty tie-breaker. 39 More recent treaties may weigh the factors differently, preferring to examine the locus of habitual abode before vital interests if the alien does not have a permanent home in either signatory nation. 40 These treaties follow the lead of the Treasury Department’s newer Proposed Model Treaty. 41

The definition of resident alien in the Code does not override the treaty tie-breaker rules. In the event of conflict between the resident alien definition and a treaty, the treaty definition prevails, and the alien is not taxable as a resident of the United States. 42 The priority of the treaty test for residence if elected by the taxpayer is made clear by the regulations under I.R.C. Section 7701(b). 43 For example, a lawful permanent resident can file as a nonresident alien under the treaty tie-breaker rules for purposes of computing his U.S. tax liability notwithstanding the fact that the individual retains a green card. 44 Note, however, that recent immigration legislative developments indicate that green-card holders using the treaty-tie-breaker provision could result in the loss of green cards.

The protections of a treaty’s tie-breaker rules only apply for treaty purposes. 45 The treaty’s limitation on an alien from being a U.S. resident for treaty purposes does not eliminate all adverse consequences of being treated as a resident under U.S. law for nontreaty purposes. For example, many treaties allow the United States to impose a tax on interest, typically with a maximum permitted rate of tax. However, the Code provides an exemption for nonresident aliens from U.S. income tax on interest paid on U.S. bank accounts. 46 If an alien is considered a resident under U.S. law, then he loses the statutory exemption for income on the bank accounts, and is subject to the treaty rate of U.S. tax.

Example 1:
X is a citizen and resident of Jamaica who has a green card. He is arguably a resident of both Jamaica and the United States. However, since he spends 11 months a year in Jamaica and one month in the United States he is deemed a resident of Jamaica under the treaty tie-breaker tests. If he is deemed to be a resident of Jamaica only for treaty purposes and not for purposes of the Code, interest on his U.S. bank deposits will not be exempt (see § 2.05[4], below); rather, it will be subject to U.S. tax at a 12.5 percent rate under Article 11(2) of the Jamaica treaty. 47

Example 2:
Y has maintained for a number of years, and still does maintain, an interest-bearing account at a U.S. bank located in the United States. Until this year, application of the green card or substantial presence test would have led to a finding of nonresidency. His interest was, thus, not subject to tax in the United States. This year Y obtained a green card and, so, the interest is subject to the graduated tax rate tables applicable to all citizens and residents. Y is a citizen of country B which has entered into an income tax convention with the United States. That treaty provides for a 5 percent withholding tax on U.S. interest income of residents of country B. Y qualifies under the treaty as a resident of country B. His tax is reduced from the applicable marginal U.S. rate to 5 percent. It is not reduced to zero.

Another adverse effect of a citizen of a treaty country becoming a resident alien of the United States is the loss of the capital gains exemption for aliens not present in the United States for 183 days. 48 A taxpayer who is a dual resident of the United States and another country, but claims treaty protection, will be deemed a U.S. resident for Code purposes, and thus will be exempt from payment of tax upon sale of a U.S. situs capital asset only if the applicable treaty itself provides protection. Most do provide protection on sale of intangibles, but not tangible property.

Example:
Z maintains nonresident status under the tie-breaker rules of the applicable United States dual income tax treaty, even though he would otherwise be treated as a U.S. person under the “substantial presence” test of I.R.C. Section 7701(b)(3). He did not, in fact, spend 183 days in the United States in 2010. He sold a capital asset with a U.S. connection in 2010. Because he will not be able to claim the exemption from tax under I.R.C. Section 871(a)(2), having instead claimed treaty protection, the capital gain will be taxable for U.S. income tax purposes unless it is sheltered from tax by the applicable treaty.

Comment:
Clearly, a resident alien selling property and returning to his native country would be wise to defer the close of escrow until January 1 of the following year and then take the necessary steps to obtain nonresidency status in that following year.

Residency under U.S. law coupled with nonresidency under a treaty may also cause corporations to become controlled foreign corporations. 49 Shareholders in these corporations become subject to tax on undistributed income. 50

If an alien is a U.S. resident under the Code, but is considered a resident of another country under a tie-breaker provision in an income tax treaty, and the alien claims a treaty benefit as a nonresident of the United States, the alien is treated as a nonresident alien of the United States for purposes of computing the alien’s income tax liability. 51 However, the alien is treated as a U.S. resident for all other purposes of the Code. 52 Thus, the alien is a resident for purposes of determining whether a corporation is a controlled foreign corporation, and is currently taxable on all income of that corporation which is not treaty protected. Conversely, a taxpayer may choose to waive treaty benefits and continue to be taxed under the Code. In a Chief Counsel Advisory Memorandum 53 the IRS National Office ruled that a Portuguese citizen residing in Portugal but who still held a green card could elect to be taxed as a U.S. resident under the Code on his worldwide income 54 and waive treaty benefits. In this Chief Counsel Advisory Memorandum, the net result of the taxpayer’s election to be taxed as a U.S. resident was a lower aggregate U.S. tax than would be payable under the applicable treaty.

An individual who qualifies as a resident in more than one country with which the United States has an income tax treaty may choose which convention will apply. 55 The United States-Swiss Confederation Income Tax Convention defined the term Swiss corporation to include a corporation created under Swiss law. 56 The corporation had its central management and control in the United Kingdom. The then-governing United States-United Kingdom Income Tax Convention provided that a corporation was a United Kingdom resident if its business was managed and controlled in the United Kingdom. 57 The corporation’s Swiss bank received loan interest from a U.S. bank located in the United States. The Swiss treaty provided for a 5 percent withholding tax on such income while the United Kingdom treaty exempted such income from tax. The taxpayer maintained that it could elect to be subject to the United States-United Kingdom treaty and thus avoid tax. The Service agreed.

This ruling presents planning opportunities for those individuals with the ability to qualify as a resident under more than one treaty. The ruling demonstrates that residence-shopping is not inconsistent with perhaps unavoidable resident status in the alien’s country of citizenship.

See § 2.08, below, for a discussion of treaties before their impact on determinations of residence.

[3] Second-Time U.S. Residents

Foreign nationals who leave the United States after being treated as U.S. residents for at least three consecutive calendar years should be aware of a tax trap for second-time U.S. residents when they decide soon to return for a substantial period of time to the United States. I.R.C. Section 7701(b)(10) provides that an alien treated as a U.S. resident for at least three consecutive calendar years (the initial residency period) who ceases to be a U.S. resident, but who resumes U.S. residence before three years after the end of the initial residency period, is subject to the alternative tax regime under I.R.C. Section 877(b) (see Ch. 1, § 1.08) for the period after the initial residency period closed until the day before the second residency began. Unlike I.R.C. Section 877(b), I.R.C. Section 7701(b)(10) applies regardless of the departing individual’s net worth or previous earnings. This rule applies whether the alien was a U.S. resident income taxpayer because he or she held an immigrant visa, or failed the “substantial presence” test, provided in either case that the alien was physically present in the United States for at least 183 days in each of the three base years. 58

The alternative tax regime under I.R.C. Section 7701(b)(10) does not apply if the individual would pay a higher U.S. tax as a nonresident alien. Under Notice 97-19 , an individual subject to I.R.C. Section 7701(b)(10) is entitled to treaty benefits in the intervening period. Such individual is also subject to various sourcing and recognition rules under I.R.C. Section 877(d) and must file Form 1040NR and certain schedules for the intervening period. Notice 97-19 allows the taxpayer an extension of time to file these forms and schedules for the intervening period, until the due date of the return (including extensions) for the first residency period after returning.

I.R.C. Section 7701(b)(10) has still not been coordinated with the new I.R.C. Section 877A.

[4] Bona Fide Residents of U.S. Possessions

Individuals who are bona fide residents of a U.S. possession can generally exclude the income from sources within the possession, or the income effectively connected with the conduct of a trade or business in such possession, from their gross income for U.S. income tax purposes. 59 In other words, such individuals are treated as nonresident aliens for purposes of the U.S. income tax, and the money they generate in the possession is not categorized as U.S. source income. These rules are based on a similar intent, but with a different manner of operation, as the estate tax rules applicable to residents of U.S. possessions discussed above in Chapter 1, § 1.03[2].

Under I.R.C. Section 937(a), an individual generally will be considered a bona fide resident of a possession only if he or she satisfies the following three conditions:
(1) The individual is physically present in the possession for 183 days during the taxable year (the presence test);

(2) The individual does not have a tax home (determined under the principles of I.R.C. Section 911(d)(3) without regard to the second sentence thereof) outside such specified possession in the taxable year (tax home test); and

(3) The individual does not have a closer connection (determined under the principals of I.R.C. Section 7701(b)(3)(B)(ii)) to the United States or a foreign country other than such specified possession (closer connection test). 60

The American Jobs Creation Act of 2004 (the “Jobs Act”) authorized the Treasury Department to create exceptions to these general requirements for individuals who are absent from a U.S. possession for non-tax reasons. 61 Specifically, the legislative history references military personnel, fishermen, and retirees. 62 Final and Temporary regulations were published consistent with the Jobs Act and its legislative history on April 11, 2005. 63

Final regulations relating to the residence rules (specifically Treasury Regulations Section 1.937-1 and Treasury Regulations Section 1.881-5T(f)(4)) were published on January 30, 2006. 64 An individual can satisfy the presence test for the taxable year if the individual: (i) spent no more than 90 days in the United States; (ii) had no earned income (as defined inTreasury Regulations Section 1.911-3(b)) in the United States in excess of the amount specified in I.R.C. Section 861(a)(3)(B) ($3,000 in the aggregate) and was present in the relevant possession longer than in the United States; or (iii) had no significant connection to the United States. 65 These alternatives enable fishermen who travel extensively at sea but spend less than 90 days in the United States, as well as retirees who spend several months a year in the United States, but earn no more than $3,000 there, and spend more time in the relevant possession, to still qualify as bona fide residents under the presence test. 66 The final regulations did not incorporate the rules of I.R.C. Section 7701(b) as an alternative to the 183-day rules of I.R.C. Section 937(a)(1) since Congress specifically rejected that option. 67

The new regulations also more clearly define a tax home as a home located at the individual’s regular or principal place of business, or if there is no such place, at the individual’s regular place of abode. 68 A specific exception is made for seafarers, who will not have a tax home outside the possession attributed to them because of employment on a ship or other vessel predominately used in local and international waters. 69 In addition, any days spent as a student or in an individual’s capacity as an elected representative outside the possession will be disregarded for the determination of whether such individual has a tax home outside the possession.

The regulations state that the factors considered in the closer connection inquiry are those listed under I.R.C. Section 7701 and its regulations, including the location of the individual’s permanent home, the location of personal belongings like automobiles, furniture and clothing, the location of social, political and cultural organizations the individual belongs to, the location where the individual conducts banking activities, and the location where the individual votes. 70 An example from the regulations is instructive:

Example:
Z, a U.S. citizen, relocates to Possession V in 2003 to start an investment consulting and venture capital business. Z’s wife and two teen-aged children remain in State C to allow the children to complete high school. Z travels back to the United States regularly to see his wife and children, to engage in business activities, and to take vacations. He has an apartment available for his full-time use in Possession V, but he remains a joint-owner of the residence in State C where his wife and children reside. Z and his family have automobiles and personal belongings such as furniture, clothing, and jewelry located at both residences. Although Z is a member of the Possession V Chamber of Commerce, Z also belongs to and has current relationships with social, political, cultural, and religious organizations in State C. Z receives mail in State C, including brokerage statements, credit card bills, and bank statements. Z is not a bona fide resident of Possession V because he has a closer connection to the United States than to Possession V. 71

The Jobs Act requires that, beginning with tax year 2001, any individual with a worldwide gross income of more than $75,000 file Form 8898 with the Service in any tax year such individual becomes, or ceases to be, a bona fide resident of American Samoa, Guam, the Commonwealth of the Northern Mariana Islands, the Commonwealth of Puerto Rico, or the U.S. Virgin Islands. 72 The Service released a new Form 8898 in January 2007, which requires the taxpayer to disclose information about time spent in the applicable possession and in the United States, and also personal information like the location of immediate family, automobiles, personal belongings, important financial and legal documents, etc. 73 Taxpayers who file Form 8840 are also instructed to keep this information on file and readily available in the event of an examination.

For purposes of the Form 8898, worldwide gross income is all income received in the form of money, goods, property and services, including income from sources outside the United States, before any deductions or credits. In determining whether worldwide gross income equals more than $75,000, an individual does not include his or her spouse’s income. If each spouse meets the test, both must file Form 8898 separately.

The tax treatment of corporations created or organized in U.S. possessions is determined under I.R.C. Section 881(b). If such a corporation meets certain requirements, it is exempt from the 30 percent tax under I.R.C. Section 881(a) imposed on the U.S.-sourced fixed or determinable annual or periodical income of foreign corporations. 74 A corporation created under the laws of the U.S. Virgin Islands, Puerto Rico, and American Samoa must meet the following criteria for exemption:
(1) At all times during such taxable year, less than 25 percent of the stock of such corporation is beneficially owned (directly or indirectly) by foreign parties;

(2) At least 65 percent of the gross income of such corporation must be effectively connected with the conduct of a trade or business in such possession or the United States for the three-year period ending with the close of the taxable year of such corporation; and

(3) No substantial part of the income of such corporation for the taxable year is used (directly or indirectly) to satisfy an obligation to persons not bona fide residents of such possession or the United States. 75

Corporations in Guam and the Northern Marinara Islands are subject to (1) above, but for purposes of (2) need only show at least 20 percent of the gross income is effectively connected. 76 Requirement (3) does not apply. The requirements for exemption in these two possessions will be the same as above if such possessions enter into an implementing agreement with the United States government. 77

§ 2.04 U.S. Trade or Business

A facts and circumstances test is applied in most cases to determine if an alien taxpayer is engaged in a U.S. trade or business. A nonresident alien performing personal services in the United States is generally engaged in a trade or business; there are exceptions. An alien maintaining an office to trade in securities or commodities for others is engaged in a trade or business. If an alien taxpayer’s agent or spouse conducts the taxpayer’s business or trade, the taxpayer may be found to be engaged in a trade or business.

The income of a nonresident alien individual that is effectively connected with a U.S. trade or business is taxed at the normal graduated rates. 1 In contrast, the income that is not effectively connected with a U.S. trade or business (investment income) and other income is generally taxed at a flat 30 percent or lower applicable treaty rate. 2 The first step in determining if a taxpayer has income effectively connected with a U.S. trade or business is to determine if the taxpayer is engaged in a trade or business. A U.S. trade or business may be actual or artificial. See § 2.04[3], below.

For purposes of determining whether income is effectively connected, or simply U.S. source income, the income is generally taken into account for the current tax year for cash basis taxpayers, but characterized as connected or unconnected with a trade or business according to the facts in the year the income accrued. If the income is attributable to a sale or exchange of property, or the performance of services in a prior tax year, the gain is treated as if it were taken into account in that other year, and taxed accordingly. 3 For example, in a recent Chief Counsel Memorandum, the Service determined that non-qualified stock options earned in a year when the taxpayer was engaged in a U.S. trade or business, but exercised in a year when he was not, would be taxed at the graduated rates applied to income connected with a U.S. business. 4 The stock options were compensation for services rendered in the United States, and would have been treated as effectively connected with a U.S. business had the taxpayer included them in income in the year they were awarded, so they were treated as such when he exercised them. The Chief Counsel advised that the income was not to be taxed as income of a United States resident, even though taxpayer had been a U.S. resident in the years during which he performed the services, but was, nevertheless, to be taxed as income effectively connected with a U.S. trade or business.

[1] Personal Services

A U.S. trade or business includes performing personal services within the United States at any time during the tax year (see Chapter 11, § 11.03[3] for rules governing services performed partly within and partly without the U.S.). 5 However, a nonresident alien individual performing personal services in the United States is not engaged in a U.S. trade or business if:
(1) The personal services are performed for a nonresident alien individual, foreign partnership, or foreign corporation not engaged in a trade or business in the United States, or for an office or place of business maintained in a foreign country or U.S. possession by an individual who is a U.S. citizen or resident or by a domestic partnership or a domestic corporation;

(2) The compensation for the services does not exceed in the aggregate $3,000; and

(3) The nonresident alien employee is temporarily present in the United States for a period or periods not exceeding a total of ninety days during the tax year. 6

The $3,000 exempt amount is for compensation only, and the employee may in addition be reimbursed for travel and other expenses, if the employee has accounted for such expenses to his employer. 7 However, the $3,000 exemption has not been revised in many years and is rarely relevant today for a taxpayer otherwise unable to claim treaty protection.

Example 1:
In 1991, A, a nonresident alien, was employed by the Munich office of YBCN, Inc., a U.S. corporation. A uses the calendar year as his tax year. He was temporarily present in the United States for forty-five days in 1991 performing personal services for the corporation’s Munich office. He was paid a total gross salary of $2,800 for those services. For 1991, A was not engaged in a trade or business in the United States.

Example 2:
The facts are the same as in Example 1, except that A’s aggregate compensation for the personal services he performed in 1991 was $3,500. He received $2,800 in 1991 and $700 in 1992. A was engaged in a trade or business by reason of his performing personal services in the United States for the corporation’s Munich office during the 1991 tax year. 8

[2] Trading in Securities or Commodities

Generally, under the rule of I.R.C. Section 864(b)(2)(A)(i), a foreign individual, corporation or trust that trades in stocks, securities or commodities in the United States is not treated as conducting a U.S. trade or business (and is therefore not subject to U.S. income tax on his or her or its “effectively connected” income, including gains from the purchase and sale of U.S. investments) if the foreign individual, corporation or trust does not have an office in the United States through which, or under the direction of which, the securities transactions are effected. Under the safe harbor of I.R.C. Section 864(b)(2)(A)(ii), however, a foreign individual, corporation or trust is not treated as conducting a U.S. trade or business even if he or she or it has an office in the United States through which, or by direction of which, the transactions in stocks, securities or commodities are effected, provided the transactions are for the taxpayer’s own account. This safe harbor applies whether the trading is conducted by the foreign taxpayer or his or her or its agent or employee, whether or not such agent or employee has discretionary authority to make decisions in effecting the transactions, whether or not the taxpayer maintains his or her or its principal office in the United States, 9 and regardless of the volume of trading activity.

For purposes of the safe harbor, the term “securities” includes any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing, as well as financial futures that provide the holder the right to purchase the underlying financial instruments. 10 The term “commodities” includes all commodities of a kind customarily dealt in on an organized commodity exchange. 11 The activities permitted by the safe harbor include buying, selling (including short sales) or trading in stocks, securities or contracts or options to buy or sell stocks or securities, on margin or otherwise, for the account and risk of the taxpayer, and any other activity closely related thereto (such as obtaining credit for the purpose of effectuating such buying, selling or trading). 12

Proposed regulations issued by the Service in 1998 provide that foreign taxpayers who effect transactions in derivative financial instruments for their own accounts are not thereby engaged in a trade or business in the United States if they are not dealers in stocks, securities, commodities, or derivatives. 13

Trading for one’s own account is generally evidenced by trading through an independent stockbroker, commission agent or custodian; whether the agent had discretionary authority, as well as the volume of transactions, is immaterial. 14

[3] Facts and Circumstances Test

In determining whether a taxpayer is engaged in a trade or business, activities of the taxpayer, other than performing personal services (§ 2.04[1], above) and trading in securities or commodities (§ 2.04[2], above), are examined in light of the facts and circumstances of each case. 15 The Service does not issue advance rulings or determination letters on a taxpayer’s status as engaging in a U.S. trade or business. 16

The facts and circumstances test examines the nature and extent of the taxpayer’s economic activities and contacts within the United States. 17

Example 1:
A foreign sugar producer sold raw sugar through independent U.S. resident brokers. He was not engaged in a U.S. trade or business. 18

Example 2:
A nonresident alien individual made postcards in his own country and then sold them in the United States under a distributorship agreement with a U.S. news company. He was engaged in a U.S. trade or business because the news company was deemed to be the alien’s agent. 19

A U.S. trade or business does not include isolated and nonrecurring transactions by a nonresident alien in the United States absent a profit motive. 20 The taxpayer must, during some substantial portion of the taxable year, have been regularly and continuously transacting a substantial portion of its ordinary business in the United States. 21

An isolated sale of embargoed merchandise purchased by a foreign company is not engaging in a U.S. trade or business by the foreign company where the embargoed goods were the only property the company had in the United States and the company had no office, salesman, employees or license in the United States. 22 However, a nonresident alien’s entry of a horse in a single race is engaging in a U.S. trade or business in the absence of definite information that the nonresident alien doesn’t intend to enter a horse in another race in the United States during the tax year. 23

Owning real estate in the United States is not a U.S. trade or business, without other activities in addition to ownership. 24 A property owner’s activity in regards to the property must be “considerable, continuous, and regular” for the Service to consider the owner engaged in a U.S. trade or business. 25 For example, a brief visit to the taxpayer’s rental property to supervise the negotiations of net leases is not engaging in a trade or business. 26 However, a taxpayer leasing and managing property through rental agents is engaging in a U.S. trade or business. 27 But when a foreign lessor paid real estate taxes, mortgage installments and cultivation fees for U.S. farmland, the payments were too sporadic to be engaging in a U.S. trade or business. 28

[4] Agency

One line of cases and rulings involves the direct activities of the foreign person and the nature and quantity of those activities. The other line of cases involves whether the alien is engaging in business in the United States through an agent. Generally, the putative agent clearly engages in business in the United States and cases focus on the relationship between alien and agent. 29 Where the agent has to request authority to perform an act, the principal is not engaging in the active conduct of a trade or business. 30 However, where the agent has a broad power of attorney which includes the power to buy, sell, lease, and mortgage real estate for and in the name of the taxpayer, keeps the taxpayers’ books, pays his taxes and mortgage, insures his property, and supervises repairs, this constitutes considerable continuous and regular activities and, therefore, the alien is engaged in a trade or business. 31

The notion that activities of the agent having authority to act on behalf of a taxpayer are attributable to the taxpayer also has led to findings of active conduct of a trade or business in several situations in which one might not readily expect such a finding. For example, a nonresident wife was found to be engaged in a U.S. trade or business because her husband was concededly engaged in a U.S. trade or business. 32 Any actions of the husband were considered actions of the marital community and the husband therefore was an agent for the community. 33

This rationale can be applied in a situation where one spouse is engaged in a U.S. trade or business and the Service contends that the independently-derived, non-FDAP U.S. source income of the other spouse is, therefore, effectively connected.

[5] Partnerships; Beneficiaries of Estates and Trusts

By statute, conduit treatment of nonresident alien individuals and foreign corporations as engaged in U.S. trade or business also applies to partners and estate and trust beneficiaries.34 A nonresident alien individual or foreign corporation is engaged in a U.S. trade or business if it is a member of a partnership engaged in a U.S. trade or business. 35 This applies to both limited and general partners who are nonresidents. 36 A nonresident alien partner must pay tax on his or her share of a partnership’s income only to the extent that the income is U.S. source or is effectively connected with the conduct of a trade or business in the United States. 37 The same rule applies to a nonresident alien partner of a limited liability company that is classified as a partnership. 38 The test to determine if a partnership is engaged in a U.S. trade or business is the same as in the case of a nonresident alien individual.39

The Service has reversed its policy regarding the treatment of partnership income under income tax treaties, such that the conduit treatment of nonresident alien partners, just discussed, is maintained. An often found treaty provision provides that personal services performed in an independent capacity by a resident of a contracting state are taxable only in that state, unless performed in the other state and attributable to a fixed base in that other state (see § 2.08 below). The Service previously took the position, specifically with regard to the U.S.-German treaty, that such a provision may exempt a nonresident alien partner from U.S. taxation of his distributive share of income derived from his partnership’s U.S. branch office, provided he has not personally worked in that office. 40 As a result, that and similar treaty provisions effectively overrode the Code’s treatment of foreign partners as effectively engaged in a U.S. trade or business when the partnership is so engaged. The Service now has revoked that Ruling, holding instead that, despite the treaty provision at issue in the prior ruling or similar provisions contained in other treaties, a partnership’s U.S. branch income is taxable to nonresident alien partners without regard to whether they personally have performed services in the United States, because a U.S. office is a fixed base attributed to all of the partners of a partnership. 41 However, certain treaties have been distinguished. In 2010, the Service ruled that a Russian resident’s distributive share of a partnership’s U.S. source income, where the Russian resident had spent less than 183 days in the United States, was not taxable in the United States as the U.S.-Russia tax treaty was distinguishable from the U.S.-Germany tax treaty based on the provision in the former of a 183-day presence requirement. 42

A nonresident alien individual or foreign corporation that is a beneficiary of an estate or trust is engaged in a U.S. trade or business if the estate or trust is so engaged. 43

Even when a trust is a complex trust (meaning the trustee is not required to distribute income to the beneficiary but exercises discretion as to trust distributions), the Service will attribute the U.S. trade or business of the trust to the beneficiary. 44 In a letter ruling the Service determined that the distributions made from various U.S. trusts to an Italian citizen beneficiary were income effectively connected with a U.S. trade or business taxable under I.R.C. Sections 1 and 55. The trusts were lessees of mineral estates with active, extractive operations that were managed through an independent contractor. The Service concluded that the trusts were, through the contractor, conducting activity in the United States beyond the mere receipt of income from rental property and the payment of expenses incidental to the collection of rental income. The Italian citizen who was the discretionary beneficiary of the trusts, therefore, was also treated as engaged in a U.S. trade or business under I.R.C. Section 875(2) and taxed accordingly, despite the fact that the trustee was not required to currently distribute income to the beneficiary. 45 The taxpayer unsuccessfully argued that he was not engaged in a U.S. trade or business and that the appropriate tax due on the trust distributions was the 30 percent withholding tax imposed on U.S.-sourced fixed or determinable annual or periodical gains, profits or income. The result is the same as that for a nonresident alien conducting U.S. business activities through an agent. 46

The Court of Claims ruled otherwise in DiPortanova v. United States, 47 where the taxpayer, a dual United States-Italian citizen, had renounced his U.S. citizenship and continued to pay United States income tax at the flat 30 percent withholding rate applicable to FDAPI, on the income he was receiving from family trusts which owned a 2.25 percent working interest in oil and gas fields in Texas. The Court of Claims held that because the trusts’ interest was so small and the taxpayer’s trusts had no role in the conduct of the working interest oil and gas leases, the taxpayer was not engaged in a U.S. trade or business. Apparently, there was no partnership, and so I.R.C. Section 875(1) did not apply, but the Court did not discuss I.R.C. Section 875(2). The Court set down for trial the question of whether I.R.C. Section 877 should apply to tax the taxpayer at graduated rates for 10 years.

Hendrickson v. Commissioner 48 provides analogous authority for taxpayers, with reference to self-employment tax. In the case, the taxpayer, a retired irrigation sprinkler salesman from Kansas, had purchased for investment purposes minority working interests in several oil wells. An oil and gas operating corporation, in which taxpayer had no interest, operated the wells. The Service attempted to subject the taxpayer’s income from the wells to self-employment tax under I.R.C. Section 1401(a). Citing DiPortanova as authority, the Tax Court held that taxpayer was not liable to pay self-employment tax because he was not employed in a U.S. trade or business.

While a nonresident alien individual (and certainly a foreign corporation) is unlikely to often be treated as engaged in a U.S. trade or business through an estate or trust, given that by their nature trusts generally do not engage in a trade or business, 49 the situation often arises through partnerships.

§ 2.05 Alien Not Engaged in U.S. Trade or Business

Income not effectively connected with the conduct of a U.S. trade or business is subject to a flat 30 percent tax unless reduced by a treaty. This includes (1) fixed or determinable annual or periodical income, (2) original issue discount, (3) portfolio interest income, and (4) gain on the sale of a capital asset. Interest on bank deposits is not subject to tax. Special rules apply to an alien who expatriates to avoid tax.

Nonresident alien individuals are subject to a flat 30 percent tax on certain U.S. source income not effectively connected with the conduct of a U.S. trade or business. 1 Income subject to the flat 30 percent tax includes:
(1) interest (other than original issue discount), dividends, compensation for services, rent, remuneration, emoluments and other fixed or determinable annual or periodical gains, profits and income (see § 2.05[1], below); 2

(2) the net U.S. source gain from the disposal of capital assets, if the recipient is present in the United States for an aggregate of 183 or more days during the tax year of receipt, and if those gains and losses would be taken into account if the nonresident alien were engaged in a U.S. trade or business during the year (see § 2.05[5], below); 3

(3) gain from the disposal with a retained economic interest of timber, coal or iron ore mined in the United States (held for more than six months); 4

(4) original issue discount accruing during the time the obligation is held by the foreign person, taxable upon the sale or exchange of the obligation or upon any payment on that obligation (see § 2.05[2], below); 5

(5) gain from the sale or exchange, after October 4, 1966, of interests in patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises and similar properties, to the extent the gain is from payment contingent upon the productivity, use or disposition of the property; 6

(6) gross income, when paid, from a real estate mortgage investment conduit, if the amount is includable in income for tax years beginning after 1986; 7

(7) one half of U.S. social security benefits received; 8 and

(8) for individuals who were 50 years old before January 1, 1986, the capital gain portion of distributions from qualified pension, profit-sharing or annuity plans. 9

[1] Fixed or Determinable Annual or Periodic Income

Fixed or determinable annual or periodic income (FDAPI) subject to the flat 30 percent tax specifically includes: 10 interest (other than original issue discount), dividends, rent, salaries, wages, premiums (though not insurance premiums), 11 annuities, compensations, remunerations and emoluments. 12 Other items of FDAPI are also subject to the tax, such as royalties, including royalties for the use of patents, copyrights, secret processes and formulas. 13 While capital gains are not generally viewed as FDAPI, gain on the disposition of Section 306 stock and distributions of net short-term capital gain by a regulated investment company (RIC) also constitute FDAPI, 14 as do “dividend equivalent” payments made after December 31, 2010. See discussion at § 2.05[2]. FDAPI also includes all other U.S. source income of a similar character. 15

While FDAPI must be fixed (paid in amounts definitely predetermined) or determinable (having a basis of calculation by which the amount to be paid may be ascertained), 16 this language is construed quite loosely, to the detriment of the alien. Payments made to a salesman working on commission are considered determinable, 17 as are payments of alimony,18 prizes, 19 and purses paid to owners of race-winning horses. 20 Gross income does not include any amounts received by the taxpayer under a life insurance contract by reason of the death of the insured. 21 But amounts received by a nonresident alien by reason of the cancellation of a United States life insurance policy, rather than by reason of the death of the insured, will be United States source FDAPI. 22 In a recent ruling, the Service examined the taxability of annuity payments and withdrawals by a nonresident alien owner from a life insurance policy issued by a foreign branch of a United States life insurance company. The Service determined that these were United States source payments under I.R.C. Section 861, taxable to the recipient under I.R.C. Section 871, and subject to 30 percent withholding (assuming no treaty) under I.R.C. Section 1441. 23 Gambling winnings in the United States of a nonresident alien also constitute FDAPI, subject to 30 percent withholding, with limited exceptions. The Code specifically exempts the proceeds from wagers at blackjack, baccarat, craps, roulette or big-6 wheel games from tax unless the Secretary determines by regulation that collection of the tax is administratively feasible. 24 Lottery winnings are subject to tax. 25

A settlement payment also qualifies as FDAPI subject to 30 percent withholding if such payment has a U.S. source. In a private letter ruling, the taxpayer requested that the Service determine the source of a settlement payment under a bankruptcy claim stemming from an alleged wrongful breach of contract between a sole proprietorship and the corporation for which it distributed sporting equipment outside the United States. 26 The Service stated that the source of the settlement payment depends upon the nature of the item for which the bankruptcy claims settled. Because the purchase of sporting equipment within the United States for sale and use in a different country would constitute foreign source income, the Service determined that the settlement payment made on account of the breach was also foreign source income.

Income is sufficiently determinable to the payor if he may readily compute at the flat rate the tax to be withheld before paying out the remainder. 27 This leaves little, if anything, indeterminable. Nor need income be paid annually or periodically, so long as the item of income falls within the class of income contemplated by the statute. 28 It is immaterial whether royalties, for instance, are paid in installments or in a lump sum. 29

[2] Dividends and Dividend Equivalents

Historically, dividends have been the most basic class of FDAP income, taxable to nonresident alien shareholders at a 30 percent rate. Many dual income treaties between the United States and its major trading partners reduce the withholding rate on dividends to 15 percent for treaty residents of the other nations, or from 15 percent for owners of significant blocks of stock. For those entitled to treaty benefits, however, the withholding tax rate on dividends is 30 percent, or twice the 15 percent rate available to U.S. shareholders on qualified dividends under current law. 30 For this reason, a foreign donor setting up a trust for beneficiaries in several jurisdictions may wish to set up a trust which pays dividends and interest to nonresident alien beneficiaries.

Until 2010, some nonresident alien investors avoided paying U.S. withholding tax on dividends by entering into securities lending or purchase and sale agreements with U.S. brokers, under which the nonresident alien who owned dividend-paying stocks would loan the stocks to the U.S. broker, who would then include the amount of the dividend in the interest payment, or would sell the stock to the broker just before it went “ex-dividend” for a purchase price which included the dividend, and would repurchase the stock from the broker the next day for a price which excluded the dividend. Market risk and transaction costs aside, the result was to recharacterize what would have been a taxable dividend as either portfolio interest (see § 2.05[4]) or short-term capital gain (see § 2.05[6]), and, in either case, avoid withholding tax.

This strategy was ended by the addition of a new I.R.C. Section 871(m), effective December 31, 2010, by the Hiring Incentive to Restore Employment (HIRE) Act. 31 The new I.R.C. Section 871(m) provides that “dividend equivalent” payments made to a nonresident alien taxpayer will be taxed to him or her at a 30 percent rate as if they were dividends. The statute defines “dividend equivalent” payments as any substitute dividend that is made pursuant to a securities lending or a sale-repurchase transaction that (directly or indirectly) is contingent upon or determined by reference to, the payment of a dividend from sources within United States, national principal contracts to the same end, or any similar arrangement which the Secretary may include by regulations. 32

[3] Original Issue Discount

Excluded from the definition of FDAPI is original issue discount (OID) which is the difference between the issue price and the stated redemption price at maturity (as defined in I.R.C. Section 1273) of a bond or other evidence of indebtedness (“original issue discount obligation”). OID received by an alien, and not effectively connected with that person’s U.S. trade or business, is subject to the flat 30 percent tax (or lower treaty rate) unless it is:
(1) portfolio income;

(2) paid on a short-term obligation (i.e., one payable within 183 days of its original issue); 33 or

(3) paid on a tax-exempt obligation. 34

Only OID accruing during the time the foreign person holds the OID obligation is subject to tax. 35 The tax is imposed upon the sale or exchange of the OID obligation 36 or any payment on the obligation. 37

The portion of a payment or an obligation taxed equals the OID accrued to the date of payment less OID previously taxed. The tax also cannot exceed the amount of the payment less any portion of the payment that represents expressly stated interest. 38

OID taxed on a payment is not taxed subsequently upon the sale or exchange of the OID obligation. 39 Upon disposition of an OID obligation, all untaxed OID accruing during the time it was held by the foreign person is taxed, even if the accrued amount exceeds the gain on disposition. 40

Stripped bonds and stripped bond coupons are treated in the same manner as OID obligations. 41

[4] Portfolio Interest Income

Portfolio interest paid to a nonresident alien is not subject to withholding. 42 “Portfolio interest” is defined as any interest (including original issue discount) that would be subject to tax under I.R.C. Section 871(a) but for I.R.C. Section 871(h) and is either:
(1) interest on a nonregistered obligation of the type described in I.R.C. Section 163(f)(2)(B), which are obligations of which there are arrangements designed to ensure that such obligations will be sold or resold only to nonresident aliens, and, if the obligation is in bearer form, interest on such obligations is only payable outside the United States, and there is a statement on the face of the obligation that any U.S. person who holds the obligations will be subject to the limitations of the U.S. income tax laws (e.g., Eurobonds); or

(2) interest on a registered obligation (with respect to which the U.S. person obligor would normally have to deduct and withhold tax) with respect to which the withholding agent has received a statement that the beneficial owner is not a U.S. person. 43

Section 502 of the Hiring Incentives to Restore Employment (HIRE) Act of 2010 amends I.R.C. Sections 163(f)(2)(B) and 871(h)(2) so as to eliminate bearer bonds from these classes of obligations which can constitute portfolio debt, effective for obligations issued after March 18, 2012, the second anniversary of the enactment of the HIRE Act.

Most long-term U.S. Treasury obligations are issued in registered form and will qualify as an instrument bearing “portfolio interest.”

Excluded from the definition of portfolio interest is any interest received by a 10 percent shareholder. 44 The latter includes any individual who owns 10 percent or more of the total combined voting power of all classes of stock or of the capital or profits interest, in the corporation or partnership, respectively, that issued the subject obligation. 45 I.R.C. Section 318 attribution rules generally apply to determine percentage of ownership. 46

In April of 2007, the Service adopted final regulations on the application of the 10 percent shareholder limitation on the withholding tax exemption for portfolio interest in cases where the interest is paid to a partnership with foreign partners. 47 Before the prior proposed regulations were issued it was unclear, when a partnership with foreign partners generated portfolio interest, whether the withholding agent should apply the 10 percent shareholder test at the partner level because the partner was the beneficial owner of the interest, or at the partnership level because the partnership owned the debt instrument. Under the proposed, and now final, regulations, the 10 percent shareholder test will be applied at the foreign partner level to the nonresident alien or foreign company that is the partner and beneficial owner of the income. The regulations apply the 10 percent shareholder test by determining each such foreign partner’s interest in the debtor corporation or entity. 48 The regulations also state that the 10 percent shareholder test will be applied at the time the withholding agent would otherwise be required to withhold from a foreign partner’s interest under I.R.C. Sections 1441 and 1442. 49

In addition, the portfolio interest exemption available to a nonresident alien or foreign corporation has been restricted to exclude contingent interest. 50 This rule is not intended to override existing treaties that reduce or eliminate U.S. withholding tax on interest paid to a foreign person. 51

Interest is contingent if the amount of the interest is determined by reference to:
(1) receipts, sales or other cash flow of the debtor or a related person;

(2) any income or profits of the debtor or a related person;

(3) any change in value of any property of the debtor or a related person; or

(4) any dividend, partnership distributions or similar payments made by the debtor or a related person. 52

The portfolio interest rule with respect to the exclusion of contingent interest applies to interest received after December 31, 1993. However, it does not apply to any interest paid or accrued with respect to any indebtedness with a fixed term that was issued on or before April 7, 1993, or was issued after such date pursuant to a written binding contract in effect on such date and at all times thereafter before such indebtedness was issued. 53

In an interesting case, 54 the taxpayer, a Colombian national, had invested $1,000,000 in a U.S. mutual fund. The fund paid her $106,682 in dividend income in 1989, and withheld at the 20 percent back-up withholding rate, because the taxpayer never gave the fund a form W-8. The Service now sought the additional 10 percent tax from taxpayer’s assets on deposit in the U.S., for the 30 percent I.R.C. Section 871 tax, while taxpayer sought a refund of all taxes paid, on the basis that the fund manager should have invested her assets in instruments bearing portfolio interest. The Tax Court found for the Service, requiring taxpayer to pay the extra 10 percent, and stating that any claim the taxpayer had for faulty investment strategy lay against her investment advisor, not the U.S. Treasury.

[5] Interest on Deposits

Interest payments received by a nonresident alien or foreign corporation on deposits with banks, savings institutions or insurance companies are exempt from tax if they are not effectively connected with the recipient’s U.S. trade or business. 55 Interest paid by a savings institution qualifies for exemption only if it is paid on deposits or withdrawable accounts and deductible by the payer for U.S. income tax purposes. 56 Interest paid by an insurance company qualifies for exemption only if it is paid on amounts held by that company under an agreement requiring the payment of interest. 57

This exemption applies only to interest received in tax years beginning after 1986 on obligations issued after December 31, 1985. 58 However, post-1985 extensions of pre-1986 obligations are treated as post-1985 obligations. 59 Before 1986, interest on deposits was treated as foreign source income and, therefore, was exempt from tax.

On January 6, 2011, the IRS and the Treasury Department issued proposed regulations that would require U.S. banks to annually report interest income paid to all nonresident alien individuals. Under the I.R.C. Section 6049 regulations currently in effect, U.S. banks are only required to report U.S. bank deposit interest paid to a U.S. person or to a nonresident alien who is a resident of Canada. The proposed regulations would extend the information reporting requirements to include bank deposit interest paid to nonresident aliens who are residents of any foreign country. 60

[6] Gain on Sale of Capital Asset

A nonresident alien’s U.S. source gain from the sale or exchange of personal property that is a capital asset is subject to a tax equal to 30 percent (or lower treaty rate) tax of the net gain, but only if: 61
(1) the gain is not taken into account as income effectively connected with a U.S. trade or business;

(2) the gain is not taxed as fixed or determinable annual or periodic income; and

(3) the recipient is physically present in the United States for 183 days during the tax year in which the property is sold or exchanged and the tax year in which the gain is received.

Gain from the sale of a U.S. real property interest is treated as income effectively connected with a U.S. trade or business. 62 For the definition of a U.S. real property interest and the treatment of gain or losses from the disposition of a U.S. real property interest as effectively connected with the seller’s trade or business, see § 2.06[4], below.

The taxable amount from the sale or exchange of a capital asset is the nonresident alien’s excess gains over losses from the sale or exchange of capital assets that are U.S. source during the tax year. The gains and losses must be treated as capital gains or losses if the person was engaged in a U.S. trade or business during the year, except that such capital gains are determined without regard to the Section 1202 exclusion for gains from certain small business stock. 63 Unused capital losses from previous years cannot be deducted as capital loss carryovers. 64 Gains from lump-sum distributions (treated as capital gains), gains from the disposition of timber, coal, gas or iron ore with a retained economic interest, and gains from the sale of patents (otherwise treated as capital gains) are excluded from the computation. 65 Losses are taken into account only if they are otherwise allowable under general tax provisions, governing the deductibility of losses. 66

Gains are taxable only if the nonresident alien was physically present in the United States for an aggregate of 183 days during the tax year (1) in which the sale or exchange occurs, and (2) in which the income is received. 67 If the recipient has not previously established a tax year for U.S. income tax purposes, it will be established as a calendar year. 68 All gains and losses in one tax year are netted, even if the taxpayer was not present in the United States when any particular sale or exchange took place. 69 Gain or loss recognized in the current year from transactions executed in a prior year are not taken into account unless the taxpayer met the 183-day requirement in the year the transaction occurred. 70 Similarly, income received in subsequent years is subject to the tax only if the taxpayer meets the 183-day requirement during that subsequent year, even though the taxpayer did meet that requirement in the year of the transaction. 71

The effect of this rule is that a nonresident alien taxpayer who is physically present in the United States for more than 182 days in the year in which a capital gain is realized may elect the installment method of accounting for the gain under I.R.C. Section 453, delay receipt of the sales proceeds until a subsequent year, and avoid U.S. tax by remaining outside of the United States for at least 183 days in the year in which the proceeds are collected.

Capital gains collected by a U.S. resident trustee are not taxable to a nonresident alien beneficiary who remains outside of the United States for at least 183 days. 72

[7] Expatriation to Avoid Tax

The rules discussed above in § 2.05 do not apply to a nonresident alien who expatriated before June 17, 2008–that is, renounced U.S. citizenship or relinquished long-term residency in the United States–and who at the time of the expatriation: (1) has an average tax liability for the prior five years of $124,000 (adjusted for inflation to $151,000 in 2012); (2) has a net worth of $2 million or more, or (3) does not certify under penalty of perjury that he or she had complied with all federal tax obligations for the previous five years. 73 Individuals who expatriate after June 17, 2008 are generally subject to the rules discussed above in this § 2.05 as well as the mark-to-market exit tax on unrealized net gain pursuant to I.R.C. Section 877A, as discussed above in § 1.08[5].

An individual who expatriated before June 17, 2008 to whom the alternative tax regime under I.R.C. Section 877 applies is subject to tax only on his or her U.S.-source gross income and gains on a net basis at the graduated rates applicable to U.S. citizens and resident aliens, rather than the rates applicable to nonresident aliens. However, for this purpose, U.S.-source income has a broader scope than it does for normal U.S. Federal tax purposes for nonresident aliens. For ten years after expatriation, U.S.-source income includes: (1) gains on the sale or exchange of property located in the United States; (2) gains on the sale or exchange of U.S. securities; (3) “portfolio interest” income (such as interest on U.S. Treasury securities) on which nonresident aliens otherwise would not be subject to income tax under I.R.C. Section 871(h); and (4) any income or gain derived from stock in a foreign corporation if the expatriate owned directly, indirectly or constructively, at any time during the two-year period ending on the date of the loss of U.S. citizenship, more than 50 percent of the voting stock or value (but only to the extent such income or gain does not exceed the earnings and profits attributable to such stock which were earned or accumulated before the loss of citizenship during periods such ownership requirements are met). The alternative tax regime applies only if it results in a higher U.S. tax liability than the liability that would result if the individual were taxed as a nonresident alien.

The 1996 amendments to the tax rules applicable to expatriates 74 provide for certain anti-abuse rules to prevent circumvention of the alternative tax regime through conversion of U.S.-source income or property to foreign income or property. In addition, the 1996 amendments extend the scope of the alternative tax regime by including foreign property acquired in nonrecognition transactions, taxing amounts earned by former citizens and long-term residents through controlled foreign corporations, and suspending the 10-year liability period during any time at which a former citizen’s or former long-term resident’s risk of loss with respect to property subject to the alternative tax regime is substantially diminished, among other measures. For reporting requirements applicable to expatriates, see § 1.08[2][d].

§ 2.06 Alien Engaged in U.S. Trade or Business–Effectively Connected Income

Nonresident aliens are taxed at the same rates applicable to U.S. citizens or residents on income effectively connected with the conduct of a trade or business. Interest or dividend income is subject to the asset use test to determine whether the asset is held in a direct relationship to a trade or business. Business activities test determines whether passive income, gain or loss is related to the conduct of a trade or business. Income from U.S. real property is subject to special rules.

A nonresident alien individual engaged in a trade or business is taxed at the same rates applicable to U.S. citizens or residents on income effectively connected with the conduct of such trade or business. 1 All U.S. source income (other than FDAPI) of a nonresident alien individual or foreign corporation engaged in a U.S. trade or business is treated as effectively connected even if the income is not derived from the U.S. trade or business. 2 I.R.C. Section 871(b)(1) was amended by The Small Business Job Protection Act of 1996, effective for tax years beginning after December 31, 1999, to eliminate the reference to I.R.C. Section 402(d)(1) with respect to taxation of lump sum pension distributions from qualified plans. These distributions remain taxable under I.R.C. Section 1.

Example:
Toyco, a foreign corporation which uses the calendar year as its taxable year, is engaged in the business of manufacturing automobiles in its own country. In 1991, Toyco establishes a branch office in the United States, which solicits orders from U.S. customers for Toyco’s cars. All negotiations with respect to such sales were carried on in the United States. By reason of its activity in the United States, Toyco is engaged in business in the United States during 1991. The income or loss from sources within the United States from such sales during 1991 is treated as effectively connected for that year with the conduct of a business in the United States by Toyco. Occasionally during 1991, the U.S. customers write directly to Toyco’s home office and the home office makes sales directly to these customers without routing the transactions through its branch office in the United States. The income or loss from sources within the United States for 1991 from these occasional direct sales by the home office is also treated as effectively connected for that year with the conduct of a business in the United States by Toyco.

U.S. source FDAPI is subject to taxation at graduated rates if effectively connected with the conduct of a U.S. trade or business, 3 and at the 30 percent withholding tax rate if not.4 FDAPI is effectively connected to a U.S. trade or business only if (1) U.S. source FDAPI is derived from assets used in, or held for use in, the conduct of a U.S. trade or business (the asset-use test), or (2) activities of a U.S. trade or business were a material factor in the realization of the income (the business-activities test). 5

A nonresident alien individual who does not engage in a U.S. trade or business during the tax year is treated as having no income, gain or loss effectively connected with the conduct of a U.S. trade or business for that year. 6 However:
(1) Income or gain of a nonresident alien attributable to a transaction that took place in another tax year is treated as income effectively connected with the conduct of a trade or business in the tax year in which it is taken into account, if the income would have been effectively connected with a U.S. trade or business in that other tax year. 7

Example:
A nonresident alien individual, A, performed personal services in the United States during 1991 for a period of 110 days for a foreign corporation. A received $5,000 in January of 1992 for the services performed in 1991. The income received in 1992 is treated as effectively connected with the conduct of a U.S. trade or business thoughA performed no services in the United States in 1992. The performance of the services in 1991 characterized the income.

(2) If property ceases to be used or held for use in connection with the conduct of a U.S. trade or business, and it is disposed of within ten years after U.S. use ceases, the determination of whether gain attributable to the sale or exchange is effectively connected with the conduct of a U.S. trade or business is made as if the sale or exchange occurred immediately before the U.S. use ceased. 8

Example:
B, a nonresident alien individual, conducted a hatmaking business in the United States between 1980 and 1985. He closed the business in December 1985 but did not sell the sewing machines used in connection with the business until 1992. Some gain was made on the sale. Gain attributable to the sale is effectively connected with the conduct of a U.S. trade or business since the sale was made less than ten years after U.S. use ceased.

[1] Asset-Use Test

The asset-use test generally, though not exclusively, applies to determinations of the character of passive income and is of primary significance where, for example, interest or dividend income is derived from sources within the United States by a nonresident alien individual or foreign corporation that is engaged in the business of manufacturing or selling goods in the United States. 9

An asset is treated as used, or held for use, in the conduct of the trade or business in the United States if it is:
(1) held for the principal purpose of promoting the present conduct of the trade or business (e.g., stock acquired and held to assure a constant source of supply);

(2) acquired and held in the ordinary course of the trade or business (e.g., an account or note receivable arising from the trade or business); or

(3) otherwise held in a direct relationship to the trade or business. 10

The most significant factor in whether an asset is held in a direct relationship is whether it is needed in the trade or business. An asset is needed if it is held to meet present needs, such as operating expenses. 11 It is not needed if it is held merely for anticipated future needs such as future diversification, future plant replacement, or future business contingencies, or for expansion of trade or business activities outside the United States. 12

Generally, stock is not an asset held for use in the conduct of a trade or business in the United States, 13 however, portfolio stock investments of a foreign insurance company are excluded from that general rule. 14 Since insurance companies may use stock investments to fund their current obligations to policy holders and to satisfy regulatory capital requirements, such stock meets a present need of the foreign insurance company and so it is an asset used in the company’s U.S. business and produces income subject to U.S. tax.

An asset is presumed to be held in a direct relationship to the trade or business if:
(1) it was acquired with funds generated by a U.S. trade or business;

(2) the income from the asset is retained or reinvested in that trade or business; and

(3) personnel who are present in the United States and actively involved in the conduct of the business exercise significant management and control over the investment of the asset. 15

Example 1:
XYZ, Inc., a foreign corporation which uses the calendar year as its taxable year, is engaged in industrial manufacturing in a foreign country. XYZ maintains a branch in the United States which acts as importer and distributor of the merchandise it manufactures abroad. By reason of these branch activities XYZ is engaged in business in the United States during 1992. The branch in the United States is required to hold a large current cash balance for business purposes, but the amount of the cash balance so required varies because of the fluctuating seasonal nature of the branch’s business. During 1992 at a time when large cash balances are not required, the branch invests the surplus amount in U.S. Treasury bills. Since these Treasury bills are held to meet the present needs of the business conducted in the United States, they are held in a direct relationship to that business, and the interest for 1992 on these bills is effectively connected for that year with the conduct of the business in the United States by XYZ. 16

Example 2:
ABC, Inc., a foreign corporation which uses the calendar year as the taxable year, is engaged in business in the United States during 1992 through its manufacturing branch in the United States. The branch holds on its books stock in domestic D corporation, a wholly owned subsidiary of ABC. There is no relationship between the business of D and the business of ABC ‘s branch in the United States, and the officers of D report to the home office of ABC and not to its U.S. branch. Dividends paid on the stock in D are paid to ABC ‘s branch in the United States and are mingled with its general funds, but the U.S. branch has no present need in its business operations for the cash received. Since the stock in D is not held in a direct relationship to the business conducted in the United States by ABC, any dividends received by ABC during 1992 on such stock are not effectively connected for that year with the conduct of that business.

The direct relationship presumption may be rebutted if the asset is held to meet future business needs. For example, an investment fund set up to carry out a program of future expansion is an asset held to meet future business needs, even if the above-cited criteria otherwise establishing a direct relationship are met. 17

Planning Note

Document Anticipated Use of Funds for Future Purposes. Evidence that funds are to be used for future diversification, plant replacement, or business contingencies should rebut the direct relationship presumption. An alien who does not sink such funds into the trade or business and who desires to avoid the direct relationship test should, therefore, be able to do so by tracking the accumulation of funds and, early on, documenting their anticipated use for future purposes. Nothing in the Code causes the income from the fund to be treated as effectively connected when it finally is used in the business. The character is determined at the time the income arises and such character does not change.

[2] Business-Activities Test

The business-activities test examines the activities of the U.S. trade or business and determines if they are a material factor in the realization of the income, gain or loss. 18 The business activities test is usually applied to evaluate passive income, gain, or loss that arises directly from the active conduct of the taxpayer’s trade or business in the United States. 19 This test is applied when:
(1) Dividends or interest are derived by a dealer in stocks or securities;

(2) Gain or loss is derived from the sale or exchange of capital assets in the active conduct of a trade or business by an investment company;

(3) Royalties are derived in the active conduct of a business consisting of the licensing of patents or similar intangible property; or

(4) Service fees are derived in the active conduct of a servicing business. 20

For the purpose of applying the business-activities test, activities that relate to the management of investment portfolios are not treated as activities of the U.S. trade or business unless the principal activity of that trade or business is the maintenance of the investments. 21

Example:
The Opus Corporation, a foreign corporation which uses the calendar year as the taxable year, has a branch in the United States which acts as an importer and distributor of merchandise; by reason of the activities of that branch, Opus is engaged in business in the United States during 1991. Opus also carries on a business in which it licenses patents to unrelated persons in the United States for use in the United States. The businesses of the licensees in which these patents are used have no direct relationship to the business carried on in Opus’s branch in the United States, although the merchandise marketed by the branch is similar in type to that manufactured under the patents. The negotiations and other activities leading up to the consummation of these licenses are conducted by employees of Opus who are not connected with the U.S. branch of that corporation, and the U.S. branch does not otherwise participate in arranging for the licenses. Royalties connected for that year with the conduct of its business in the United States because the activities of that business are not a material factor in the realization of such income. 22

The Treasury Regulations set forth special rules supplementing the asset-use test and the business-activities test for banking, financing, or similar activities by nonresident alien individuals or foreign corporations. 23 The foreign taxpayer will be considered to be engaging in a trade or business in the United States in classic banking activities such as making loans, accepting deposits, or providing trust services. 24 The more difficult issue arises, in modification of the asset-use test and business-activities test, if a foreign person engaged in the banking or financing business in the United States also receives dividends, interest, or capital gains from United States sources during the taxable year. The foreign person will have effectively connected income if he or it receives dividends, interest or gains upon securities used or received in the conduct of the banking or financing business in the United States. 25 In the case of other debt securities, 26 not used or received in the conduct of the banking or financing business in the United States, interest earned upon the securities will be deemed to be effectively connected with the taxpayer’s conduct of a trade or business in the United States if the debt securities have a maturity of no more than one year, 27or are issued by the United States, or any agency or instrumentality thereof, 28 or otherwise is determined by a formula, such that of the entire interest earned on debt securities with United States sourcing, at least 10 percent is deemed effectively connected income but the percentage of income from the debt securities producing U.S. source income which is taxed as effectively connected income will decline from 100 percent as the portion of assets of the foreign taxpayer’s U.S. office which is not debt securities increases. 29 InPrivate Letter Ruling 200811018 , the Service was asked to consider application of the 10 percent rule of Treasury Regulations Section 1.864-4(c)(5)(ii)(b)(3) to a securities account maintained in the United States by a foreign taxpayer engaged in the banking and financing business for trading for its own account. The Service ruled that the Treasury Regulations Section 1.864-4(c)(5)(ii)(b)(3) rule applied to all U.S. debt securities, whether held for investment or trading, which were not used directly in the conduct of the United States banking or financing business.

[3] Election to Treat Income From U.S. Real Property as Effectively Connected

Income (other than capital gains) derived by a nonresident alien from U.S. real property is taxed at the flat 30 percent rate if that income is not effectively connected with a U.S. trade or business. 30 All gain or loss on the disposition of a U.S. real property interest by a nonresident alien or foreign corporation is deemed to be effectively connected with a U.S. trade or business and taxed at the applicable graduated rates. 31

A nonresident alien may elect to treat income derived from U.S. real property as effectively connected with the conduct of a U.S. trade or business. 32 A nonresident alien individual must hold the real property of interest therein for the production of income to qualify for the election. 33 This election is allowed when the taxpayer is not actually engaged in a trade or business during the tax year and the real property income is not effectively connected with a U.S. trade or business. 34

The election may not be made for U.S. source income that would otherwise be treated as effectively connected income, 35 or when the taxpayer has no U.S. real property income that is taxed as fixed or determinable annual or periodical income. 36 The election applies to all classes of income 37 from real property located in the United States, including: 38
(1) gains from the sale or exchange of the property or any interest;

(2) rents or royalties from mines, oil or gas wells, or other natural resources;

(3) gains from dispositions of timber, coal, or iron ore with a retained economic interest; and

(4) income received by the beneficiary of a trust or estate if that income 39 is characterized as real property income in the beneficiaries’ hands. 40

Income from real property, or an interest in real property, does not include: 41
(1) interest on a debt obligation secured by a mortgage of real property;

(2) any portion of a dividend 42 paid by a corporation or trust, including a real estate investment trust, that derives income from real property;

(3) for a nonresident alien individual, income from real property, such as a personal residence, that is not held for the production of income or from any transaction in property that was not entered into for profit;

(4) rentals from personal property or royalties from intangible personal property, when a sales agreement or rental or royalty agreement affects both real and personal property; or

(5) income that is effectively connected without regard to the election.

If a foreign taxpayer derives income from a transaction based upon a sales agreement, or rental or royalty agreement that affects both real and personal property, he must allocate the income between the real property and the personal property. The allocation is made in proportion to the respective fair market values of real and personal property unless otherwise specified in the agreement. For a rental or royalty agreement, the respective fair market values are determined when the agreement is signed. 43

The income to which the election applies is aggregated with all of the foreign taxpayer’s other income that is effectively connected. 44 This aggregated effectively connected income is taxed net of deductions allocable to it, according to the regular graduated U.S. income tax rates. The deductions connected with the real property are treated as effectively connected with the conduct of a U.S. trade or business. 45 Thus, the net income is not subject to the 30 percent withholding tax applied to fixed or determinable annual or periodical income.

The election does not cause a foreign taxpayer who is not actually engaged in a U.S. trade or business to be treated as such for any purpose other than treating the taxpayer’s U.S. real property income as effectively connected income. 46

The real property, or interest therein, is treated as a capital asset that, if allowable, is subject to depreciation. 47 The real property, or interest therein, however, is not treated as property used in a trade or business for the purposes of gain or loss attributable to a trade or business, determining a net operating loss, property not constituting a capital asset, and the special rules for treatment of gains and losses on property used in a trade or business. 48

The election is made by attaching a statement to the taxpayer’s return. The statement must list all the U.S. real property that the taxpayer beneficially owns, and provide each property’s location, the extent of ownership, a description of substantial improvements to the property, and details of any previous elections made regarding the treatment of the taxpayer’s real estate income. 49

Once made, the election remains in effect until revoked, even for years in which there is no income from real estate. The initial election is made without the Service’s consent, and it may be revoked without consent during the period allowed for making the initial election. The initial election may be made within the normal time for filing for a credit or refund, that is, three years from the due date of the tax or two years from the payment of the tax. A revocation of the initial election is made by filing an amended return. To revoke the election for a subsequent year after the time period allowed for making the initial election expires, a taxpayer must obtain the Service’s consent. If an election is revoked, a taxpayer may not make a new election before the fifth tax year after the tax year for which the revocation is effective, unless he obtains the Service’s consent to make a new election. 50

Comment:
In many cases, the election will result in a lower overall tax because of deductions which will result in less net income, even at the normal graduated rate. But the taxpayer needs to consider the possible effect of treaties reducing the withholding rate if the election is not made.

[4] Gain or Loss From Disposition of U.S. Real Property Interest as Effectively Connected (FIRPTA)

Gains and losses realized by foreign investors from the disposition of a U.S. real property interest 51 are treated as effectively connected with a U.S. trade or business. 52 Transferees are required to withhold tax on these transfers. 53 The taxation, withholding and reporting provisions providing for this treatment are collectively known as the Foreign Investment in Real Property Tax Act (FIRPTA). 54 Prior to this legislation, this potential gain generally had escaped U.S. taxation entirely for foreign investors who were not present in the United States for more than 182 days in the year a gain was realized, as remains the case for gains from the sale of other U.S. situs property. At a time of increased foreign investment in U.S. real estate in the late 1970’s, FIRPTA was enacted so as to tax gains from foreign investment in U.S. real estate.

In calculating tax liability, consideration must be given to the alternative minimum tax. The term “alternative minimum taxable income” means the taxpayer’s taxable income for the tax year:
(1) determined with the adjustments provided in I.R.C. Sections 56 and 58; and

(2) increased by the amount of the items of tax preference discussed in I.R.C. Section 57. 55

The alternative minimum tax is imposed on the “taxable excess,” which is the amount of the alternative minimum taxable income for the tax year that exceeds the exemption amount.56 For nonresident aliens, the taxable excess for purposes of I.R.C. Section 55(b)(1)(A) is not less 57 than the lesser of their alternative minimum taxable income 58 or their net U.S. real property gain. 59

The definition of U.S. real property interest includes land located in the United States or the Virgin Islands with attendant improvements and associated personal property. 60 The definition further includes an interest, other than an interest solely as a creditor, in any entity fitting the statutory definition of a U.S. real property holding corporation. 61 A corporation is a U.S. real property holding corporation if, on determination dates, the fair market value of its U.S. real property interests equals or exceeds 50 percent of the aggregate of the fair market value of its U.S. real property interests, its real property interests located outside the United States and any other assets that are held or used in its trade or business. 62

Excluded from the definition of U.S. real property interest are any interest in a domestically controlled real estate investment trust (REIT), 63 any interest in a corporation that has disposed of all its U.S. real property interests in transactions in which gain was fully taxed, 64 interests of no greater than 5 percent in publicly traded corporations 65 or publicly traded partnerships, 66 and any interest held solely as a creditor. 67

An interest in a corporation continues to be a U.S. real property interest for FIRPTA purposes for five years after the corporation ceases to be a U.S. real property holding corporation, but can be purged of its U.S. real property interest characterization earlier if the corporation has completely disposed of all its U.S. real property interests in transactions in which all gain was recognized. 68

The nonrecognition provisions of the Code apply to sale or exchange by a foreign investor of a U.S. real property interest only if the interest that is acquired in the exchange will be fully subject to taxation upon sale. 69

Ownership includes fee ownership or co-ownership, leaseholds, and options. It includes easements, royalties, life estates, remainders, reversions (whether vested or contingent), rights of first refusal and, probably, time shares. 70 It should be noted that the concept of ownership is inclusive, and should encompass contracts of sale, and all types of normal real estate interests. 71 Further, dispositions by sale or exchange of an interest in a partnership, trust or estate is treated under I.R.C. Section 897 as a sale of property by a pass through entity, subjecting the nonresident alien to the FIRPTA tax. 72

I.R.C. Section 121 allows a taxpayer to exclude up to $250,000 ($500,000 for certain joint returns) of gain on the sale of property if, during the five-year period ending on the date of the sale, the property was owned and used as the taxpayer’s principal residence for at least two years. The Service has confirmed that the provisions of I.R.C. Section 121 apply to the sale of a U.S. principal residence by a nonresident alien who is taxable under I.R.C. Section 897, unless the provisions of I.R.C. Section 877(a)(1), pertaining to expatriates, apply to the individual. 73

Treaties that exempt capital gains from income tax have been preempted by FIRPTA unless the treaties have been renegotiated to provide for an additional two-year grace period. 74

The general FIRPTA withholding requirement is that the transferee of any U.S. real property interest transferred by a foreign transferor must withhold a tax equal to 10 percent of the amount realized on the disposition. 75 The amount realized is the total of consideration paid for the interest, generally equal to the contract price. 76 For example, the transferee of an option to acquire U.S. real estate transferred by a nonresident alien was required to deduct and withhold 10 percent of the amount realized by the transferor when the option was sold. 77 The transferee was held liable for the tax because he had failed to comply with the FIRPTA withholding requirements. 78

Withholding is not required if:
The transferor is not a foreign person; 79

The transferred property is not a U.S. real property interest; 80

The transferred property is a residence worth no more than $300,000; 81

A nonrecognition provision applies to the transaction; 82

The transferee receives a withholding certificate that specifically excuses withholding. 83

The transferee is not required to withhold any amount in excess of the transferor’s maximum tax liability. 84

A withholding certificate that reduces or excuses withholding may be obtained when an exemption from the FIRPTA taxation or withholding requirements exists, or when an agreement for the payment of the tax is entered into with the Service. 85

The fact that the transferee has withheld tax does not relieve the transferor from the obligation to file a Form 1040-NR and report the transaction. See § 2.11.

FIRPTA can be an unexpected tax burden upon a nonresident alien individual investing in U.S. enterprises through a partnership, if one or more of the corporations in which the partnership invests is found to be a United States real property holding corporation. This can be the case, for example, with investments in electric or water utilities companies.

[5] Taxation of FDAPI Income to Taxpayers with Effectively Connected Income

The fact that a nonresident alien has effectively connected income in a given year does not mean that all of her income will be taxed as effectively connected income. The Treasury Regulations 86 make clear that the taxpayer is to segregate each class of income collected by her, and distinguish income which is effectively connected with the conduct of a U.S. trade or business from income which is not so connected. Tax will be determined at the flat 30 percent or lower treaty rate on income not effectively connected with the conduct of a trade or business in the same manner as if the taxpayer had no effectively connected income for the year in question. 87 The same principle applies to income received by a nonresident alien taxpayer through a partnership. 88

§ 2.07 Foreign Source Income

Foreign source income is effectively connected with a U.S. trade or business if foreign income is attributable to a taxpayer’s U.S. office. To qualify, an office or fixed place of business must be a material factor in the realization of income and regularly carry on activities that produce income.

Foreign source income, gain or loss may be treated as effectively connected with a U.S. trade or business if the taxpayer maintains a U.S. office or fixed place of business and the foreign income is attributable to that location. 1

The following three groups of foreign source income may be effectively connected with the conduct of a U.S. trade or business:
(1) rents and royalties for the use of or the privilege of using intangible property (intangible property includes patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises and other like properties); 2

(2) dividends or interest if either is derived in the active conduct of a banking, financing or similar business in the United States or is received by a corporation whose principal business is trading in stocks and securities for its own account; 3 and

(3) income from the sale or exchange of inventory or property held for sale in the ordinary course of business unless the property is sold or exchanged for use outside the United States and an office or other fixed place of business of the taxpayer in a foreign country participates materially in the sale. 4

The rules discussed above do not affect dividends, interest, or royalties paid by related foreign corporations (more than 50 percent owned) and subpart F income of a controlled foreign corporation. The dividends or income are not treated as effectively connected with a U.S. trade or business. 5

[1] Office or Other Fixed Place of Business

Income, gain or loss is not considered attributable to an office or other fixed place of business in the United States unless the office or fixed place of business is a material, though not necessarily major, factor in the realization of the income and regularly carries on activities of the type that produced the income. 6 The office must provide a significant contribution to, by being an essential economic element in, the realization of the income gain or loss. For example, meetings in the United States of the board of directors of a foreign corporation do not of themselves constitute a material factor. An office or other fixed place of business located in the United States at some time during a tax year may be a material factor in the realization of an item of income gain or loss for that year even though the office or other fixed place of business is not present in the United States when the income, gain or loss is realized. 7

An office or other fixed place of business is defined as a place, site, structure, or other similar fixed facility through which a nonresident alien engages in a trade or business. 8 The determination of the existence of an office depends on the facts and circumstances of each case, especially to the nature of the taxpayer’s trade or business and the physical facilities actually required in the ordinary course of that trade or business. 9 Foreign law is not controlling. 10

An office or other fixed place of business includes, but is not limited to, a:
factory;

store or other sales outlet;

workshop; and

mine, quarry or other place of extraction of natural resources. 11

The office of an agent is disregarded in determining if the foreign taxpayer has an office or other fixed place of business in the United States unless the agent:
(1) has the authority to conclude contracts in the name of the alien and regularly exercises that authority or has a stock of merchandise from which it regularly fills orders on behalf of the alien; and

(2) is not a general commission agent, broker or other agent of independent status acting in the ordinary course of his business. 12

An office of a person controlling a foreign corporation from which the general supervision and control over its policies are exercised does not, by itself, cause that corporation to have an office in the country where that person is located. Similarly, a foreign corporation is not deemed to have an office in a country solely because top management decisions are made there. 13

Example:
XYZ Co., a foreign corporation, is engaged in the business of buying and selling tangible personal property. XYZ is a wholly owned subsidiary of ABC Corp., a domestic corporation engaged in the business of buying and selling similar property, which has an office in the United States. Officers of ABC are generally responsible for the policies followed by XYZ and are directors of XYZ but XYZ has an independent group of officers, none of whom are regularly employed in the United States. In addition to this group of officers, XYZ has a chief executive officer, D, who is also an officer of ABC but who is permanently stationed outside the United States. The day-to-day conduct of XYZ’s business is handled by D and the other officers of XYZ, but they regularly confer with the officers of ABC and on occasion temporarily visit ABC’s offices in the United States, at which time they continue to conduct the business of XYZ. XYZ does not have an office or other fixed place of business in the United States for purposes of Treasury Regulations § 1.864-7(c).

Nor is the office of a related person imputed to a nonresident alien (or foreign corporation). 14

Section 865 of the Code governs the taxation of sales of personal property by foreign persons, including inventory property attributable to a U.S. office maintained by such foreign persons. In a recently released Chief Counsel Advice Memorandum, 15 the Service stated that, under I.R.C. Section 865(e)(3), inventory sales by a non-resident attributable to a U.S. office or fixed place of business when production occurred outside the United States would not generate exclusively U.S. source income. The case involved a nonresident alien who raised livestock in Mexico but contracted with a dependant U.S. company to fatten the cattle and sell them to U.S. packing houses or other buyers. According to the Service, Congress intended that where place of production and place of sale were different, the income should be apportioned under I.R.C. Section 865(e)(2) between the appropriate U.S. and foreign sources, allowing for any reasonable apportionment method that the taxpayer can prove fulfills Congressional intent. Such methods, according to the Advice, would include the use of any formula in the regulations promulgated under I.R.C. Section 863, as long the formula chosen sourced some of the income to the United States. Specifically, the Chief Counsel recommended for this factual situation the “50-50 method” contained in Example 2 of Treasury Regulations Section 1.863-3T(b)(2).

It may be desirable for an alien to have certain income characterized as effectively connected. As has been noted, FDAPI and certain U.S. source capital gains are taxed at a flat 30 percent rate with no allowance for expenses while effectively connected income is taxed at graduated rates after permissible deductions. Where the cost of producing the FDAPI is high, the alien may wish to plan so that the income is effectively connected. Moreover, depending on the applicable tax bracket, the graduated income tax rates may make effectively connected status advantageous even where costs are low or nonexistent.

The alien and his counsel must carefully consider the adverse consequences before following such a path, however. For example, it is always better that non-FDAPI not be effectively connected because there is no tax on such income; therefore, an alien who creates effectively connected FDAPI by nominally engaging in a trade or business may be “penny wise and pound foolish.” He may save a few percent by having his FDAPI taxed at graduated rates rather than withholding rates and lose a fortune when all his (otherwise nonincludable) U.S. source non-FDAPI is, by virtue of the force of attraction principle, treated as effectively connected to the conduct of the nominal trade or business and taxed at graduated rates. Indeed, the alien might have avoided most or all of the withholding tax in the first place had he resorted to treaty protection. While planning opportunities exist in using the characterization of income as effectively connected, the disadvantages must be identified and evaluated.

§ 2.08 Treaties

U.S. tax treaties generally contain specific provisions on benefits, source and character for common types of income and taxpayers. They generally give primary right of taxation to the nation of the taxpayer’s domicile, and reduce or eliminate tax by the non-domiciliary nation on most passive income arising in that nation. Even where income is effectively connected to active conduct of a U.S. trade or business, a taxpayer who is entitled to treaty benefits may avoid taxation if he does not have a permanent establishment, i.e., a fixed place of business, in the U.S. through which business of foreign enterprise is carried on. Most treaties also contain provisions on exchanges about information on taxpayers by the taxing authorities.

The U.S. has entered into income tax treaties with most of its major trading partners and many other countries with important economic relationships with the U.S. The Treasury Department in recent years has been continuing to extend and broaden the U.S. tax treaty network by negotiating new agreements with emerging economies, including the entry into force of the treaty with Sri Lanka and Bulgaria, and the signing of a treaty with Bangladesh 1 and ongoing negotiations for an income tax treaty with Brazil. 2 Generally these are bilateral. All are negotiated by the Treasury Department and must be approved by the Senate. 3 A list of those nations with which the United States has bilateral income tax treaties in force, and those with which new treaties are pending, is appended as Appendix A to this section, § 2.08, below. In February 2010, tax treaties with Chile and Hungary were signed and now await ratification by the U.S. Senate. 4 In May 2012, President Obama formally sent the treaty with Chile to the Senate for its advice and consent to ratification. 5 Also in May, Spain and the United States initialed an amending protocol to the 1990 U.S.-Spain Income Tax Treaty; the protocol still awaits official signature. 6 In July 2012, the Senate Foreign Relations Committee favorably voted out of committee the treaty with Hungary and proposed protocols to the tax treaties with Switzerland and Luxembourg. 7 There are ongoing treaty negotiations with South Korea. 8

Treaties and statutes are entitled equal priority under the United States Constitution and in case of conflict between a treaty and a statute, that enacted or ratified most recently prevails. 9 Conflicting provisions in treaties and regulations are not accorded equal treatment. For example, in a decision involving the taxation of the U.S. branch of a foreign banking corporation conducting business in the United States, the Court of Claims held that application of a provision of the Treasury regulations affecting allocation of deductible interest for U.S. operations of a foreign business 10 conflicted with, and was overridden by, the provisions of the (now supplanted) United States-United Kingdom Income Tax Treaty dated December 31, 1975, 11 and that taxpayer was therefore entitled to income tax refunds for the year 1981–once the interest was deducted in accordance with the Treaty. 12

Where a taxpayer takes a position that a treaty under which the taxpayer is entitled to claim benefits overrides the Code in a manner which reduces the taxpayer’s income tax liability, the taxpayer must now attach a statement to his return disclosing his treaty-based return position. 13 See § 1.13[4] for a discussion of similar rules for estate tax liability. Under revised Treasury regulations effective on January 1, 2001, it is specifically required that, among other things, taxpayers report on a return a claim that a treaty’s nondiscrimination provision precludes the application to them of an otherwise controlling Code provision 14 or a treaty reduces or modifies the taxation of gain or loss to the taxpayer from the disposition of a United States real property interest. 15 However, the regulations generally exempt nonresident aliens from reporting to the Service a treaty based claim for reduced withholding upon FDAPI. 16 That treaty position will have been reported to the withholding agent by the taxpayer, and the withholding agent will report the treaty based claim to the Service. 17 The Service has announced an intention to broaden some of the exemptions from reporting treaty positions in connection with withholding tax. 18

Bilateral income tax treaties today are to the fullest extent possible based upon the U.S. and OECD model treaties, as modified from time to time, with specific negotiated variations for historic or other reasons in individual cases. Generally, treaties provide for income tax priority to the nation of the taxpayer’s domicile on most classes of passive income not connected with a trade or business, but do not eliminate a residual right in the United States to tax its citizens on their worldwide income, after credit for taxes paid to the nation of their domicile. 19 The United States is unique among major Western nations in taxing individuals on their worldwide income based upon citizenship, regardless of residency or domicile.

Treaties often reduce the rate of income tax, sometimes to zero, upon passive income (or certain classes of passive income, such as interest income) earned in the United States by foreign nationals, and they provide a framework to determine taxing priority between the two jurisdictions for taxpayers who have connections to both jurisdictions. Generally a taxpayer is entitled to claim the benefits of an income tax treaty only if he or she, as an individual, is a resident of the country whose treaty benefits he or she is claiming, 20 subject to income tax in the other country upon his or her worldwide income. 21 In the case of taxpayers who are not individuals, most modern treaties include a limitation of benefits article that denies the benefit of the treaty to corporations or trusts which are nominally resident in the treaty partner country, but not beneficially owned by individuals resident in that country. 22 For example, in the German protocol entered into force on December 28, 2007, the limitation on benefits provisions for companies were expanded to allow a German corporation with U.S. source income to qualify for the benefits of the Treaty only if: i) its principal class of shares is regularly traded on a recognized stock exchange and primarily traded on such an exchange in Germany, ii) its principal class of shares is regularly traded on a recognized stock exchange and the corporation’s primary management and control are in Germany, iii) shares representing at least 50 percent of the corporation (by vote and value) are owned either directly or indirectly through a chain of U.S. resident or German resident owners, by no more than five corporations that satisfy i) or ii) above, or iv) shares representing at least 95 percent of the corporation (by vote and value) are owned by no more than seven persons who are either individual residents of Germany or the United States, or corporate residents that meet i) above, or residents of an EU member state, or a NAFTA party state entitled to benefits under an applicable income tax treaty and not subject to higher withholding rates under that treaty. These types of limitations are typical in newer treaties, and are being added in other recent Protocols like those with France and Sweden. In addition, I.R.C. Section 894 enacted by Congress in the Taxpayer Relief Act of 1997 and Treasury regulations enacted thereunder in 2000 deny treaty-reduced withholding rates with respect to payments of U.S. source income passing through an intermediate “hybrid” entity that is treated as transparent for U.S. tax purposes (e.g., a partnership or a grantor trust) but treated as a taxable entity in the home country of the entity and the home country of the interest holders. 23 Further complications may arise in the case of persons who may be resident in more than one country. The Service has ruled that a corporation cannot claim the benefits of the United States income tax treaty with Country X, if the corporation is resident in both Country X and Country Y, but for purposes of the bilateral treaty between Country X and Country Y the corporation is treated as a resident of Country Y. 24

Most treaties between the U.S. and other contracting states authorize the competent taxing authorities to enter into mutual agreements with respect to certain cross-border tax issues that may affect treaty interpretations. The Service publishes various pronouncements under the foregoing authority to construe treaty provisions with the mutual agreement of the other contracting state. In some cases such mutual agreement provisions may enable the Service and the competent taxing authorities of the other contracting state to enter into mutual understandings which may deal with issues not specifically contained in the applicable treaty. Oftentimes, such mutual agreements will provide tax benefits to persons in either contracting state based on reciprocity as between the contracting states. For instance, in Notice 99-47 , the Service announced that the American and Canadian tax authorities had entered into certain mutual agreements pursuant to Article XXVI of the United States-Canada Income Tax Convention. 25 Such agreements provide that certain charitable organizations exempt from tax in one jurisdiction will be recognized as exempt from tax in the other jurisdiction without the requirement of an application for tax exemption in such other jurisdiction, simplifying the availability of charitable deductions from income tax for donations by a domiciliary of one state made to organizations recognized as exempt from tax in the other state. (Absent a treaty provision, a U.S. taxpayer cannot obtain an income tax deduction for a gift to a foreign charity. See Chapter 13.)

Finally, treaties provide tie-breaking rules for taxation of income by the two nations and for exchange of information about taxpayers. 26

[1] Income Not Connected with a United States Business

Treaties generally reduce or eliminate any U.S. income tax (imposed as a flat withholding tax) on income not connected with the conduct of a U.S. trade or business earned by a nonresident alien individual or a foreign corporation. The taxation of specific classes of such income is discussed below in § 2.09, below.

An alien who resides in a country that has signed a treaty with the United States typically may dramatically reduce or altogether avoid U.S. tax withholding on interest, 27 royalties,28 pensions, 29 annuities, 30 alimony (but not necessarily child support), 31 gains from the sale of personal property, 32 income from independent (and, occasionally, dependent) personal services, 33 and may greatly reduce his tax on dividends, 34 but only if the income is not attributable to a permanent establishment. 35

The United States-Japan income tax convention greatly reduces, and sometimes eliminates, withholding taxes on the payments of cross-border dividends. 36 Under the U.S.-Japan treaty, withholding is eliminated on payments of cross-border dividends from a subsidiary to its parent company if the parent owns at least 50 percent of the subsidiary. If the parent owns between 10 percent and 50 percent of the subsidiary the rate is 5 percent, and all other dividends are subject to a 10 percent tax rate. Recent agreements with the Netherlands, the U.K., Mexico and Australia and the Protocol with Sweden also eliminate dividend withholding tax, but only if the parent owns at least 80 percent of the subsidiary. 37These recent agreements, along with the Japan treaty, show a trend of reduction of, and even elimination of, mandatory withholding on U.S. source income not connected with a U.S. business. Treaties also provide for relief in some instances from tax imposed by the alien’s state of residence. 38

Under amendments made to I.R.C. Section 894 by the Taxpayer Relief Act of 1997, foreign taxpayers are to be denied reduced rates of withholding of U.S. income tax on FDAPI collected through partnerships or other entities that are transparent for U.S. income tax purposes unless the income is taxable to the taxpayer in his or her country of domicile. I.R.C. Section 894(c) provides that a foreign person shall not be entitled under any income tax treaty of the United States with a foreign country to any reduced rate of U.S. withholding tax on any items of U.S. source income which is derived through a partnership or other fiscally transparent entity if:

(A) such item is not treated for purposes of the taxation laws of such foreign country as an item of income to such person,

(B) the treaty does not contain a provision addressing the applicability of the treaty in the case of an item of income derived through a partnership, and

(C) the foreign country does not impose tax on a distribution of such item of income from such entity to such person.

The provision became effective August 5, 1997.

[2] Income Connected with a Permanent Establishment

Although the term permanent establishment and the term engaged in a trade or business (see § 2.04, above) are not synonymous, both relate to the same concept and imply the same general conditions. Both imply a place for carrying on a trade or business in the United States. 39 The U.S. model treaty defines permanent establishment as a fixed place of business in one country through which the business of an enterprise of a resident of the other country is wholly or partly carried on. 40 This includes a place of management, a branch, an office, a factory, a workshop, and a mine or other place of extraction of natural resources, 41 but generally excludes warehouses, and purchasing or information-gathering facilities. 42 Nor does mere ownership and leasing of property constitute a permanent establishment. A permanent establishment implies the existence of an office, staffed and capable of carrying on business from day to day, or a plant or facility equipped to carry on the ordinary routine of a business activity. 43

The activities of a dependent agent who has and exercises general authority to conclude contracts in the name of the taxpayer are attributed to the taxpayer. For example, a taxpayer had a permanent establishment by virtue of his interest in a limited partnership whose general partner exercised his authority to act on the taxpayer’s behalf. 44

There are differences, however, between engaging in a trade or business and having a permanent establishment. Where the agent is independent, an alien may be engaged in a trade or business for purposes of the Code, yet lack a permanent establishment. 45 For example, a nonresident alien engaged in a trade or business through local real estate agents who negotiated or renewed leases, arranged for repairs, collected rents and paid taxes since the activities were considerable, continuous and regular. The court decided, however, that the taxpayer did not maintain a permanent establishment because the applicable treaty provided that carrying on business dealings through a broker or independent agent acting in the ordinary course of his business as such did not amount to having a permanent establishment. 46

Where a nonresident alien client has income that is subject only to withholding because it is not effectively connected to a U.S. trade or business, the appropriate article of the treaty, applied to the category of income involved, shows the relevant rate of tax (if any). However, even where income is effectively connected to the active conduct of a U.S. trade or business, a taxpayer entitled to the benefits of a treaty may avoid taxation if he can demonstrate that he does not have a permanent establishment. 47 Where there is a permanent establishment, the United States has renounced the right to tax income if it (1) is not effectively connected to the conduct of a U.S. trade or business, and (2) is of a certain type, primarily FDAPI. 48

[3] Appendix A: Status of U.S. Income Tax Treaties
U.S. Income Tax Treaties in Force as of 07/01/12
Treaty    Signed    Amended
__________________________________________
Australia    1982    2001
Austria    1956    1996, 2004
Bangladesh    2004
Barbados    1984    1991, 2004
Belgium    2006
Bermuda 49
1986
Bulgaria    2007    2008
CIS/Former USSR 50
1973
Canada    1980    1983, 1984, 1995, 1997, 2007
China 51
1984    1986, 2008
Cyprus    1984
Czech Republic    1993
Denmark    1999    2006
Egypt    1980
Estonia    1998
Finland    1989    2006
France    1994    2004
Germany    1989    2006
Greece    1950
Iceland 52
2007
India    1989
Indonesia    1988    1996
Ireland    1997    1999
Israel    1975    1980, 1993
Italy    1999
Jamaica    1980    1981
Japan 53
2003
Kazakstan    1993
Korea    1976
Latvia    1998
Lithuania    1998
Luxembourg    1962    1996
Malta    2008
Mexico    1992    1994, 2002
Morocco    1977
Netherlands    1992    1993, 2004
Netherlands Antilles 54
1948    1955, 1963, 1995
New Zealand    1982    2008
Norway    1971    1980
Pakistan    1957
Philippines    1976
Poland    1974
Portugal    1994
Romania    1973
Russia    1992
Slovakia    1993
Slovenia    1999
South Africa    1997
Spain    1990
Sri Lanka    1985    2002
Sweden    1994    2005
Switzerland    1996
Thailand    1996
Trinidad and Tobago    1970
Tunisia    1985    1989
Turkey    1996
Ukraine    1994    2000
United Kingdom    2001    2002
Venezuela    1999

U.S. Income Tax Treaties and Protocols Signed and Awaiting Senate Approval
U.S. Income Tax Treaties and Protocols Not Yet in Force as of 07/01/12
Treaty    Signed    Amended
__________________________________________
Chile    2010
Hungary    2010
Luxembourg    2009
Switzerland    2009

§ 2.09 Determination of the Source of Income (START OF WEEK 3)

Subject to treaty provisions, the source of income determines whether a foreign person’s income is subject to U.S. taxation. U.S. interest is treated as U.S. source income no matter where or how paid. The source of dividend payments is generally wherever the paying corporation is created or incorporated. Source of rental, royalty and real property sales income depends on the location of the property. Personal services income is U.S. source if performed in the United States. Personal property income is sourced to the seller’s residence. Trust or estate income is subject to conduit treatment. Sourcing rules also apply to partnership income, international transportation and communications activities, ocean and space activities and insurance underwriting income.

Because the United States imposes tax (but with few exceptions, see § 2.07, above) only upon U.S. source income, the determination of the source of an item of income as foreign or domestic is important. When a treaty applies, the source-of-income rules contained in the Internal Revenue Code may, however, be trumped by the treaty resourcing provisions. Nevertheless, there are situations when a treaty partner may legitimately impose tax on income that is also domestic-source under the Code. Therefore, most U.S. income tax treaties contain resourcing provisions designed to bridge the gap between the treaty’s allocation of taxing jurisdiction to the other country and Code source rules that treat the income as domestic-source. 1

Different rules for sourcing apply to different types of income so separate discussions of the treatment of each follows.

[1] Interest

Interest from the U.S. or any agency of the U.S. or any state or subdivision thereof and interest on bonds, notes or other interest-bearing obligations of individuals resident in the United States, domestic partnerships engaged in trade or business in the United States, any domestic corporation, or foreign partnerships or corporations engaged in trade or business in the United States, is treated as income from sources within the United States. 2 For example, income from sources within the United States includes interest received on any refund of income tax imposed by the United States or any state. 3 The method by which, or the place where, payment of the interest is made is immaterial in determining whether interest is derived from sources within the United States. 4 Interest paid on foreign government obligations, bonds or notes and interest paid by nonresident individuals to U.S. citizens or resident aliens is foreign source income. 5

For exemption from tax for portfolio interest and interest on deposits paid foreign investors, regardless of U.S. source classification, see § 2.05[3] and [4], above.

Foreign, rather than U.S., source treatment may result due to statutory exception even though the interest arises from within the United States. For example, interest received from a resident alien individual or domestic corporation is foreign source if the individual or corporation meets the 80 percent foreign business requirement. 6 The requirement is met if it is shown to the Secretary’s satisfaction that at least 80 percent of the gross income from all sources of the individual or corporation for the testing period is active foreign business income. 7 The testing period is the three-year period ending with the close of the tax year of the individual or corporation preceding the payment. 8 Active foreign business income is gross income derived from sources outside the United States and attributable to the active conduct of a trade or business in a foreign country or possession of the United States by the individual or corporation. 9 The active conduct test may be met by including the income of foreign or domestic subsidiaries controlled by the U.S. corporation (at least 50 percent owned). 10

Interest paid by an 80/20 payer to a related party is deemed to be partly from United States and partly from foreign sources. The portion of interest treated as foreign source income equals the portion of the payer’s total gross income for the three-year period which is from sources outside the United States. 11 A corporation is related to the payer if it owns, directly or indirectly, at least 10 percent of the total voting power of all voting stock, or 10 percent of the total value of the corporation. A partnership, trust or estate is a related party if the individual owns, directly or indirectly, at least 10 percent (by value) of the beneficial interest in the entity. 12

There is a special rule regarding interest earned on deposits with the foreign branch of a domestic corporation or partnership of a commercial banking enterprise. Such interest is statutorily excluded from U.S. source income. 13 For example, the interest earned from a United Kingdom branch of Bank of America would not be considered U.S. source income. Similarly, interest on deposits with persons carrying on the banking business, certain savings and loans, and certain interest payments from insurance companies are not considered U.S. source income. 14 For example, interest on deposits in general, paid by a U.S. bank or savings and loan, or certain insurance company payments, even though U.S. source income to a nonresident alien, are excluded from U.S. tax. The policy, obviously, is to foster commercial U.S. banking transactions, particularly deposits.

Planning Note

Monies on Deposit. It is advisable to make sure that significant monies on deposit not be held by a brokerage firm, or in certain money market accounts, but rather with a bank or savings and loan.

The allocation of interest between U.S. and foreign sources applies to interest payments after December 31, 1986 unless paid pursuant to obligations outstanding on December 31, 1985. There is no grandfathering, though, of payments made pursuant to an extension or renewal of an obligation to which the parties agreed after 1985. 15

In the case of interest paid to a related person benefiting from this grandfather rule, the payments are treated as payments from a controlled foreign corporation for foreign tax credit purpose. As such they retain their character and source. 16 There would be no allocation of interest paid on obligations outstanding pre-December 31, 1985, that have not been extended or renewed, and the old law would apply, even if 20 percent or more of the gross income from all sources are derived from U.S. sources for the three-year measuring period.17

Under the Model Treaty, 18 and most treaties, interest collected by a taxpayer domiciled in a foreign country from a U.S. payor is not taxed by the United States.

[2] Dividends

The source of dividend payments is generally the jurisdiction in which the paying corporation is created or incorporated. Dividends paid by U.S. corporations are U.S. source income unless the corporation has elected to be treated as a possessions corporation. 19 For exemption from tax of a portion of dividends when received by a foreign person from a U.S. corporation that earns more than 80 percent of its income from active foreign business, see § 2.05[1], above.

Dividends from foreign corporations also are U.S. source unless less than 25 percent of gross income over a three-year period is effectively connected to the conduct of a U.S. trade or business. 20 If 25 percent or more of gross income is effectively connected then U.S. source characterization attaches, but only in proportion to the ratio of effectively connected income to noneffectively connected gross income. 21

Dividends received from a domestic international sales corporation (DISC) or former DISC are treated as U.S. source income except to the extent attributable to qualified exports receipts of the DISC. 22

Under the Model Treaty, 23 dividends collected by a foreign taxpayer from U.S. payors are primarily taxed in the jurisdiction in which the payee is domiciled, but remain subject to tax by the United States, at reduced rates.

[3] Rentals and Royalties

The source of rental or royalty income depends on the location of the property giving rise to the income. 24 U.S. source income includes rentals and royalties from property located in the United States or from any interest in such property, including rentals or royalties for use of, or for the privilege of using, in the United States, patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises and other similar property. 25

For example, in a Chief Counsel Advice Memorandum released in 2005, the Service determined that income paid to a nonresident alien (a Brazilian citizen neither present in the United States for 183 days nor engaged in a trade or business in the United States) by a United States publishing company for the right to copy and distribute musical works owned by a nonresident alien was royalty income from sources within the United States and subject to the 30 percent withholding tax. 26 The taxpayer tried to analogize his situation to Boulez v. Commissioner, 27 in which CBS contracted with a conductor to make recordings for CBS records. In that case the Tax Court determined that the contract was a contract for personal services and payments made to the conductor were not royalty payments because the conductor was not conveying pre-existing property, and the recordings would be solely the property of CBS records. The Chief Counsel distinguished Boulez because the Brazilian musician had composed and copyrighted the music prior to his connection with the U.S. publisher, who, unlike CBS in Boulez, did not have any involvement in the writing or production of the final product. The payments made to the Brazilian musician were therefore royalties with a U.S. source and subject to the 30 percent withholding tax.

Moreover, gains from the sale or exchange of such property are U.S. source to the extent that they are from payments for use of property in the United States that are contingent upon productivity, use, or disposition of the property sold or exchanged. 28

Under the Model Treaty, 29 royalties may only be taxed in the nation in which the payee is resident.

[4] Personal Services Income

Compensation for labor or personal services is U.S. source income if performed in the United States 30 and foreign source income if performed outside the United States. 31 Other factors, such as whether the person is an individual, corporation or partnership, the nationality or residence of the performer or the recipient of the services, the place where the contract was negotiated or signed, and the time, place or currency of payment, are irrelevant. 32

A nonresident alien individual’s income from labor or personal services performed in the United States is not U.S. source income if:
(1) He is not present in the United States for an aggregate of more than ninety days during a tax year;

(2) He earns, in the aggregate, less than $3,000 per tax year for services performed in the United States; and

(3) He is an employee of, or under a contract with:
(a) a foreign person not engaged in a trade or business in the United States,

(b) a U.S. person if the services are performed for the U.S. person’s office located in a foreign country or U.S. possession, 33 or

(c) a foreign office of a U.S. government agency. 34

Treasury Regulations Section 1.861-4(b) provides rules for determining source when services are performed by either individuals or non-individuals partly within and partly without the United States. 35 In that case, the amount to be included in gross income is determined on the basis that reflects the most proper source of the income under the facts and circumstances of the particular case, which the regulations conclude is an apportionment on a time basis. 36

An individual may determine the source of compensation under an alternative basis, other than a time basis, if the individual can establish to the Commissioner’s satisfaction that the alternative basis is the more appropriate and more accurate way to source the income under the facts and circumstances of the particular case. 37 The regulations also require that the taxpayer source certain fringe benefits, including housing stipends, payment of qualified tuition expenses, transportation fringes and moving expense benefits, on a geographical basis. 38

Employer contributions to an annuity or pension plan also constitute personal services income. 39 For an employee who performed personal services both inside and outside the United States, the Service determines the source of the pension or annuity payments similarly to the way it determines the source of current compensation. The portion of the annuity or pension payments attributable to employee contributions for services rendered in the United States is income from U.S. sources, the portion attributable to services performed outside the United States is treated as income from non-U.S. sources, and any earnings or accretions to the contributions of either the employer or the employee is treated as income from sources within the United States. 40 If the actual amount of the employer contributions is unknown, the regulations provide a formula to determine that amount, and then allocate the employer contributions based on the employee’s time worked either inside or outside the United States. 41

An applicable tax treaty may alter whether pension or annuity payments are determined to be U.S. source or foreign source income as discussed above. 42 In Private Letter Ruling 200416008 the Service determined that under the U.S.-Australia Income Tax Treaty, distributions from a retirement plan for a nonresident alien who had worked both inside and outside the United States were exempt from U.S. income tax. Under Article 18 of the Treaty, pension payments and other periodic payments made by reason of retirement or death are taxable only in the contracting state in which the recipient resides. The nonresident alien lived in Australia, so his payments were taxable there and not in the United States.

[5] Income from Sales of Real Property Interests

Income from the disposition of a U.S. real property interest is treated as income from sources within the United States. 43 However, income from the sale of a U.S. real property interest located in the Virgin Islands is foreign source income. 44 Income from the sale or exchange of real property located without the United States is foreign source income. 45

For the definition of a U.S. real property interest and the treatment of gain or losses from the disposition of a U.S. real property interest as effectively connected with the seller’s trade or business, see § 2.06[4], above.

[6] Income from Sales of Personal Property

The source of income from the sale of personal property generally follows the residence of the seller. Thus, income from sales by a U.S. resident is sourced in the United States and from a nonresident is sourced outside the United States. 46

Basing source on residency of the seller generally could help nonresident aliens. A special definition, applicable only for purposes of I.R.C. Section 865, is provided for distinguishing between resident and nonresident. See § 2.03, above, for the general rules for determining residency. A U.S. resident is a U.S. citizen or a resident alien if he does not have a tax home in a foreign country or a nonresident alien who has a tax home in the United States. 47 Generally, an individual’s tax home is defined for purposes of I.R.C. Section 865, as it is for purposes of I.R.C. Section 7701(b)(3)(B)(ii) (the so-called “closer connection” test), by reference to the code provisions defining “tax home” for purposes of allowing an income tax deduction for travel expenses while away from “home.” 48 These rules deny an income tax deduction for commutation expenses, 49 and define “home” generally based upon all of the facts and circumstances of an individual’s center of interests.

Exceptions to the source of income following the residence of the seller exist for inventory, 50 depreciable property 51 and intangibles. 52

All gain attributable to U.S. depreciation is U.S. source and the excess is sourced as though the property is inventory property, although there is an exception for allocation of depreciation deductions where the property is used predominantly either inside the United States or out. 53 To the extent that payments for intangible property are contingent, the payments are sourced as though they are royalties. 54 See § 2.09[3], above.

Income from the sale of personal property, including inventory, attributable to a nonresident’s office or fixed place of business in the United States is U.S. source income. However, it remains foreign source income if it is attributable to the sale of inventory for use, consumption, or disposition outside the United States and an office of the nonresident outside the United States materially participates in the sale. 55

For transactions entered into before March 19, 1986, income from personal property sales was sourced under the passage of title test. 56 Gains from the sale or exchange of personal property were treated as derived from the country in which the property was sold, 57 a determination turning on where title passed. 58 This rule was subject to manipulation. Those desirous of having foreign source income from sales of personal property to those abroad merely specified in the sales agreement that title (and risk of loss) passed at the time that the property reached foreign shores. A foreign person sources all income from an installment sale executed before March 19, 1986, under the old rules, regardless of when received. Income from installment sales executed after March 18, 1986, are sourced under the current rules. 59

[7] Income from a U.S. Trust or Estate

The character of income distributed by a simple or complex trust or estate is determined by application of the “conduit theory” which provides that the income has the same character in the hands of the beneficiary as it would have had if paid in the first instance to the beneficiary rather than to the trust or estate and then to the beneficiary. 60 For example, interest earned by a simple trust on a deposit in a U.S. bank and distributed to nonresident aliens is foreign source income. 61

However, conduit treatment is inappropriate for income not currently distributed. For example, if a complex trust accumulates and distributes income in a later year, the income loses its original source and is sourced according to the residence of the trust. 62

[8] Income from Partnerships

The character of any item of income included in a partner’s distributive share is determined as if the item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership. 63 Therefore, a distribution received by a foreign-based partner from a partnership having U.S. source income retains the same character when received by the partner. 64 The conduit theory may produce results amenable to the taxpayer: Payments from a U.S. partnership that derive from foreign sources should retain their foreign character in the hands of the nonresident alien. Similarly, income of a foreign partnership from U.S. services that is allocable to foreign partners will be taxable to them as U.S. source income. In a private letter ruling, the Service has said that where a German law firm practicing as a partnership has a U.S. office and allocates all profits of the U.S. branch to the U.S. partners, the U.S. partners will have solely U.S. source income and report the same on their returns, but if any residual income is allocated to the German partners, they will also have U.S. source income. 65

The entity approach supplants the conduit theory if the payments are paid to the partner for services or the use of capital, for such payments are considered made to one who is not a member of the partnership. 66 The source of these “guaranteed payments” turns on the nature of and the reason for the payment to the parties who, therefore, may acquire foreign source income though paid from funds that originally were U.S. source. Payments for use of capital should constitute interest and the determination of source made pursuant to rules governing source of interest income: Interest paid by a foreign partnership should be foreign source. See § 2.08[1], above. Similarly, the source of payments for services should be determined in accordance with the proper method for characterizing source of income paid for provision of services. See § 2.08[4], above. The guaranteed payments exception to the conduit theory allows taxpayers to transform distributions of effectively connected U.S. source income taxable at graduated rates into compensation deductible from partnership gross income by, for example, maximizing guaranteed payments to partners for services to the partnership rendered abroad. Variations on this planning theme certainly exist, as well.

Example:
A is a Swiss citizen and resident, and a partner in a domestic U.S. partnership engaging in the management and operation of a shopping center. The partnership has an investment portfolio in the United Kingdom that is not effectively connected with its shopping center operation in the United States. A’s distributive share of income from the investment portfolio is not U.S. source income, although obviously his shopping center derived income does have a U.S. source.

In Private Letter Ruling 200811019 , 67 the Service considered the U.S. federal income taxation of income derived from a U.S. partnership by a foreign corporation that was in fact engaged in the banking and financing business within the United States, within the meaning of Treasury Regulations Section 1.864-4(c)(5). The taxpayer had sold U.S. securities to a partnership for cash which it had contributed to the partnership with other investors. The partnership was a true partnership, holding its assets for investment. The taxpayer represented that the securities in question had been held in a trading account by the taxpayer, but were now held for investment by the partnership. The Service ruled that that change was possible. However, as to whether the entity approach should be applied to the partnership, or the aggregate (conduit) approach, the Service ruled that the taxpayer had transferred the securities to the partnership and managed the partnership. The Service ruled that the income produced by the securities should be taxed as effectively connected income based upon application of the 10 percent test of Treasury Regulations Section 1.864-4(c)(5)(ii)(b)(3), as if taxpayer held them directly.

Tax treaties may provide for different sourcing rules for partnership income. In the tax treaty between the U.S. and Germany, Article 14 provides that income derived by a resident of one contracting state from the performance of services shall be taxable only in that state, unless such services are performed in the other contracting state and the income is attributed to a fixed base regularly available to the individual in that other state. 68 In Revenue Ruling 2004-3 , a nonresident partner in a service partnership with a fixed base in the United States was subject to U.S. tax on income attributable to that fixed base even though the partner never performed services in the United States. 69 As interpreted in the partnership context, because the fixed base is attributed to all partners for the purposes of applying Article 14, the Service stated it did not matter that the partner had never performed services in the United States. The ruling also stated that provisions similar to Article 14 in other treaties would also be interpreted the same way.

I.R.C. Section 894(c) denies treaty benefits to nonresident aliens otherwise entitled to reduction of income tax upon covered classes of income earned through certain “hybrid entities.” The Code provision makes clear that in order to claim treaty protection the entity must be treated similarly (i.e., either as a taxable entity or as tax transparent) both for purposes of U.S. income tax law and for purposes of income tax law of the treaty partner. The regulations 70 make clear that a hybrid entity must be treated identically by both treaty partners, so that an individual nonresident alien taxpayer who is a partner of a United States partnership may not claim treaty benefits upon income from that partnership if the income from that partnership is taxable in her country of residence under the treaty to the entity, rather than to her.

Planning Note

Structure Payments of Sheltered Income to Reduce Taxes. If a principal partner of a partnership can personally shelter compensation by the appropriate deductions in the United States, the careful planner may be able to structure the overall payments so that less tax will be paid, assuming a legitimate compensation arrangement. The overall tax impact, of course, needs to be considered, but often in a partnership arrangement a guaranteed payment structure can be optional, depending upon the economics of each circumstance.

[9] Income from International Transportation and Communication Activities

Income from transportation either beginning or ending in the United States is one-half U.S. source and one-half foreign source. 71 A 4 percent tax is imposed on a foreign person’s gross U.S. transportation income, 72 unless the foreign person is a qualifying resident of a country that grants an equivalent exemption to U.S. persons. 73

A similar sourcing rule applies to communications income for U.S. persons. 74 A foreign person’s communications income is foreign source, unless it maintains a fixed place of business in the United States. The communications income attributable to the fixed place of business is U.S. source. Transportation or communications between different points within the United States is U.S. source even if transportation or communications go beyond the country’s boundaries. 75 Income from vessels or craft leased before January 1, 1986, is also U.S. source. 76

Example 1:
A cruise line carrying A, B and C departs Maine for Europe but stops in Florida and discharges A before crossing the Atlantic. B disembarks in Europe while C returns home to the United States with the ship. Transportation of A began and ended in the United States and all income attributable to his transport is U.S. source. The transport ofB and C is deemed not to have begun and ended in the United States. Only half the income attributable to their transport is deemed U.S. source income. 77

Example 2:
D travels from Canada to Mexico, stopping in New York, but continuing on to Mexico on the same Canadian Airways plane. Cargo on the Canadian flight is removed from the plane in New York and loaded onto another Canadian Airways plane for transport to Mexico, but only after the cargo passes through U.S. customs. D has not been involved in U.S. transportation, but the cargo has. It has ended a Canadian flight in the United States and begun a trip to Mexico in the United States. Half the income attributable to each leg is U.S. source income.

Nonresident aliens and foreign corporations are subject to a 4 percent tax on U.S. source gross transportation income. 78

[10] Income from Ocean and Space Activities

Income derived from space and ocean activities is U.S. source income if derived by a U.S. person, and foreign source income if derived by a foreign person. 79 I.R.C. Section 863defines space activity to include any activity conducted in space, and ocean activity to include any activity conducted on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, the United States or a U.S. possession. 80 Activities covered include the performance and provision of services, leasing of equipment, licensing of technology or other intangibles, manufacturing of property, and the leasing of a vessel so long as the vessel does not transport cargo or persons for hire between ports of call. 81

Space and ocean activities do not include the sale of property on the high seas, activities generating transportation income, activities involving mines, oil and gas wells, or other natural deposits located within the jurisdiction of any country, or activities giving rise to international communications income. 82 In 1986, Congress directed that regulations be issued further defining ocean and space activities. 83 Regulations were proposed in 2001 and received much comment, but were never adopted. In September of 2005, the 2001 regulations were withdrawn and new regulations under I.R.C. Section 863(d) and (e) were proposed. The notice accompanying the new regulations claimed that the initial regulations were withdrawn because technological advancements in the aerospace, telecommunications and related industries, and material changes brought about by the American Jobs Creation Act of 2004, made the 2001 regulations obsolete. 84 Final regulations were issued on December 27, 2006. 85

The regulations provide that a U.S. person’s space and ocean income will be sourced outside the United States only to the extent that such income, based on all facts and circumstances, is attributable to functions performed, resources employed or risks assumed in a foreign country. 86 Otherwise, all space and ocean income will be U.S. source income.87 For purposes of determining the source of the space and ocean income of controlled foreign corporations (see § 4.10[1]), the Service will treat such corporations as U.S. persons.88 For foreign persons, space and ocean income will be foreign source income unless it is attributable to functions performed, resources employed or risks assumed within the United States. 89 The 2001 regulations included a presumption that the space and ocean income of foreign persons engaged in a trade or business within the United States was U.S. source income, but this was removed from the final regulations. 90

Under the final regulations, income from the sale of property in space or international water is included in the definition of space and ocean activity, and therefore is sourced underI.R.C. Section 863. 91 This definition excludes sales of inventory property in space or international water for use, consumption or disposition outside space or international water, which is sourced under Treasury Regulations Section 1.861-7(c). 92

The definition of space is also clarified by the final regulations to include the entire area outside the jurisdiction of any country or U.S. possession, extending from just above the surface of international water, through, and beyond the Earth’s atmosphere. 93 This definition was part of the 2001 regulations, but some commentators had proposed that the definition of space should be limited to areas beyond the Earth’s atmosphere. The Service rejected such comments and retained the definition in the final regulations, including international airspace in the definition of space.

For tax years beginning before January 1, 1987, ocean and space activities generated foreign source income. 94

[11] Insurance Underwriting Income

Amounts received as underwriting income from the insurance or reinsurance of U.S. risks is U.S. source income. 95 Other underwriting income is foreign source income. 96 Underwriting income includes premiums earned on insurance contracts less losses and expenses incurred. 97 U.S. risks are risks in connection with property in the United States, liability arising from an activity in the United States, or in connection with the lives or health of U.S. residents, or as a result of an arrangement in which another corporation receives a substantially equal amount for insuring or reinsuring U.S. risks. 98

Premiums received by foreign insurers and reinsurers of hazards, risks, losses, or liabilities within the United States are subject to an excise tax, unless the foreign insurer or reinsurer is authorized to do business in the United States. Its income is then subject to taxation at regular corporate tax rates. 99 A special exemption from the excise tax was allowed for life, sickness, and accident insurance and annuity contract premiums for insurance and annuity contracts for U.S. citizens and residents. The exemption applied if the foreign insurer was subject to tax under the rules determining the minimum amount of net investment income treated as effectively connected with the conduct of a trade or business in the United States. The exemption was repealed effective for premiums paid after December 10, 1988. 100 However, the general exemption for premiums effectively connected with the conduct of a trade or business in the United States (effective for premiums paid after December 10, 1988) applies to these insurance and annuity contracts. 101

The excise tax is in lieu of the tax on gross income and not subject to withholding. Thus, insurance premiums derived by a foreign insurer or reinsurer not engaged in a trade or business in the United States are not considered fixed or determinable annual or periodic income. 102 Exemption from excise tax on premiums on insurance policies may be granted under some tax treaties. 103

§ 2.10 Deductions and Credits

Business costs, losses and expenses may be deducted from nonresident alien’s income effectively connected with a U.S. trade or business. A deduction or credit for foreign taxes paid on this income is also allowed. Generally, no deductions are allowed for income not effectively connected with a U.S. trade or business. Exceptions include theft or casualty losses, charitable contributions and personal exemptions.

A nonresident alien’s income that is effectively connected with a trade or business in the United States is taxable under the same rules as those that apply to domestic taxpayers. 1 A nonresident alien, however, is disallowed deductions and credits if he or she fails to file a timely U.S. income tax returns, unless the Commissioner waives the filing deadlines. 2 The Service may waive a filing deadline unless the non-filer either (1) knew the return had to be filed and chose not to file such return or (2) does not cooperate in the process of determining its income tax liability for the tax year for which it did not file a return. 3 Foreign persons who are subject to a flat 30 percent tax (or lower applicable treaty rate) on certain U.S. source income that is not effectively connected with the conduct of a U.S. trade or business are generally not entitled to any deductions from their gross income in computing U.S. taxable income. 4

[1] Income Effectively Connected with U.S. Trade or Business

A foreign person engaged in a U.S. trade or business may deduct the business’s costs, losses, and expenses against gross income effectively connected with a U.S. trade or business.5 The deductions may not be offset against other U.S. source income. Expenses relating to both U.S. source and foreign source income must be apportioned between those sources.6 A foreign person cannot elect to capitalize real estate taxes, mortgage interest and other carrying charges incurred on unproductive U.S. real property, 7 if during the tax year in which the expenses are incurred, they are not deductible. 8

The allocation of interest expense by a foreign corporation is determined by a three-step process outlined in Treasury Regulations Section 1.882-5. Step one determines the total value of the foreign corporation’s U.S. assets, which generally are those that produce income effectively connected with the foreign corporation’s U.S. trade or business. 9 Step two determines the total amount of U.S. connected liabilities for the taxable year. The corporation can multiply the value of the U.S. assets determined under step one by an actual ratio of worldwide liabilities to worldwide assets, or the corporation can elect to use a fixed ratio. 10 Step three determines the amount of interest expenses that are allocable to U.S. effectively connected income under the U.S. booked liabilities method or the separate currency pools method. Under the U.S. booked liabilities method, the corporation looks to the interest expense on the foreign corporation’s U.S. books and it adjusts that booked interest expense up or down depending on the figure determined under step two. 11 The corporation can also elect to determine the interest allocation under the separate currency pools method. Here, the interest expense allocated to effectively connected income is the sum of the separate interest deductions for each of the currencies in which the foreign corporation has U.S. assets, multiplied by the corporation’s worldwide rate for liabilities in such currency. 12

The provisions of Treasury Regulations Section 1.882-5, discussed above, no longer provide the exclusive rules for determining the interest expense attributable to the business profits of a permanent establishment under any U.S. income tax treaty. Treaties have been entered into with the United Kingdom and Japan which permit United Kingdom and Japanese resident financial institutions to use an alternative method to determine taxable income without using the steps outlined in Treasury Regulations Section 1.882-5 for interest allocation. The IRS temporary regulations allow taxpayers to use alternative approaches for allocating interest deductions under tax treaties. 13 Taxpayers with the opportunity to use a different method under a tax treaty may continue to use the Treasury Regulations Section 1.882-5 method if they so choose provided they apply either the domestic law or the alternative rules expressly provided in the treaty in their entirety.

A foreign person may deduct or receive a credit for foreign taxes paid on income effectively connected with that person’s U.S. trade or business. However, a deduction or a credit is not allowed for foreign taxes paid on U.S. source effectively connected U.S. trade or business income if the taxes are imposed solely because the taxpayer is a resident of, or created or organized in, the jurisdiction imposing the tax. 14

As a pre-requisite to claiming allowable deductions and credits, a nonresident alien individual must file an accurate and timely return of the taxpayer’s effectively connected income.15 In addition, the taxpayer must be able to substantiate any deductions taken on the filed return. 16 For income tax return filing requirements for nonresident aliens, see Chapter 10.

The return filing requirement does not prevent a nonresident alien individual from claiming credits for: 17
(1) amounts withheld from wages; 18

(2) earned income; 19

(3) amounts withheld at source on nonresident aliens; 20

(4) use of gasoline and special fuels; 21 and

(5) tax on net capital gain deemed paid by shareholders of regulated investment companies. 22

In a recent Tax Court case, the deduction taken by a Canadian citizen on Form 1040NR for medical expenses was denied because the expenses were not effectively connected with a U.S. trade or business. 23

[2] Income Not Effectively Connected with U.S. Trade or Business

Generally, foreign taxpayers are not allowed deductions in determining the amount of their U.S. source noneffectively connected income that is subject to U.S. tax. There are, however, some exceptions. 24

The following deductions are allowed against income not effectively connected with a U.S. trade or business:
(1) losses for theft or casualty, subject to the general limitations on the deductibility of theft or casualty losses 25 and only if the loss is to property located in the United States and to the extent not compensated by insurance; 26

(2) charitable contributions to domestic corporations or other charitable organizations created in the U.S.; 27 and

(3) personal exemptions allowable to, and on the same terms as, U.S. residents 28 but taxpayers not residents of Canada or Mexico, or U.S. nationals are allowed only one exemption. 29

Deductions for losses on the sale or exchange of capital assets are allowed only against gain on the sale or exchange of capital assets.

To claim the allowable deductions and credits, a foreign person must file a timely and accurate return under the general rules for filing returns. 30 For income tax return filing requirements, see Chapter 10.

Regardless of whether a return is filed, a nonresident is entitled to credits for: 31
amounts withheld from wages; 32

earned income; 33

amounts withheld at the source by the payer; 34

taxes paid for the use of gasoline and special fuels; 35 and

the credit for taxes deemed paid by stockholder in a regulated investment company. 36

§ 2.11 Return Requirements

Generally, a nonresident alien individual with income which is effectively connected with the conduct of a U.S. trade or business must file an income tax return on Form 1040NR and pay the tax.

While income tax on fixed or determinable annual or periodic income is generally collected through withholding at the source (see discussion at § 2.12, below), income tax on effectively connected income is to be remitted by the taxpayer and reported on a timely filed Form 1040NR. 1 A nonresident alien individual whose tax has been fully paid at the source and who has no effectively connected income need not file a return, unless he seeks a refund of overpaid taxes. But if the nonresident alien has any gross income, from any source, and is engaged in a trade or business in the United States, even one which has produced no income, he must file a Form 1040NR. 2 The IRS has announced an intention to amend Treasury Regulations Section 1.6012-1(b)(2) to except from the obligation to file a Form 1040NR a nonresident alien whose only U.S. source income is wages in an amount less than one personal exemption for United States income tax purposes. 3 Because income collected by a nonresident alien from disposition of an investment in U.S. real property is treated under I.R.C. Section 897 as income which is effectively connected with a U.S. trade or business, the taxpayer must report the gain on a Form 1040NR even if she believes the tax was fully withheld. 4

§ 2.12 Withholding Requirements

A nonresident alien’s U.S. source income not effectively connected with a U.S. trade or business is subject to 30 percent withholding tax at the source. Normal graduated withholding rates apply to a foreign taxpayer’s U.S. source compensation for personal services (other than self-employment income). A withholding agent withholds and pays over the tax. Taxpayers eligible for the benefits of a tax treaty may be subject to partial or full exemption from withholding on income specified in the treaty.

A nonresident alien’s U.S. source income that is not effectively connected with a U.S. trade or business is subject to tax at a flat 30 percent rate unless otherwise provided by treaty. 1

A withholding agent is the person required to deduct, withhold and pay the tax of a nonresident alien. This duty is imposed on all persons, acting in whatever capacity, that have the control, receipt, custody, disposal or payment of any of the items subject to withholding. 2 Withholding agents specifically include lessees and mortgagors of realty or personalty, fiduciaries, employers, and officers and employees of the United States. 3

A withholding agent may be a foreign person.

A withholding agent is both liable for the tax withheld and indemnified against any person claiming any tax properly withheld and paid over to the U.S. Treasury. 4 Tax withheld at the source upon income paid to a fiduciary is deemed to have been paid by the taxpayer (i.e., beneficiary) ultimately liable for the tax upon the income. 5 Thus, U.S. income tax withheld at the source upon dividends paid to a trustee may be claimed as a credit against tax by a trust beneficiary, but may not be claimed as a credit against tax by the shareholder of a foreign holding company.

A nonresident alien who has U.S. source income must generally file an income tax return. However, a foreign person is not required to file a return if his tax liability is fully satisfied by the withholding provisions, provided the foreign person is not engaged in a U.S. trade or business during the tax year. 6

[1] Income Subject to Withholding

Withholding applies to any U.S. source fixed or determinable annual or periodical income and certain other gains from disposition of property paid to a nonresident alien that is not effectively connected with a U.S. trade or business. 7

Fixed or determinable annual or periodical income includes:
(1) interest (except original issue discount);

(2) certain payments of original issue discount by the original issuer or a related obligor, as defined in regulations;

(3) dividends;

(4) rent;

(5) royalties;

(6) salaries;

(7) alimony;

(8) wages;

(9) premiums;

(10) annuities;

(11) compensations;

(12) remunerations;

(13) gains from timber, coal and domestic iron ore;

(14) qualified scholarships and fellowships; and

(15) distributive shares from U.S. partnerships to the extent they include the foregoing. 8

[2] Income Not Subject to Withholding

The following categories of income are not subject to withholding:
(1) income (other than compensation for personal services) effectively connected with a U.S. trade or business; 9

(2) foreign source income; 10

(3) portfolio interest paid on bearer obligations that are described in I.R.C. Section 871(h)(2)(A) or 881(c)(2)(A) and Treasury Regulations Section 1.871-14(b); 11

(4) interest received by foreign central banks of issue and the Bank for International Settlement; 12

(5) passive income paid from U.S. sources to a U.S. possessions corporation; 13

(6) compensation of nonresident aliens engaged in a U.S. trade or business; 14

(7) per diem subsistence payments to military trainees; 15

(8) annuities received under qualified plans for services performed outside the United States or if received from plan satisfying 90 percent U.S. employee test; 16

(9) income exempt under a tax treaty between the United States and a foreign country;

(10) dividends from domestic corporations satisfying the foreign active business requirement test; 17 and

(11) salary and wages otherwise subject to withholding by the employer. 18

[3] Treasury Regulations

On April 15, 1996, the Treasury Department proposed the first comprehensive revisions to the withholding regulations under I.R.C. Section 1441 in 40 years. 19 These broad provisions were then subjected to extensive debate, and, in substantially revised form, were reissued and made final on October 6, 1997. 20 Generally, the new regulations were to become effective for withholding agents with respect to any payments made to foreign taxpayers after December 31, 1999. The effective date was then extended by the Service to payments made after December 31, 2000, and the Service announced that it would treat 2001 as part of the base audit period for paying agents and not demand absolute compliance for those financial institutions that wished the benefit of an additional transition year. But as of January 1, 2002, the new regulations apply to all payments made to foreign persons of U.S. source interest, dividends, and other fixed and determinable annual or periodic income payments. The regulations are over 100 single-spaced pages in length, and are extremely detailed.

The final regulations significantly revise the U.S. withholding tax and information reporting rules, including the rules for withholding on dividends, the rules regarding eligibility for tax treaty benefits, the withholding tax exemption for payments that are effectively connected with the conduct of a U.S. business of a foreign person, and the treatment of payments to intermediaries and foreign partnerships.

The 1997 rules were criticized by practitioners for their complexity. In response to those criticisms, and to effectuate the government’s broad policy goals of identifying U.S. taxpayers who put assets into foreign bank accounts and to ensure that treaty benefits are granted only to residents of treaty countries, the Service issued final regulations underI.R.C. Section 1441 on May 15, 2000 dealing with the withholding obligations of both qualified and non-qualified intermediaries, which regulations modify the 1997 regulations and are effective January 1, 2001. 21 In general, the balance of the Section 1441 regulations not covered in the final regulations remain effective. Although many of the provisions are beyond the scope of this text, certain provisions warrant attention.

First, Treasury Regulations Section 1.1441-1(c)(6) now provides that for withholding purposes, the beneficial owners of a payment to a foreign simple trust are the trust beneficiaries. The beneficial owners of a payment to a foreign grantor trust are the owners of the trust, and foreign complex trusts and estates are considered to be the beneficial owners of income paid to such entities. Simple trusts and grantor trusts are defined by reference to the applicable provisions of Subchapter J of the Internal Revenue Code. 22 Whether a foreign complex trust or estate can claim a reduced rate of withholding under a treaty depends on the country of residence, the application of any treaty benefits limitation provision and whether such trust or estate derives income under I.R.C. Section 894.

Second, Treasury Regulations Section 1.1441-5(b) now provides that a U.S. simple trust is a withholding agent for the distributable net income (DNI) includible in the gross income of a foreign beneficiary to the extent the DNI consists of an amount subject to withholding. Similarly, a U.S. complex trust is a withholding agent on DNI includible in the gross income of a foreign beneficiary to the extent the DNI consists of an amount subject to withholding that is, or is required to be, distributed currently. U.S. simple trusts and complex trusts are permitted to make reasonable estimates of the portion of a distribution that constitute DNI consisting of amounts subject to withholding. A U.S. grantor trust must withhold on any income includible in the taxable income of a foreign person that is treated as an owner to the extent the amount includible consists of an amount subject to withholding.

Third, interest or original issue discount (“OID”) realized on the sale or exchange (but not redemption) of a short-term OID instrument is no longer required to be reported to a withholding agent (provided such sale or exchange is not undertaken with the principal purpose of avoiding tax and that the withholding agent does not know and has reason to know of any such tax-avoidance plan).

Fourth, amounts that would be excluded from gross income without regard to whether the recipient of such amounts is a U.S. or non-U.S. person are not treated as FDAPI. However, income under I.R.C. Section 892 or 115 is reportable as FDAPI and is subject to withholding.

Fifth, income from notional principal contracts is no longer treated as effectively connected income unless paid to a U.S. Qualified Business Unit of a foreign person or the withholding agent knows (or has reason to know) that the payment is effectively connected income. The preamble to the regulations indicates that it is not expected that a withholding agent will be considered to have reason to know that a notional principal contract is effectively connected income merely because the foreign payee has a U.S. Qualified Business Unit to which a portion of the payment may be allocated pursuant to the regulations on global dealing. Specific provisions of the final regulations include the items below.

[a] Portfolio Interest

The final regulations provide that U.S. tax is not required to be withheld from “portfolio interest” paid on a registered form debt obligation if the beneficial owner 23 of the obligation provides the withholding agent with an Internal Revenue Service Form W-8 (“Form W-8”). The Form W-8 must (i) be signed by the beneficial owner under penalties of perjury, (ii) certify that the owner is not a United States person, or in the case of an individual, that the owner is neither a citizen nor a resident of the United States, and (iii) provide the beneficial owner’s name, permanent residence address and, in the case of an entity, country of organization and classification. 24

[b] Dividends

Under the final regulations, a foreign beneficial owner must furnish the withholding agent with a Form W-8 in order to obtain a reduced rate of withholding under a tax treaty. 25 The beneficial owner will generally be required to provide a taxpayer identification number (or “TIN”) on the Form W-8, except that a TIN will not be required in the case of (i) dividends on stock that is actively traded on a U.S. national securities exchange or NASDAQ, 26 (ii) dividends on any redeemable security issued by an investment company registered under the Investment Company Act of 1940, that is, mutual fund shares, and (iii) dividends from units of beneficial interest in publicly-offered SEC-registered unit investment trusts. The final regulations eliminate the so-called “address rule” which had permitted a withholding agent to generally assume that dividends paid to an address in a foreign country which has a treaty with the United States permitting withholding at a reduced rate were entitled to that reduced rate. Now the recipient must file a Form W-8 in order to obtain the reduced rate.

[c] Other Income Eligible for Treaty Benefits

Under the final regulations, a foreign beneficial owner claiming tax treaty benefits with respect to other types of income (including royalties and interest that is not eligible for the portfolio interest exemption) must provide the withholding agent with a Form W-8 (containing the information listed above under ” Portfolio Interest”) that generally includes the TIN of the beneficial owner. A withholding agent may withhold at a reduced rate without having a completed Form W-8 if the withholding agent has personal knowledge of the alien’s eligibility for the treaty rate, but such knowledge will be rare. In 2003, the Service adopted further regulations covering special situations in which a withholding agent who is also an acceptance agent authorized to act on behalf of taxpayers seeking taxpayer identification numbers 27 may remit an “unexpected payment,” such as a death benefit or casino winnings, without having a TIN or a completed Form W-8, because the taxpayer has not had time to obtain a TIN. 28

[d] Effectively Connected Income

Under the final regulations, a foreign beneficial owner claiming an exemption from withholding for income that is effectively connected with a U.S. trade or business must furnish to the withholding agent a Form W-8 (containing the information listed above under ” Portfolio Interest”) that includes the TIN of the beneficial owner. This rule is similar to that of the existing regulations. 29 Under the final regulations, the existing IRS Forms W-8, 1001 (relating to treaty benefits) and 4224 (relating to income effectively connected with a U.S. trade or business) are all combined in a new Form W-8 containing all of the required information, which must be signed under penalties of perjury. A Form W-8 will now generally remain valid for 3 years, except that a Form W-8 which contains the beneficial owner’s TIN will remain valid for an indefinite time.

[e] U.S. Source Bank Deposit Interest and Short-Term Original Issue Discount (“OID”) 30

Payments of these types of income to foreign persons are generally not subject to withholding tax. A beneficial owner is not required to furnish documentation establishing foreign status to a withholding agent in order to obtain the withholding tax exemption. Documentation of the beneficial owner’s status may be necessary, however, in order to establish exemption from backup withholding and information reporting.

[f] Notional Principal Contracts

Payments made pursuant to notional principal contracts (including foreign currency notional principal contracts) are not subject to withholding. 31 If paid to a U.S. Qualified Business Unit of a foreign person, however, they are presumed to be effectively connected income and, as such, are required to be reported by a withholding agent on Forms 1042 and 1042-S. In the event that the withholding agent knows or has reason to know that the notional principal contract payments are effectively connected income, then the payments will be treated as such and subject to withholding accordingly.

[g] Payments to Intermediaries

In a case where a withholding agent makes a payment of interest, dividends or similar income to a person acting as an intermediary (e.g., a financial institution that receives payments on behalf of its customers), the final regulations would permit the withholding agent to rely upon an “intermediary withholding certificate” furnished by the intermediary to establish the foreign status of the beneficial owner(s) of the payment and the applicability of an exemption from, or reduced rate of, withholding. 32

[h] Payments to Domestic Trusts and Partnerships

Because no withholding is required for a payment to a U.S. payee, a withholding agent is not required to withhold taxes upon payments which the withholding agent may “reliably associate” with a U.S. domestic partnership or trust. 33 The U.S. partnership 34 or trust 35 is then required to withhold tax when remitting payments to foreign owners: the partners or beneficiaries.

[i] Payments to Foreign Partnerships

The final regulations adopt a look through approach for payments to foreign partnerships. Under the final regulations, a payment made to a foreign partnership is generally treated as made to the partners, rather than to the partnership, and the determination of whether (and how much) to withhold is therefore based upon the status of the individual partners. 36In the case of tiered foreign partnerships, the withholding agent is required to look through all tiers of foreign partnerships until it reaches a partner (or partners) that is not subject to the look-through rule.

A foreign partnership that is acting for its own account generally must furnish to a withholding agent a Form W-8 attaching appropriate withholding certificates (e.g., Forms W-8 or W-9, or an applicable intermediary withholding certificate) for each of its partners and including information on each partner’s distributive share of a payment. The final regulations provide certain exceptions to this general rule.

[j] Payments of Foreign Partners’ Shares of Effectively Connected Income

I.R.C. Section 1446 governs withholding upon a foreign partner’s share of the income of a partnership (whether domestic or foreign) that is effectively connected with the conduct of a U.S. trade or business. Treasury proposed regulations under I.R.C. Section 1446 37 on September 3, 2003 which, in modified form, became final on May 18, 2005. 38

I.R.C. Section 1446 generally requires a partnership, whether domestic or foreign, which has income that is effectively connected with the conduct of a trade or business in the United States, to withhold and pay U.S. income tax on a quarterly basis on such income allocable to a foreign partner, whether or not it is paid to him or her. Withholding under the statute is at the highest marginal tax rate applicable to individuals or corporations, as the case may be, 39 but the regulations provide relief for foreign partners who file certificates with the Service setting forth deductions and credits to which the partner is entitled. 40 The partnership is to file the foreign partners certificate with the Form 8813, or Forms 8804 or 8805, whichever is applicable. In meeting its withholding obligations for a foreign partner under I.R.C. Section 1446, the partnership may determine the status of a foreign partner by reference to the Form W-9, W-8 BEN, or another form completed by the partner for purposes of withholding under I.R.C. Section 1441.

[k] Payments to Foreign Trusts

Payments made to a foreign complex trust will be treated as made to the trust so that any eligibility for treaty relief depends upon the status of the foreign trust. 41 Payments made to a foreign simple trust are subject to withholding based upon the status of the income beneficiary, and the withholding agent must receive a valid and complete Form W-9 containing all relevant data regarding the income beneficiaries. 42 Similarly, payments made to a foreign grantor trust are subject to withholding based upon the status of the owner, and the withholding agent must receive a valid and complete Form W-9 containing all relevant data regarding the trust’s owner. 43

[l] Payments to Qualified Intermediaries

An important new feature of the withholding regulations, as proposed and then, in modified form, adopted as final, is the concept of a qualified intermediary. A “qualified intermediary,” or “QI,” is defined in the final regulations 44 as a foreign financial institution or a foreign clearing organization, or a foreign branch or office of a U.S. financial institution, or a foreign corporation for purposes of presenting claims of benefits under an income tax treaty on behalf of its shareholders, or “any other person acceptable to the IRS,” “that is a party to a withholding agreement with the Internal Revenue Service.” That is, a QI is a foreign person, acting on its own behalf or on behalf of others, that effectively agrees to withhold taxes due to the United States upon payments remitted abroad, so that the U.S. payor shall not have to withhold the tax. Under the terms of the withholding agreement, the QI becomes subject to the applicable withholding and reporting provisions which would otherwise have applied to the U.S. withholding agent paying the amounts abroad. 45 The QI must obtain the documentation from ultimate beneficial owners which otherwise would have had to be furnished on a Form W-8 to the U.S. paying agents, and itself make determinations of applicable withholding rates for each payee. The QI will then, under the terms of its withholding agreement with the Service, withhold and remit the taxes due. Alternatively, the QI can act as a compiler of information which it furnishes to the U.S. paying agent, advising the paying agent on an aggregate basis of the applicable withholding rate for payments being remitted to the QI on behalf of all of its customers, and the U.S. paying agent will withhold the tax, while the QI will compile the information and have it available to the Service.

The result of such an arrangement is that foreign banks and brokerage houses can themselves act as withholding agents, relieving their customers of filing requirements in the United States with respect to their U.S. investment securities, and alleviating the need that information be on hand in the United States concerning the investor. However, under the terms of the withholding agreement between the QI and the Service, that information will be available to the Service upon request. The United States Senate recently published a report investigating the degree to which foreign banks have been manipulating their reporting obligations under the QI reporting program. In particular, the Senate report found that UBS AG of Switzerland engaged in practices, as part of its efforts to open accounts in Switzerland for high net worth U.S. clients, that could and did facilitate tax evasion by allowing the U.S. clients to structure their accounts so as to avoid the QI reporting requirements. Based on its findings, the Senate report recommends that the QI reporting program be strengthened by, in addition to stepping up enforcement of existing law, requiring QI participants to file an IRS Form 1099 for all U.S. persons who are either the direct or beneficial owners of an account (whether or not the U.S. client has U.S. securities or receives U.S. source income, and whether or not the account is held in the name of a foreign corporation, foundation, trust, or other entity). 46

The Service published a model withholding agreement for QIs on January 7, 2000 47 and explained its approach to QIs. An institution wishing to qualify as a QI must file a detailed application with the Service which sets forth information on its account opening procedures, types of account holders, types of U.S. investment assets its account holders own, and establishing that it has the resources to “know its customers” and their accounts, and comply with the requirements of its withholding agreement with the Service. The Service has discretion to enter into a withholding agreement with an applicant, and thereby constitute the applicant as a QI, or to decline to enter into the agreement. Generally, its has been found desirable by foreign financial institutions for competitive reasons that they qualify as QIs, and many have done so. For examples, Article 4 of the U.S.-Bahamas Information Exchange Agreement signed on January 25, 2002, includes a provision intended to facilitate a Bahamian financial institution’s achieving QI status.

In Revenue Procedure 2005-77 , 48 the Service published amended forms of withholding foreign partnership and foreign trust agreements. A qualifying foreign trust is one which enters into a withholding agreement with the Service. 49 A series of amendments to the final regulations were adopted in March 2006. 50 These amendments do not alter significantly any of the substantive provisions of the final regulations, but rather, in response to comments from various taxpayers, provide relief from various reporting and other requirements. 51

[m] Payments to Foreign Financial Institutions with United States Accounts

The Service has indicated that it is re-examining its policies with respect to withholding on payments to qualified intermediaries in the light of scandals involving foreign bank accounts held by U.S. persons.

The Foreign Account Tax Compliance Act (“FATCA”), first introduced as legislation in Congress on October 29, 2009, 52 was enacted into law on March 18, 2010 as Title V, Subtitle A of the Hiring Incentives to Restore Employment (“HIRE”) Act. Included among its provisions, in Section 501 of the Act, are new I.R.C. Sections 1471 through 1474 imposing new withholding tax obligations on U.S. payors. The new provisions are effective for payments made to foreign accounts after December 31, 2012. 53

New I.R.C. Section 1471 provides for a 30 percent tax withholding on the amount of any payment made by a U.S. payor to a foreign financial institution which is a “withholdable payment,” absent an agreement of the payee with the U.S. Treasury that payments to that payee are not to be withheld on. “Withholdable payment” is defined by new I.R.C. Section 1473(1) as any payment of fixed or determinable annual or periodic income made to a foreign financial institution or other foreign entity. Payments of income which are effectively connected with the conduct of a U.S. trade or business are not subject to withholding.

With respect to payments made to foreign financial institutions, new I.R.C. Section 1471 provides that a U.S. payor must withhold 30 percent upon any payment of FDAP income unless, prior to December 31, 2012, the payee financial institution has entered into an agreement with the U.S. Treasury by which the foreign financial institution agrees to determine which of its accounts are “United States accounts,” defined as accounts in which one or more U.S. persons have interests valued at $50,000 or more (per U.S. person for all accounts at the foreign financial institution). 54 In order to avoid the 30 percent withholding, the foreign financial institution must agree to provide to the Internal Revenue Service the name, address, taxpayer identification number and full account asset, income and withdrawal information on all U.S. account holders, and to withhold at a 30 percent rate on the interests of all “recalcitrant” account holders who refuse to allow the foreign financial institution to provide the required information. 55

With respect to payments made by United States payors to foreign entities which are not foreign financial entities, new I.R.C. Section 1472 requires the same 30 percent withholding unless, prior to December 31, 2012, the foreign entity provides the payor with a certification that it has no substantial United States beneficial owners 56 or provides full taxpayer information on all U.S. owners. Publicly traded companies are not included in the reach of new I.R.C. Section 1472.

These new provisions are intended to reach payments of income to foreign accounts which directly or indirectly benefit U.S. persons and are not being reported as income by the U.S. owner beneficiaries.

International Estate Planning

Copyright 2012, Matthew Bender & Company, Inc., a member of the LexisNexis Group.

CHAPTER 1 U.S. Estate, Gift and Generation-Skipping Transfer Taxation of Nonresident Aliens

§ 2.01 Summary of this Chapter

§ 2.02 Basis for Income Taxation of Nonresident Aliens. Nonresident alien individuals are subject to U.S. income tax on U.S. source income and income effectively connected with a U.S. trade or business. Income effectively connected with a U.S. trade or business is taxed at graduated rates similar to tax on U.S. persons. Gross U.S. source income not effectively connected with a U.S. trade or business is taxed at a flat 30 percent, or lower, treaty rate.

§ 2.03 Determining Residency. Lawful permanent resident and substantial presence tests determine resident alien status for income tax purposes. The income tax rules are different from the estate and gift tax rules. An individual taxpayer is deemed U.S. resident for income tax purposes if either test is met or if the taxpayer elects resident status. U.S. tax treaties contain tie-breaker rules for determining residency. Code residency rule does not override these treaties. However, an alien protected by a treaty may be affected by the Code definition in situations not covered by the treaty.

§ 2.04 U.S. Trade or Business. A facts and circumstances test is applied in most cases to determine if an alien taxpayer is engaged in a U.S. trade or business. A nonresident alien performing personal services in the United States is generally engaged in a trade or business; there are exceptions. An alien maintaining an office to trade in securities or commodities for others is engaged in a trade or business. If an alien taxpayer’s agent or spouse conducts the taxpayer’s business or trade, the taxpayer may be found to be engaged in a trade or business.

§ 2.05 Alien Not Engaged in a U.S. Trade or Business. U.S. source income not effectively connected with the conduct of a U.S. trade or business is subject to a flat 30 percent tax unless reduced by a treaty. This includes (1) fixed or determinable annual or periodical income, (2) original issue discount, (3) portfolio interest income, and (4) gain on the sale of a capital asset. Interest on bank deposits is not subject to tax. Special rules apply to an alien who expatriates to avoid tax.

§ 2.06 Alien Engaged in U.S. Trade or Business–Effectively Connected Income. Nonresident aliens are taxed at the same rates applicable to U.S. citizens or residents on income effectively connected with the conduct of a trade or business. Interest or dividend income is subject to the asset use test to determine whether the asset is held in a direct relationship to a trade or business. Business activities test determines whether passive income, gain or loss is related to the conduct of a trade or business. Income from U.S. real property is subject to special rules.

§ 2.07 Foreign Source Income. Foreign source income is effectively connected with a U.S. trade or business if foreign income is attributable to a taxpayer’s U.S. office. To qualify, an office or fixed place of business must be a material factor in the realization of income and regularly carry on activities that produce income.

§ 2.08 Treaties. U.S. tax treaties generally contain specific provisions on benefits, source and character for common types of income and taxpayers. They generally give primary right of taxation to the nation of the taxpayer’s domicile, and reduce or eliminate tax by the non-domiciliary nation on most passive income arising in that nation. Even where income is effectively connected to active conduct of a U.S. trade or business, a taxpayer who is entitled to treaty benefits may avoid taxation if he does not have a permanent establishment, i.e., a fixed place of business, in the U.S. through which business of foreign enterprise is carried on. Most treaties also contain provisions on exchanges of information about taxpayers by the taxing authorities.

§ 2.09 Determination of the Source of Income. Subject to treaty provisions, the source of income determines whether a foreign person’s income is subject to U.S. taxation. U.S. interest is treated as U.S. source income no matter where or how paid. The source of dividend payments is generally wherever the paying corporation is created or incorporated. Source of rental, royalty and real property sales income depends on the location of the property. Personal services income is U.S. source if performed in the United States. Personal property income is sourced to the seller’s residence. Trust or estate income is subject to conduit treatment. Sourcing rules also apply to partnership income, international transportation and communications activities, ocean and space activities and insurance underwriting income.

§ 2.10 Deductions and Credits. Business costs, losses and expenses may be deducted from a nonresident alien’s income effectively connected with a U.S. trade or business. A deduction or credit for foreign taxes paid on this income is also allowed. Generally, no deductions are allowed for income not effectively connected with a U.S. trade or business. Exceptions include theft or casualty losses, charitable contributions and personal exemptions.

§ 2.11 Return Requirements. Generally a nonresident alien individual with income which is effectively connected with the conduct of a U.S. trade or business must file an income tax return on Form 1040-NR and pay the tax.

§ 2.12 Withholding Requirements. A nonresident alien’s U.S. source income not effectively connected with a U.S. trade or business is subject to 30 percent withholding tax at its source. Normal graduated withholding rates apply to foreign taxpayer’s U.S. source compensation for personal services (other than self-employment income). A withholding agent withholds and pays over the tax. Taxpayers eligible for benefits of a tax treaty may be subject to partial or full exemption from withholding on income specified in the treaty.

§ 2.02 Basis for Income Taxation of Nonresident Aliens

Nonresident alien individuals are subject to U.S. income tax on U.S. source income and income effectively connected with a U.S. trade or business. Income effectively connected with a U.S. trade or business is taxed at graduated rates similar to tax on U.S. persons. Gross U.S. source income not effectively connected with a U.S. trade or business is taxed at a flat 30 percent, or lower, treaty rate.

The United States is now the only nation which subjects its citizens to income taxation of their worldwide income even if they are nonresidents of the United States. 1 Thus, residence or non-residence is not relevant to a United States citizen for income tax purposes, and the discussion below of residence is relevant only to aliens, that is, non-citizens, of the United States.

Nonresident aliens of the United States must include in gross income for U.S. income tax purposes all income that is effectively connected with the conduct of a trade or business in the United States (see § 2.04, below), 2 as well as any income from U.S. sources even if it is not so connected. See § 2.05, below. 3 For purposes of our discussion of the income tax, nonresident alien individuals are divided into two classes: (1) nonresident alien individuals who at no time during the taxable year are engaged in a trade or business in the United States, and (2) nonresident alien individuals who at any time during the taxable year are engaged in a trade or business in the United States. 4

While status as a nonresident alien for U.S. estate and gift tax purposes is based upon a factual determination of domicile (see Chapter 1, § 1.03), status as a nonresident alien for U.S. income tax purposes has since January 1, 1985 been based upon the clear statutory tests of I.R.C. Section 7701(b). See § 2.03, below.

For discussion of income tax return filing and other reporting requirements for nonresident aliens, see Chapter 10.

An alien benefits from a finding of nonresidency. The Code’s definition of residence gives foreign persons leeway to conduct business and personal matters in the United States without jeopardizing nonresident status. See § 2.03, below. Treaty residence tie-breakers provide some protection, but their application is too imprecise to rely upon other than as a last resort. Even if the alien maintains nonresident standing, he may fall prey to withholding and graduated rate taxes depending upon the type of income. See § 2.03[1], below. Treaties can be particularly helpful in mitigating withholding, but are less so if the income is effectively connected because the concept of a permanent establishment is so similar to that of “engaging in a trade or business.” See § 2.08, below.

In most instances, whether a nonresident alien is engaged in a U.S. trade or business is determined by a “facts and circumstances” test. See § 2.04, below. Aliens not engaged in a trade or business are usually taxed at a flat rate of 30 percent on fixed determinable income derived from sources within the United States. Other income, such as gain from the sale or exchange of property and portfolio interest, usually remains tax-free. See § 2.05, below. Certain foreign source income is taxed if effectively connected to a U.S. trade or business.

The nonresident alien’s income from a U.S. trade or business must be effectively connected in order to be taxed. Several tests are applied under the Code. See § 2.06, below.

Deductions and credits available to nonresident aliens are discussed in § 2.10, below. See § 2.11, below, for withholding requirements.

FOOTNOTES:
Footnote 1. The Philippines formerly subjected its citizens to worldwide income tax, regardless of their residence, but ceased to do so in 1995. Most countries subject their citizens to taxation of their worldwide income only if they remain resident in their home country, or have emigrated to a tax haven and retain ties to their home country. For example, (1) Germany subjects to an income tax those German citizens who emigrate to a tax-haven country or do not assume residence in any country and who maintain substantial economic ties with Germany as measured in terms of the individual’s German-source income or assets; (2) Italian citizens who remove themselves from the residents’ Civil Registry and move to a tax haven continue to be subject to an income tax; and (3) a Swedish citizen may continue to be taxed on his or her worldwide income if he or she maintains essential ties with Sweden after ceasing to be its resident. See a nonexhaustive, but broad, survey of other countries’ taxation of citizens and residents by the Joint Committee on Taxation in theReview of the Present-law Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-term Residency (JCS-2-3), February 2003, 140-176. See also Reuven S. Avi-Yonah, The Case Against Taxing Citizens, draft paper published 3/22/10 by the Berkeley Electronic Press.

§ 2.03 Determining Residency

Lawful permanent resident and substantial presence tests determine resident alien status for income tax purposes. The income tax rules are different from the estate and gift tax rules. An individual taxpayer is deemed U.S. resident for income tax purposes if either test is met or if the taxpayer elects resident status. U.S. tax treaties contain tie-breaker rules for determining residency. Code residency rule does not override these treaties. However, an alien protected by a treaty may be affected by Code definition in situations not covered by the treaty.

The determination of residence can have significant impact upon the tax liability of an individual since U.S. residents pay U.S. tax on worldwide income 1 while nonresidents generally are taxed only on U.S. source income and certain foreign source income effectively connected to a U.S. trade or business. 2

[1] Statutory Rules

Since January 1, 1985, an alien individual is by statute treated as a resident alien for U.S. income tax purposes if he satisfies either one of two tests: (1) the lawful permanent resident test, 3 or (2) the substantial presence test. 4 A nonresident alien can also elect resident status under certain circumstances. 5

A lawful permanent resident is an individual who has been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws (that is, he holds a green card, discussed below) and whose status has not been revoked or judicially or administratively determined to have been abandoned. 6 A lawful permanent resident under U.S. immigration law is a resident alien for tax purposes, regardless of the length of time he spends in the United States in any particular year. 7

The lawful permanent resident test is commonly referred to as the green card test. A green card is the alien registration receipt card (Immigration Form I-551) given to an alien individual who has been granted under the U.S. immigration laws the privilege of residing permanently in the United States. The term derives from the fact that the card was once green in color, though it is now blue and white. Resident alien status under the green card test terminates only when green card status has been revoked or administratively or judicially determined to have been abandoned. 8 For immigration purposes, an alien’s green card status may change by abandonment which occurs when the alien leaves the United States for other than temporary purposes. The intention to abandon permanent resident status may be inferred from the length and purpose of the alien’s absence, the retention of ties to the United States, and other factors that a given case may present. For purposes of the immigration law, a formal determination of abandonment may not take place until many years after the actual abandoning act, because the Immigration and Naturalization Service does not need to know the alien’s status until he or she tries to return to the United States. For tax purposes, however, a green card holder permanently living abroad is to be treated as a lawful permanent resident of the United States under the green card test until there has been a formal determination that his or her status had been abandoned. 9 Note that the Service took a contrary position, and lost to taxpayer’s estate (which claimed continued U.S. domicile for a green card holder who had left the United States to return to his native Pakistan five years prior to his death in 1991) in Estate of Kahn v. Commissioner. 10

[a] Substantial Presence Test

The substantial presence test is entirely independent of and makes no inquiry into the immigration status of the alien taxpayer. Instead it simply looks to the number of days that an alien has spent in the United States during the current calendar year and the two preceding calendar years. 11 If an alien has spent enough time in the United States such individual is deemed to have a “substantial presence” and is a U.S. resident for income tax purposes in the year for which the calculation is being made. A new determination of residence for U.S. income tax purposes is made annually.

Assuming the individual is not lawfully admitted for residence, the alien is a nonresident if the weighted number of days spent in the United States in the current and two preceding years combined is less than 183 days or the individual spent less than thirty-one days in the United States during the current year. The weighted number is determined by adding, to the total number of days the alien is present in the current year, one-third the number of days he was present in the preceding year and one-sixth of the number of days he was present during the second preceding year. 12 Fractions of days are treated as such and not rounded, so that if, under the formula, the alien is determined to have spent 182.5 days in the United States over a three-year period, she will be treated as a nonresident alien. 13

Example 1:
A is an alien who was present in the United States on 140 days during 1991, 90 days in 1990 and 120 days in 1989. The sum of days is calculated as follows to determine her status:

1991    140    x    1    =    140
1990    90    x    1/3    =    30
1989    120    x    1/6    =    20

140    +    30    +    20 = 190
Since the total number of days on which A was present in the United States for the last three calendar years is (equal to or) greater than 183, she is a resident alien under the substantial presence test.

Example 2:
B is an alien who spent 360 days in the United States in 1989, 300 days in the United States in 1990 and 23 days in 1991. B is a resident alien of the United States in each of 1989 and 1990, but is a nonresident alien under the substantial presence test for 1991. Even though the sum of the number of days present (using the applicable multipliers) in the last three years equals 183, B spent less than 31 days in the United States during the current year.

Example 3:
C is an alien who was present in the United States on 182 days during 1991. She was never in the United States before. Since the total number of days she was present in the United States between 1989 and 1991 is less than 183, she is a nonresident alien under the substantial presence test.

The provisions of I.R.C. Section 7701(b) are an absolute test for income tax purposes, so that an alien is a resident only if he meets the requirements of one or both of the tests. 14If the individual fails either test, he may look to exceptions for:
(1) foreign government-related individuals, teachers, teacher-trainees, and students; 15

(2) those with medical conditions arising while the individual is in the United States and that prevent departure; 16 and

(3) those who spend less than half the year in the United States and who have a closer connection to a foreign country (the “closer connection” test). 17

Resort also may be made to treaties. See § 2.03[1], below.

[b] Exceptions

[i] Closer Connection Test

Under the closer connection test, an individual whose presence over three years equals or exceeds 183 days on the weighted presence test of I.R.C. Section 7701(b)(3) is still deemed a nonresident alien if he is present in the United States for less than 183 days in the year in question and can demonstrate that his “tax home” is in another country. 18 The definition of tax home, under I.R.C. Section 911(d)(3), is by reference to the statute 19 and case law defining “tax home” for purposes of allowing a deduction for traveling expenses while away from home, 20 which the Service and most Circuit Courts have interpreted to mean the place of the taxpayer’s regular or principal place of business or employment, and not where the taxpayer’s personal residence is located. 21 The inquiry under I.R.C. Section 911(d)(3), which governs the ability of U.S. citizens living abroad to exclude amounts of earned income from United States income tax (see discussion in Chapter 12, § 12.03, below), begins with whether the taxpayer’s “regular or principal place of business is in a foreign country.” 22 The inquiry under the I.R.C. Section 7701(b) regulations is more comprehensive, however, and the various facts and circumstances relevant to determining a “closer connection” include the location of a permanent home, membership in social and religious organizations, bank accounts, personal belongings, family ties and voting records. 23 These factors are similar to those the Service previously considered when residency for income tax purposes involved a case-by-case inquiry.

This exception from the substantial presence test is the most important way in which an alien who spends extended time in the United States can retain nonresident status. An individual claiming “closer connection” status must file a full disclosure statement with the Service on Form 8840 no later than the due date for filing an income tax return as a nonresident for the year with respect to which a closer connection is claimed. 24 Taxpayers who file Form 8840 are also instructed to keep this information on file and readily available in the event of an examination. The closer connection exception cannot apply if the individual had applied for an adjustment of his alien status or taken other steps toward gaining lawful permanent residency in the United States. 25

[ii] Other Exceptions

The day count toward an individual’s substantial presence is also subject to modification. An individual will not be treated as being present in the United States on any day if the individual is an “exempt individual” for that day 26 or if the individual was unable to leave the United States on such day due to a medical condition that arose while the person was present in the United States. 27

A person is an exempt individual for any day if, for that day, the person is:
(1) a foreign government-related individual;

(2) a teacher or trainee;

(3) a student; or

(4) a professional athlete in the United States temporarily to compete in a charitable sports event. 28

To be treated as absent from the United States on a given day under one of these exemptions, it is important that the alien individual not be conducting activities in the United States which would be barred under the exempt visa classifications. 29 The primary visa classifications under which a taxpayer is not “present” in the United States for income tax purposes are the A visa, for accredited diplomats from foreign countries and their families, the F visa, for students and their families, the G visa, for foreign government representatives and foreign staff members and their families to U.S. postings for many non-government international organizations, like the World Bank but including many organizations, and the J visa, for teachers or trainers, but in common use of the visa, approved by the State Department in issuing the visas, used by foreign businessmen as well as full-time teachers in teaching at and assisting U.S. universities which sponsor them. Teachers or trainers in the United States under a J visa are limited in the number of years they may exclude their presence in the United States under a J visa to two of any six years or, if they were employed and received compensation described in I.R.C. Section 872(b)(3), to four of the six preceding calendar years. 30

An individual’s U.S. residence “day count,” apart from special visas, is also reduced in some cases by the medical condition exception. The simple rule, which may be difficult to apply on the facts of an individual case, is that if a nonresident alien enters the United States for medical treatment, he cannot exclude any of his days of presence here for treatment for that condition, but if he enters the United States for personal or business reasons not related to his medical condition, and while here suffers some medical event–a stroke, a heart attack–or, while here, is diagnosed with a medical issue unknown to him before, and the doctor certifies that the individual is not able to travel, not able to leave the United States while undergoing treatment or recuperating, then the days of extended presence will not be covered. 31

The mere application for a green card can have serious consequences even though residency does not date to the time of application. The exception to the substantial presence test for those who spend less than half a year in the United States and have a closer connection to a foreign country is not available to those who have applied for a change to permanent status. 32 Legislative history indicates that an application filed by a relative (as allowed under current immigration law) does not have the same adverse effect. 33

Planning Note

Delay Green Card Application to Maintain Nonresident Status. If one desires to maintain nonresident status for an additional year, it may be appropriate to delay slightly an end-of-year application or have a relative file the application. Filing by the alien of INS Form I-508 (Waiver of Immunities), INS Form I-485 (Application for Status as Permanent Resident), and Department of State Form OF-230 (Application for Immigrant Visa and Alien Registration) are considered affirmative steps to change status that preclude use of the closer connection exception. 34

[2] Effect of Treaties

The United States has numerous income tax treaties with foreign countries. These treaties do not define residence within either the United States or the foreign country. Instead, they allow each country to determine resident status under its own laws. This creates the possibility for more than one country to claim an individual as a resident. To deal with this possibility, many treaties contain tie-breaker rules to determine residence. 35

If a nonresident alien finds himself categorized as a resident by both the United States and another country, he should examine the definition of residence contained in any treaty between the two countries. 36 Such definitions, found in most treaties, articulate subjective criteria for determining which of two states may claim the individual as a resident (though the priority given to each criterion varies by treaty). 37 Typical are the conventions signed with Canada, Japan and the United Kingdom which set forth the factors for consideration in the following order:
(1) One is a resident where there is a permanent home, and if there is one in both states or in neither state, then home is where the center of vital interests is located (that is, where personal and economic relations are closer);

(2) If the center of vital interests is not ascertainable, then residence is where there is an habitual abode;

(3) If there is an abode in both or neither state, then where he is a national; and

(4) If he is a national of both or neither, then residence is decided by material agreement of the competent authorities of the two states. 38

This tracks the Treasury’s Model Treaty tie-breaker. 39 More recent treaties may weigh the factors differently, preferring to examine the locus of habitual abode before vital interests if the alien does not have a permanent home in either signatory nation. 40 These treaties follow the lead of the Treasury Department’s newer Proposed Model Treaty. 41

The definition of resident alien in the Code does not override the treaty tie-breaker rules. In the event of conflict between the resident alien definition and a treaty, the treaty definition prevails, and the alien is not taxable as a resident of the United States. 42 The priority of the treaty test for residence if elected by the taxpayer is made clear by the regulations under I.R.C. Section 7701(b). 43 For example, a lawful permanent resident can file as a nonresident alien under the treaty tie-breaker rules for purposes of computing his U.S. tax liability notwithstanding the fact that the individual retains a green card. 44 Note, however, that recent immigration legislative developments indicate that green-card holders using the treaty-tie-breaker provision could result in the loss of green cards.

The protections of a treaty’s tie-breaker rules only apply for treaty purposes. 45 The treaty’s limitation on an alien from being a U.S. resident for treaty purposes does not eliminate all adverse consequences of being treated as a resident under U.S. law for nontreaty purposes. For example, many treaties allow the United States to impose a tax on interest, typically with a maximum permitted rate of tax. However, the Code provides an exemption for nonresident aliens from U.S. income tax on interest paid on U.S. bank accounts. 46 If an alien is considered a resident under U.S. law, then he loses the statutory exemption for income on the bank accounts, and is subject to the treaty rate of U.S. tax.

Example 1:
X is a citizen and resident of Jamaica who has a green card. He is arguably a resident of both Jamaica and the United States. However, since he spends 11 months a year in Jamaica and one month in the United States he is deemed a resident of Jamaica under the treaty tie-breaker tests. If he is deemed to be a resident of Jamaica only for treaty purposes and not for purposes of the Code, interest on his U.S. bank deposits will not be exempt (see § 2.05[4], below); rather, it will be subject to U.S. tax at a 12.5 percent rate under Article 11(2) of the Jamaica treaty. 47

Example 2:
Y has maintained for a number of years, and still does maintain, an interest-bearing account at a U.S. bank located in the United States. Until this year, application of the green card or substantial presence test would have led to a finding of nonresidency. His interest was, thus, not subject to tax in the United States. This year Y obtained a green card and, so, the interest is subject to the graduated tax rate tables applicable to all citizens and residents. Y is a citizen of country B which has entered into an income tax convention with the United States. That treaty provides for a 5 percent withholding tax on U.S. interest income of residents of country B. Y qualifies under the treaty as a resident of country B. His tax is reduced from the applicable marginal U.S. rate to 5 percent. It is not reduced to zero.

Another adverse effect of a citizen of a treaty country becoming a resident alien of the United States is the loss of the capital gains exemption for aliens not present in the United States for 183 days. 48 A taxpayer who is a dual resident of the United States and another country, but claims treaty protection, will be deemed a U.S. resident for Code purposes, and thus will be exempt from payment of tax upon sale of a U.S. situs capital asset only if the applicable treaty itself provides protection. Most do provide protection on sale of intangibles, but not tangible property.

Example:
Z maintains nonresident status under the tie-breaker rules of the applicable United States dual income tax treaty, even though he would otherwise be treated as a U.S. person under the “substantial presence” test of I.R.C. Section 7701(b)(3). He did not, in fact, spend 183 days in the United States in 2010. He sold a capital asset with a U.S. connection in 2010. Because he will not be able to claim the exemption from tax under I.R.C. Section 871(a)(2), having instead claimed treaty protection, the capital gain will be taxable for U.S. income tax purposes unless it is sheltered from tax by the applicable treaty.

Comment:
Clearly, a resident alien selling property and returning to his native country would be wise to defer the close of escrow until January 1 of the following year and then take the necessary steps to obtain nonresidency status in that following year.

Residency under U.S. law coupled with nonresidency under a treaty may also cause corporations to become controlled foreign corporations. 49 Shareholders in these corporations become subject to tax on undistributed income. 50

If an alien is a U.S. resident under the Code, but is considered a resident of another country under a tie-breaker provision in an income tax treaty, and the alien claims a treaty benefit as a nonresident of the United States, the alien is treated as a nonresident alien of the United States for purposes of computing the alien’s income tax liability. 51 However, the alien is treated as a U.S. resident for all other purposes of the Code. 52 Thus, the alien is a resident for purposes of determining whether a corporation is a controlled foreign corporation, and is currently taxable on all income of that corporation which is not treaty protected. Conversely, a taxpayer may choose to waive treaty benefits and continue to be taxed under the Code. In a Chief Counsel Advisory Memorandum 53 the IRS National Office ruled that a Portuguese citizen residing in Portugal but who still held a green card could elect to be taxed as a U.S. resident under the Code on his worldwide income 54 and waive treaty benefits. In this Chief Counsel Advisory Memorandum, the net result of the taxpayer’s election to be taxed as a U.S. resident was a lower aggregate U.S. tax than would be payable under the applicable treaty.

An individual who qualifies as a resident in more than one country with which the United States has an income tax treaty may choose which convention will apply. 55 The United States-Swiss Confederation Income Tax Convention defined the term Swiss corporation to include a corporation created under Swiss law. 56 The corporation had its central management and control in the United Kingdom. The then-governing United States-United Kingdom Income Tax Convention provided that a corporation was a United Kingdom resident if its business was managed and controlled in the United Kingdom. 57 The corporation’s Swiss bank received loan interest from a U.S. bank located in the United States. The Swiss treaty provided for a 5 percent withholding tax on such income while the United Kingdom treaty exempted such income from tax. The taxpayer maintained that it could elect to be subject to the United States-United Kingdom treaty and thus avoid tax. The Service agreed.

This ruling presents planning opportunities for those individuals with the ability to qualify as a resident under more than one treaty. The ruling demonstrates that residence-shopping is not inconsistent with perhaps unavoidable resident status in the alien’s country of citizenship.

See § 2.08, below, for a discussion of treaties before their impact on determinations of residence.

[3] Second-Time U.S. Residents

Foreign nationals who leave the United States after being treated as U.S. residents for at least three consecutive calendar years should be aware of a tax trap for second-time U.S. residents when they decide soon to return for a substantial period of time to the United States. I.R.C. Section 7701(b)(10) provides that an alien treated as a U.S. resident for at least three consecutive calendar years (the initial residency period) who ceases to be a U.S. resident, but who resumes U.S. residence before three years after the end of the initial residency period, is subject to the alternative tax regime under I.R.C. Section 877(b) (see Ch. 1, § 1.08) for the period after the initial residency period closed until the day before the second residency began. Unlike I.R.C. Section 877(b), I.R.C. Section 7701(b)(10) applies regardless of the departing individual’s net worth or previous earnings. This rule applies whether the alien was a U.S. resident income taxpayer because he or she held an immigrant visa, or failed the “substantial presence” test, provided in either case that the alien was physically present in the United States for at least 183 days in each of the three base years. 58

The alternative tax regime under I.R.C. Section 7701(b)(10) does not apply if the individual would pay a higher U.S. tax as a nonresident alien. Under Notice 97-19 , an individual subject to I.R.C. Section 7701(b)(10) is entitled to treaty benefits in the intervening period. Such individual is also subject to various sourcing and recognition rules under I.R.C. Section 877(d) and must file Form 1040NR and certain schedules for the intervening period. Notice 97-19 allows the taxpayer an extension of time to file these forms and schedules for the intervening period, until the due date of the return (including extensions) for the first residency period after returning.

I.R.C. Section 7701(b)(10) has still not been coordinated with the new I.R.C. Section 877A.

[4] Bona Fide Residents of U.S. Possessions

Individuals who are bona fide residents of a U.S. possession can generally exclude the income from sources within the possession, or the income effectively connected with the conduct of a trade or business in such possession, from their gross income for U.S. income tax purposes. 59 In other words, such individuals are treated as nonresident aliens for purposes of the U.S. income tax, and the money they generate in the possession is not categorized as U.S. source income. These rules are based on a similar intent, but with a different manner of operation, as the estate tax rules applicable to residents of U.S. possessions discussed above in Chapter 1, § 1.03[2].

Under I.R.C. Section 937(a), an individual generally will be considered a bona fide resident of a possession only if he or she satisfies the following three conditions:
(1) The individual is physically present in the possession for 183 days during the taxable year (the presence test);

(2) The individual does not have a tax home (determined under the principles of I.R.C. Section 911(d)(3) without regard to the second sentence thereof) outside such specified possession in the taxable year (tax home test); and

(3) The individual does not have a closer connection (determined under the principals of I.R.C. Section 7701(b)(3)(B)(ii)) to the United States or a foreign country other than such specified possession (closer connection test). 60

The American Jobs Creation Act of 2004 (the “Jobs Act”) authorized the Treasury Department to create exceptions to these general requirements for individuals who are absent from a U.S. possession for non-tax reasons. 61 Specifically, the legislative history references military personnel, fishermen, and retirees. 62 Final and Temporary regulations were published consistent with the Jobs Act and its legislative history on April 11, 2005. 63

Final regulations relating to the residence rules (specifically Treasury Regulations Section 1.937-1 and Treasury Regulations Section 1.881-5T(f)(4)) were published on January 30, 2006. 64 An individual can satisfy the presence test for the taxable year if the individual: (i) spent no more than 90 days in the United States; (ii) had no earned income (as defined inTreasury Regulations Section 1.911-3(b)) in the United States in excess of the amount specified in I.R.C. Section 861(a)(3)(B) ($3,000 in the aggregate) and was present in the relevant possession longer than in the United States; or (iii) had no significant connection to the United States. 65 These alternatives enable fishermen who travel extensively at sea but spend less than 90 days in the United States, as well as retirees who spend several months a year in the United States, but earn no more than $3,000 there, and spend more time in the relevant possession, to still qualify as bona fide residents under the presence test. 66 The final regulations did not incorporate the rules of I.R.C. Section 7701(b) as an alternative to the 183-day rules of I.R.C. Section 937(a)(1) since Congress specifically rejected that option. 67

The new regulations also more clearly define a tax home as a home located at the individual’s regular or principal place of business, or if there is no such place, at the individual’s regular place of abode. 68 A specific exception is made for seafarers, who will not have a tax home outside the possession attributed to them because of employment on a ship or other vessel predominately used in local and international waters. 69 In addition, any days spent as a student or in an individual’s capacity as an elected representative outside the possession will be disregarded for the determination of whether such individual has a tax home outside the possession.

The regulations state that the factors considered in the closer connection inquiry are those listed under I.R.C. Section 7701 and its regulations, including the location of the individual’s permanent home, the location of personal belongings like automobiles, furniture and clothing, the location of social, political and cultural organizations the individual belongs to, the location where the individual conducts banking activities, and the location where the individual votes. 70 An example from the regulations is instructive:

Example:
Z, a U.S. citizen, relocates to Possession V in 2003 to start an investment consulting and venture capital business. Z’s wife and two teen-aged children remain in State C to allow the children to complete high school. Z travels back to the United States regularly to see his wife and children, to engage in business activities, and to take vacations. He has an apartment available for his full-time use in Possession V, but he remains a joint-owner of the residence in State C where his wife and children reside. Z and his family have automobiles and personal belongings such as furniture, clothing, and jewelry located at both residences. Although Z is a member of the Possession V Chamber of Commerce, Z also belongs to and has current relationships with social, political, cultural, and religious organizations in State C. Z receives mail in State C, including brokerage statements, credit card bills, and bank statements. Z is not a bona fide resident of Possession V because he has a closer connection to the United States than to Possession V. 71

The Jobs Act requires that, beginning with tax year 2001, any individual with a worldwide gross income of more than $75,000 file Form 8898 with the Service in any tax year such individual becomes, or ceases to be, a bona fide resident of American Samoa, Guam, the Commonwealth of the Northern Mariana Islands, the Commonwealth of Puerto Rico, or the U.S. Virgin Islands. 72 The Service released a new Form 8898 in January 2007, which requires the taxpayer to disclose information about time spent in the applicable possession and in the United States, and also personal information like the location of immediate family, automobiles, personal belongings, important financial and legal documents, etc. 73 Taxpayers who file Form 8840 are also instructed to keep this information on file and readily available in the event of an examination.

For purposes of the Form 8898, worldwide gross income is all income received in the form of money, goods, property and services, including income from sources outside the United States, before any deductions or credits. In determining whether worldwide gross income equals more than $75,000, an individual does not include his or her spouse’s income. If each spouse meets the test, both must file Form 8898 separately.

The tax treatment of corporations created or organized in U.S. possessions is determined under I.R.C. Section 881(b). If such a corporation meets certain requirements, it is exempt from the 30 percent tax under I.R.C. Section 881(a) imposed on the U.S.-sourced fixed or determinable annual or periodical income of foreign corporations. 74 A corporation created under the laws of the U.S. Virgin Islands, Puerto Rico, and American Samoa must meet the following criteria for exemption:
(1) At all times during such taxable year, less than 25 percent of the stock of such corporation is beneficially owned (directly or indirectly) by foreign parties;

(2) At least 65 percent of the gross income of such corporation must be effectively connected with the conduct of a trade or business in such possession or the United States for the three-year period ending with the close of the taxable year of such corporation; and

(3) No substantial part of the income of such corporation for the taxable year is used (directly or indirectly) to satisfy an obligation to persons not bona fide residents of such possession or the United States. 75

Corporations in Guam and the Northern Marinara Islands are subject to (1) above, but for purposes of (2) need only show at least 20 percent of the gross income is effectively connected. 76 Requirement (3) does not apply. The requirements for exemption in these two possessions will be the same as above if such possessions enter into an implementing agreement with the United States government. 77

§ 2.04 U.S. Trade or Business

A facts and circumstances test is applied in most cases to determine if an alien taxpayer is engaged in a U.S. trade or business. A nonresident alien performing personal services in the United States is generally engaged in a trade or business; there are exceptions. An alien maintaining an office to trade in securities or commodities for others is engaged in a trade or business. If an alien taxpayer’s agent or spouse conducts the taxpayer’s business or trade, the taxpayer may be found to be engaged in a trade or business.

The income of a nonresident alien individual that is effectively connected with a U.S. trade or business is taxed at the normal graduated rates. 1 In contrast, the income that is not effectively connected with a U.S. trade or business (investment income) and other income is generally taxed at a flat 30 percent or lower applicable treaty rate. 2 The first step in determining if a taxpayer has income effectively connected with a U.S. trade or business is to determine if the taxpayer is engaged in a trade or business. A U.S. trade or business may be actual or artificial. See § 2.04[3], below.

For purposes of determining whether income is effectively connected, or simply U.S. source income, the income is generally taken into account for the current tax year for cash basis taxpayers, but characterized as connected or unconnected with a trade or business according to the facts in the year the income accrued. If the income is attributable to a sale or exchange of property, or the performance of services in a prior tax year, the gain is treated as if it were taken into account in that other year, and taxed accordingly. 3 For example, in a recent Chief Counsel Memorandum, the Service determined that non-qualified stock options earned in a year when the taxpayer was engaged in a U.S. trade or business, but exercised in a year when he was not, would be taxed at the graduated rates applied to income connected with a U.S. business. 4 The stock options were compensation for services rendered in the United States, and would have been treated as effectively connected with a U.S. business had the taxpayer included them in income in the year they were awarded, so they were treated as such when he exercised them. The Chief Counsel advised that the income was not to be taxed as income of a United States resident, even though taxpayer had been a U.S. resident in the years during which he performed the services, but was, nevertheless, to be taxed as income effectively connected with a U.S. trade or business.

[1] Personal Services

A U.S. trade or business includes performing personal services within the United States at any time during the tax year (see Chapter 11, § 11.03[3] for rules governing services performed partly within and partly without the U.S.). 5 However, a nonresident alien individual performing personal services in the United States is not engaged in a U.S. trade or business if:
(1) The personal services are performed for a nonresident alien individual, foreign partnership, or foreign corporation not engaged in a trade or business in the United States, or for an office or place of business maintained in a foreign country or U.S. possession by an individual who is a U.S. citizen or resident or by a domestic partnership or a domestic corporation;

(2) The compensation for the services does not exceed in the aggregate $3,000; and

(3) The nonresident alien employee is temporarily present in the United States for a period or periods not exceeding a total of ninety days during the tax year. 6

The $3,000 exempt amount is for compensation only, and the employee may in addition be reimbursed for travel and other expenses, if the employee has accounted for such expenses to his employer. 7 However, the $3,000 exemption has not been revised in many years and is rarely relevant today for a taxpayer otherwise unable to claim treaty protection.

Example 1:
In 1991, A, a nonresident alien, was employed by the Munich office of YBCN, Inc., a U.S. corporation. A uses the calendar year as his tax year. He was temporarily present in the United States for forty-five days in 1991 performing personal services for the corporation’s Munich office. He was paid a total gross salary of $2,800 for those services. For 1991, A was not engaged in a trade or business in the United States.

Example 2:
The facts are the same as in Example 1, except that A’s aggregate compensation for the personal services he performed in 1991 was $3,500. He received $2,800 in 1991 and $700 in 1992. A was engaged in a trade or business by reason of his performing personal services in the United States for the corporation’s Munich office during the 1991 tax year. 8

[2] Trading in Securities or Commodities

Generally, under the rule of I.R.C. Section 864(b)(2)(A)(i), a foreign individual, corporation or trust that trades in stocks, securities or commodities in the United States is not treated as conducting a U.S. trade or business (and is therefore not subject to U.S. income tax on his or her or its “effectively connected” income, including gains from the purchase and sale of U.S. investments) if the foreign individual, corporation or trust does not have an office in the United States through which, or under the direction of which, the securities transactions are effected. Under the safe harbor of I.R.C. Section 864(b)(2)(A)(ii), however, a foreign individual, corporation or trust is not treated as conducting a U.S. trade or business even if he or she or it has an office in the United States through which, or by direction of which, the transactions in stocks, securities or commodities are effected, provided the transactions are for the taxpayer’s own account. This safe harbor applies whether the trading is conducted by the foreign taxpayer or his or her or its agent or employee, whether or not such agent or employee has discretionary authority to make decisions in effecting the transactions, whether or not the taxpayer maintains his or her or its principal office in the United States, 9 and regardless of the volume of trading activity.

For purposes of the safe harbor, the term “securities” includes any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing, as well as financial futures that provide the holder the right to purchase the underlying financial instruments. 10 The term “commodities” includes all commodities of a kind customarily dealt in on an organized commodity exchange. 11 The activities permitted by the safe harbor include buying, selling (including short sales) or trading in stocks, securities or contracts or options to buy or sell stocks or securities, on margin or otherwise, for the account and risk of the taxpayer, and any other activity closely related thereto (such as obtaining credit for the purpose of effectuating such buying, selling or trading). 12

Proposed regulations issued by the Service in 1998 provide that foreign taxpayers who effect transactions in derivative financial instruments for their own accounts are not thereby engaged in a trade or business in the United States if they are not dealers in stocks, securities, commodities, or derivatives. 13

Trading for one’s own account is generally evidenced by trading through an independent stockbroker, commission agent or custodian; whether the agent had discretionary authority, as well as the volume of transactions, is immaterial. 14

[3] Facts and Circumstances Test

In determining whether a taxpayer is engaged in a trade or business, activities of the taxpayer, other than performing personal services (§ 2.04[1], above) and trading in securities or commodities (§ 2.04[2], above), are examined in light of the facts and circumstances of each case. 15 The Service does not issue advance rulings or determination letters on a taxpayer’s status as engaging in a U.S. trade or business. 16

The facts and circumstances test examines the nature and extent of the taxpayer’s economic activities and contacts within the United States. 17

Example 1:
A foreign sugar producer sold raw sugar through independent U.S. resident brokers. He was not engaged in a U.S. trade or business. 18

Example 2:
A nonresident alien individual made postcards in his own country and then sold them in the United States under a distributorship agreement with a U.S. news company. He was engaged in a U.S. trade or business because the news company was deemed to be the alien’s agent. 19

A U.S. trade or business does not include isolated and nonrecurring transactions by a nonresident alien in the United States absent a profit motive. 20 The taxpayer must, during some substantial portion of the taxable year, have been regularly and continuously transacting a substantial portion of its ordinary business in the United States. 21

An isolated sale of embargoed merchandise purchased by a foreign company is not engaging in a U.S. trade or business by the foreign company where the embargoed goods were the only property the company had in the United States and the company had no office, salesman, employees or license in the United States. 22 However, a nonresident alien’s entry of a horse in a single race is engaging in a U.S. trade or business in the absence of definite information that the nonresident alien doesn’t intend to enter a horse in another race in the United States during the tax year. 23

Owning real estate in the United States is not a U.S. trade or business, without other activities in addition to ownership. 24 A property owner’s activity in regards to the property must be “considerable, continuous, and regular” for the Service to consider the owner engaged in a U.S. trade or business. 25 For example, a brief visit to the taxpayer’s rental property to supervise the negotiations of net leases is not engaging in a trade or business. 26 However, a taxpayer leasing and managing property through rental agents is engaging in a U.S. trade or business. 27 But when a foreign lessor paid real estate taxes, mortgage installments and cultivation fees for U.S. farmland, the payments were too sporadic to be engaging in a U.S. trade or business. 28

[4] Agency

One line of cases and rulings involves the direct activities of the foreign person and the nature and quantity of those activities. The other line of cases involves whether the alien is engaging in business in the United States through an agent. Generally, the putative agent clearly engages in business in the United States and cases focus on the relationship between alien and agent. 29 Where the agent has to request authority to perform an act, the principal is not engaging in the active conduct of a trade or business. 30 However, where the agent has a broad power of attorney which includes the power to buy, sell, lease, and mortgage real estate for and in the name of the taxpayer, keeps the taxpayers’ books, pays his taxes and mortgage, insures his property, and supervises repairs, this constitutes considerable continuous and regular activities and, therefore, the alien is engaged in a trade or business. 31

The notion that activities of the agent having authority to act on behalf of a taxpayer are attributable to the taxpayer also has led to findings of active conduct of a trade or business in several situations in which one might not readily expect such a finding. For example, a nonresident wife was found to be engaged in a U.S. trade or business because her husband was concededly engaged in a U.S. trade or business. 32 Any actions of the husband were considered actions of the marital community and the husband therefore was an agent for the community. 33

This rationale can be applied in a situation where one spouse is engaged in a U.S. trade or business and the Service contends that the independently-derived, non-FDAP U.S. source income of the other spouse is, therefore, effectively connected.

[5] Partnerships; Beneficiaries of Estates and Trusts

By statute, conduit treatment of nonresident alien individuals and foreign corporations as engaged in U.S. trade or business also applies to partners and estate and trust beneficiaries.34 A nonresident alien individual or foreign corporation is engaged in a U.S. trade or business if it is a member of a partnership engaged in a U.S. trade or business. 35 This applies to both limited and general partners who are nonresidents. 36 A nonresident alien partner must pay tax on his or her share of a partnership’s income only to the extent that the income is U.S. source or is effectively connected with the conduct of a trade or business in the United States. 37 The same rule applies to a nonresident alien partner of a limited liability company that is classified as a partnership. 38 The test to determine if a partnership is engaged in a U.S. trade or business is the same as in the case of a nonresident alien individual.39

The Service has reversed its policy regarding the treatment of partnership income under income tax treaties, such that the conduit treatment of nonresident alien partners, just discussed, is maintained. An often found treaty provision provides that personal services performed in an independent capacity by a resident of a contracting state are taxable only in that state, unless performed in the other state and attributable to a fixed base in that other state (see § 2.08 below). The Service previously took the position, specifically with regard to the U.S.-German treaty, that such a provision may exempt a nonresident alien partner from U.S. taxation of his distributive share of income derived from his partnership’s U.S. branch office, provided he has not personally worked in that office. 40 As a result, that and similar treaty provisions effectively overrode the Code’s treatment of foreign partners as effectively engaged in a U.S. trade or business when the partnership is so engaged. The Service now has revoked that Ruling, holding instead that, despite the treaty provision at issue in the prior ruling or similar provisions contained in other treaties, a partnership’s U.S. branch income is taxable to nonresident alien partners without regard to whether they personally have performed services in the United States, because a U.S. office is a fixed base attributed to all of the partners of a partnership. 41 However, certain treaties have been distinguished. In 2010, the Service ruled that a Russian resident’s distributive share of a partnership’s U.S. source income, where the Russian resident had spent less than 183 days in the United States, was not taxable in the United States as the U.S.-Russia tax treaty was distinguishable from the U.S.-Germany tax treaty based on the provision in the former of a 183-day presence requirement. 42

A nonresident alien individual or foreign corporation that is a beneficiary of an estate or trust is engaged in a U.S. trade or business if the estate or trust is so engaged. 43

Even when a trust is a complex trust (meaning the trustee is not required to distribute income to the beneficiary but exercises discretion as to trust distributions), the Service will attribute the U.S. trade or business of the trust to the beneficiary. 44 In a letter ruling the Service determined that the distributions made from various U.S. trusts to an Italian citizen beneficiary were income effectively connected with a U.S. trade or business taxable under I.R.C. Sections 1 and 55. The trusts were lessees of mineral estates with active, extractive operations that were managed through an independent contractor. The Service concluded that the trusts were, through the contractor, conducting activity in the United States beyond the mere receipt of income from rental property and the payment of expenses incidental to the collection of rental income. The Italian citizen who was the discretionary beneficiary of the trusts, therefore, was also treated as engaged in a U.S. trade or business under I.R.C. Section 875(2) and taxed accordingly, despite the fact that the trustee was not required to currently distribute income to the beneficiary. 45 The taxpayer unsuccessfully argued that he was not engaged in a U.S. trade or business and that the appropriate tax due on the trust distributions was the 30 percent withholding tax imposed on U.S.-sourced fixed or determinable annual or periodical gains, profits or income. The result is the same as that for a nonresident alien conducting U.S. business activities through an agent. 46

The Court of Claims ruled otherwise in DiPortanova v. United States, 47 where the taxpayer, a dual United States-Italian citizen, had renounced his U.S. citizenship and continued to pay United States income tax at the flat 30 percent withholding rate applicable to FDAPI, on the income he was receiving from family trusts which owned a 2.25 percent working interest in oil and gas fields in Texas. The Court of Claims held that because the trusts’ interest was so small and the taxpayer’s trusts had no role in the conduct of the working interest oil and gas leases, the taxpayer was not engaged in a U.S. trade or business. Apparently, there was no partnership, and so I.R.C. Section 875(1) did not apply, but the Court did not discuss I.R.C. Section 875(2). The Court set down for trial the question of whether I.R.C. Section 877 should apply to tax the taxpayer at graduated rates for 10 years.

Hendrickson v. Commissioner 48 provides analogous authority for taxpayers, with reference to self-employment tax. In the case, the taxpayer, a retired irrigation sprinkler salesman from Kansas, had purchased for investment purposes minority working interests in several oil wells. An oil and gas operating corporation, in which taxpayer had no interest, operated the wells. The Service attempted to subject the taxpayer’s income from the wells to self-employment tax under I.R.C. Section 1401(a). Citing DiPortanova as authority, the Tax Court held that taxpayer was not liable to pay self-employment tax because he was not employed in a U.S. trade or business.

While a nonresident alien individual (and certainly a foreign corporation) is unlikely to often be treated as engaged in a U.S. trade or business through an estate or trust, given that by their nature trusts generally do not engage in a trade or business, 49 the situation often arises through partnerships.

§ 2.05 Alien Not Engaged in U.S. Trade or Business

Income not effectively connected with the conduct of a U.S. trade or business is subject to a flat 30 percent tax unless reduced by a treaty. This includes (1) fixed or determinable annual or periodical income, (2) original issue discount, (3) portfolio interest income, and (4) gain on the sale of a capital asset. Interest on bank deposits is not subject to tax. Special rules apply to an alien who expatriates to avoid tax.

Nonresident alien individuals are subject to a flat 30 percent tax on certain U.S. source income not effectively connected with the conduct of a U.S. trade or business. 1 Income subject to the flat 30 percent tax includes:
(1) interest (other than original issue discount), dividends, compensation for services, rent, remuneration, emoluments and other fixed or determinable annual or periodical gains, profits and income (see § 2.05[1], below); 2

(2) the net U.S. source gain from the disposal of capital assets, if the recipient is present in the United States for an aggregate of 183 or more days during the tax year of receipt, and if those gains and losses would be taken into account if the nonresident alien were engaged in a U.S. trade or business during the year (see § 2.05[5], below); 3

(3) gain from the disposal with a retained economic interest of timber, coal or iron ore mined in the United States (held for more than six months); 4

(4) original issue discount accruing during the time the obligation is held by the foreign person, taxable upon the sale or exchange of the obligation or upon any payment on that obligation (see § 2.05[2], below); 5

(5) gain from the sale or exchange, after October 4, 1966, of interests in patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises and similar properties, to the extent the gain is from payment contingent upon the productivity, use or disposition of the property; 6

(6) gross income, when paid, from a real estate mortgage investment conduit, if the amount is includable in income for tax years beginning after 1986; 7

(7) one half of U.S. social security benefits received; 8 and

(8) for individuals who were 50 years old before January 1, 1986, the capital gain portion of distributions from qualified pension, profit-sharing or annuity plans. 9

[1] Fixed or Determinable Annual or Periodic Income

Fixed or determinable annual or periodic income (FDAPI) subject to the flat 30 percent tax specifically includes: 10 interest (other than original issue discount), dividends, rent, salaries, wages, premiums (though not insurance premiums), 11 annuities, compensations, remunerations and emoluments. 12 Other items of FDAPI are also subject to the tax, such as royalties, including royalties for the use of patents, copyrights, secret processes and formulas. 13 While capital gains are not generally viewed as FDAPI, gain on the disposition of Section 306 stock and distributions of net short-term capital gain by a regulated investment company (RIC) also constitute FDAPI, 14 as do “dividend equivalent” payments made after December 31, 2010. See discussion at § 2.05[2]. FDAPI also includes all other U.S. source income of a similar character. 15

While FDAPI must be fixed (paid in amounts definitely predetermined) or determinable (having a basis of calculation by which the amount to be paid may be ascertained), 16 this language is construed quite loosely, to the detriment of the alien. Payments made to a salesman working on commission are considered determinable, 17 as are payments of alimony,18 prizes, 19 and purses paid to owners of race-winning horses. 20 Gross income does not include any amounts received by the taxpayer under a life insurance contract by reason of the death of the insured. 21 But amounts received by a nonresident alien by reason of the cancellation of a United States life insurance policy, rather than by reason of the death of the insured, will be United States source FDAPI. 22 In a recent ruling, the Service examined the taxability of annuity payments and withdrawals by a nonresident alien owner from a life insurance policy issued by a foreign branch of a United States life insurance company. The Service determined that these were United States source payments under I.R.C. Section 861, taxable to the recipient under I.R.C. Section 871, and subject to 30 percent withholding (assuming no treaty) under I.R.C. Section 1441. 23 Gambling winnings in the United States of a nonresident alien also constitute FDAPI, subject to 30 percent withholding, with limited exceptions. The Code specifically exempts the proceeds from wagers at blackjack, baccarat, craps, roulette or big-6 wheel games from tax unless the Secretary determines by regulation that collection of the tax is administratively feasible. 24 Lottery winnings are subject to tax. 25

A settlement payment also qualifies as FDAPI subject to 30 percent withholding if such payment has a U.S. source. In a private letter ruling, the taxpayer requested that the Service determine the source of a settlement payment under a bankruptcy claim stemming from an alleged wrongful breach of contract between a sole proprietorship and the corporation for which it distributed sporting equipment outside the United States. 26 The Service stated that the source of the settlement payment depends upon the nature of the item for which the bankruptcy claims settled. Because the purchase of sporting equipment within the United States for sale and use in a different country would constitute foreign source income, the Service determined that the settlement payment made on account of the breach was also foreign source income.

Income is sufficiently determinable to the payor if he may readily compute at the flat rate the tax to be withheld before paying out the remainder. 27 This leaves little, if anything, indeterminable. Nor need income be paid annually or periodically, so long as the item of income falls within the class of income contemplated by the statute. 28 It is immaterial whether royalties, for instance, are paid in installments or in a lump sum. 29

[2] Dividends and Dividend Equivalents

Historically, dividends have been the most basic class of FDAP income, taxable to nonresident alien shareholders at a 30 percent rate. Many dual income treaties between the United States and its major trading partners reduce the withholding rate on dividends to 15 percent for treaty residents of the other nations, or from 15 percent for owners of significant blocks of stock. For those entitled to treaty benefits, however, the withholding tax rate on dividends is 30 percent, or twice the 15 percent rate available to U.S. shareholders on qualified dividends under current law. 30 For this reason, a foreign donor setting up a trust for beneficiaries in several jurisdictions may wish to set up a trust which pays dividends and interest to nonresident alien beneficiaries.

Until 2010, some nonresident alien investors avoided paying U.S. withholding tax on dividends by entering into securities lending or purchase and sale agreements with U.S. brokers, under which the nonresident alien who owned dividend-paying stocks would loan the stocks to the U.S. broker, who would then include the amount of the dividend in the interest payment, or would sell the stock to the broker just before it went “ex-dividend” for a purchase price which included the dividend, and would repurchase the stock from the broker the next day for a price which excluded the dividend. Market risk and transaction costs aside, the result was to recharacterize what would have been a taxable dividend as either portfolio interest (see § 2.05[4]) or short-term capital gain (see § 2.05[6]), and, in either case, avoid withholding tax.

This strategy was ended by the addition of a new I.R.C. Section 871(m), effective December 31, 2010, by the Hiring Incentive to Restore Employment (HIRE) Act. 31 The new I.R.C. Section 871(m) provides that “dividend equivalent” payments made to a nonresident alien taxpayer will be taxed to him or her at a 30 percent rate as if they were dividends. The statute defines “dividend equivalent” payments as any substitute dividend that is made pursuant to a securities lending or a sale-repurchase transaction that (directly or indirectly) is contingent upon or determined by reference to, the payment of a dividend from sources within United States, national principal contracts to the same end, or any similar arrangement which the Secretary may include by regulations. 32

[3] Original Issue Discount

Excluded from the definition of FDAPI is original issue discount (OID) which is the difference between the issue price and the stated redemption price at maturity (as defined in I.R.C. Section 1273) of a bond or other evidence of indebtedness (“original issue discount obligation”). OID received by an alien, and not effectively connected with that person’s U.S. trade or business, is subject to the flat 30 percent tax (or lower treaty rate) unless it is:
(1) portfolio income;

(2) paid on a short-term obligation (i.e., one payable within 183 days of its original issue); 33 or

(3) paid on a tax-exempt obligation. 34

Only OID accruing during the time the foreign person holds the OID obligation is subject to tax. 35 The tax is imposed upon the sale or exchange of the OID obligation 36 or any payment on the obligation. 37

The portion of a payment or an obligation taxed equals the OID accrued to the date of payment less OID previously taxed. The tax also cannot exceed the amount of the payment less any portion of the payment that represents expressly stated interest. 38

OID taxed on a payment is not taxed subsequently upon the sale or exchange of the OID obligation. 39 Upon disposition of an OID obligation, all untaxed OID accruing during the time it was held by the foreign person is taxed, even if the accrued amount exceeds the gain on disposition. 40

Stripped bonds and stripped bond coupons are treated in the same manner as OID obligations. 41

[4] Portfolio Interest Income

Portfolio interest paid to a nonresident alien is not subject to withholding. 42 “Portfolio interest” is defined as any interest (including original issue discount) that would be subject to tax under I.R.C. Section 871(a) but for I.R.C. Section 871(h) and is either:
(1) interest on a nonregistered obligation of the type described in I.R.C. Section 163(f)(2)(B), which are obligations of which there are arrangements designed to ensure that such obligations will be sold or resold only to nonresident aliens, and, if the obligation is in bearer form, interest on such obligations is only payable outside the United States, and there is a statement on the face of the obligation that any U.S. person who holds the obligations will be subject to the limitations of the U.S. income tax laws (e.g., Eurobonds); or

(2) interest on a registered obligation (with respect to which the U.S. person obligor would normally have to deduct and withhold tax) with respect to which the withholding agent has received a statement that the beneficial owner is not a U.S. person. 43

Section 502 of the Hiring Incentives to Restore Employment (HIRE) Act of 2010 amends I.R.C. Sections 163(f)(2)(B) and 871(h)(2) so as to eliminate bearer bonds from these classes of obligations which can constitute portfolio debt, effective for obligations issued after March 18, 2012, the second anniversary of the enactment of the HIRE Act.

Most long-term U.S. Treasury obligations are issued in registered form and will qualify as an instrument bearing “portfolio interest.”

Excluded from the definition of portfolio interest is any interest received by a 10 percent shareholder. 44 The latter includes any individual who owns 10 percent or more of the total combined voting power of all classes of stock or of the capital or profits interest, in the corporation or partnership, respectively, that issued the subject obligation. 45 I.R.C. Section 318 attribution rules generally apply to determine percentage of ownership. 46

In April of 2007, the Service adopted final regulations on the application of the 10 percent shareholder limitation on the withholding tax exemption for portfolio interest in cases where the interest is paid to a partnership with foreign partners. 47 Before the prior proposed regulations were issued it was unclear, when a partnership with foreign partners generated portfolio interest, whether the withholding agent should apply the 10 percent shareholder test at the partner level because the partner was the beneficial owner of the interest, or at the partnership level because the partnership owned the debt instrument. Under the proposed, and now final, regulations, the 10 percent shareholder test will be applied at the foreign partner level to the nonresident alien or foreign company that is the partner and beneficial owner of the income. The regulations apply the 10 percent shareholder test by determining each such foreign partner’s interest in the debtor corporation or entity. 48 The regulations also state that the 10 percent shareholder test will be applied at the time the withholding agent would otherwise be required to withhold from a foreign partner’s interest under I.R.C. Sections 1441 and 1442. 49

In addition, the portfolio interest exemption available to a nonresident alien or foreign corporation has been restricted to exclude contingent interest. 50 This rule is not intended to override existing treaties that reduce or eliminate U.S. withholding tax on interest paid to a foreign person. 51

Interest is contingent if the amount of the interest is determined by reference to:
(1) receipts, sales or other cash flow of the debtor or a related person;

(2) any income or profits of the debtor or a related person;

(3) any change in value of any property of the debtor or a related person; or

(4) any dividend, partnership distributions or similar payments made by the debtor or a related person. 52

The portfolio interest rule with respect to the exclusion of contingent interest applies to interest received after December 31, 1993. However, it does not apply to any interest paid or accrued with respect to any indebtedness with a fixed term that was issued on or before April 7, 1993, or was issued after such date pursuant to a written binding contract in effect on such date and at all times thereafter before such indebtedness was issued. 53

In an interesting case, 54 the taxpayer, a Colombian national, had invested $1,000,000 in a U.S. mutual fund. The fund paid her $106,682 in dividend income in 1989, and withheld at the 20 percent back-up withholding rate, because the taxpayer never gave the fund a form W-8. The Service now sought the additional 10 percent tax from taxpayer’s assets on deposit in the U.S., for the 30 percent I.R.C. Section 871 tax, while taxpayer sought a refund of all taxes paid, on the basis that the fund manager should have invested her assets in instruments bearing portfolio interest. The Tax Court found for the Service, requiring taxpayer to pay the extra 10 percent, and stating that any claim the taxpayer had for faulty investment strategy lay against her investment advisor, not the U.S. Treasury.

[5] Interest on Deposits

Interest payments received by a nonresident alien or foreign corporation on deposits with banks, savings institutions or insurance companies are exempt from tax if they are not effectively connected with the recipient’s U.S. trade or business. 55 Interest paid by a savings institution qualifies for exemption only if it is paid on deposits or withdrawable accounts and deductible by the payer for U.S. income tax purposes. 56 Interest paid by an insurance company qualifies for exemption only if it is paid on amounts held by that company under an agreement requiring the payment of interest. 57

This exemption applies only to interest received in tax years beginning after 1986 on obligations issued after December 31, 1985. 58 However, post-1985 extensions of pre-1986 obligations are treated as post-1985 obligations. 59 Before 1986, interest on deposits was treated as foreign source income and, therefore, was exempt from tax.

On January 6, 2011, the IRS and the Treasury Department issued proposed regulations that would require U.S. banks to annually report interest income paid to all nonresident alien individuals. Under the I.R.C. Section 6049 regulations currently in effect, U.S. banks are only required to report U.S. bank deposit interest paid to a U.S. person or to a nonresident alien who is a resident of Canada. The proposed regulations would extend the information reporting requirements to include bank deposit interest paid to nonresident aliens who are residents of any foreign country. 60

[6] Gain on Sale of Capital Asset

A nonresident alien’s U.S. source gain from the sale or exchange of personal property that is a capital asset is subject to a tax equal to 30 percent (or lower treaty rate) tax of the net gain, but only if: 61
(1) the gain is not taken into account as income effectively connected with a U.S. trade or business;

(2) the gain is not taxed as fixed or determinable annual or periodic income; and

(3) the recipient is physically present in the United States for 183 days during the tax year in which the property is sold or exchanged and the tax year in which the gain is received.

Gain from the sale of a U.S. real property interest is treated as income effectively connected with a U.S. trade or business. 62 For the definition of a U.S. real property interest and the treatment of gain or losses from the disposition of a U.S. real property interest as effectively connected with the seller’s trade or business, see § 2.06[4], below.

The taxable amount from the sale or exchange of a capital asset is the nonresident alien’s excess gains over losses from the sale or exchange of capital assets that are U.S. source during the tax year. The gains and losses must be treated as capital gains or losses if the person was engaged in a U.S. trade or business during the year, except that such capital gains are determined without regard to the Section 1202 exclusion for gains from certain small business stock. 63 Unused capital losses from previous years cannot be deducted as capital loss carryovers. 64 Gains from lump-sum distributions (treated as capital gains), gains from the disposition of timber, coal, gas or iron ore with a retained economic interest, and gains from the sale of patents (otherwise treated as capital gains) are excluded from the computation. 65 Losses are taken into account only if they are otherwise allowable under general tax provisions, governing the deductibility of losses. 66

Gains are taxable only if the nonresident alien was physically present in the United States for an aggregate of 183 days during the tax year (1) in which the sale or exchange occurs, and (2) in which the income is received. 67 If the recipient has not previously established a tax year for U.S. income tax purposes, it will be established as a calendar year. 68 All gains and losses in one tax year are netted, even if the taxpayer was not present in the United States when any particular sale or exchange took place. 69 Gain or loss recognized in the current year from transactions executed in a prior year are not taken into account unless the taxpayer met the 183-day requirement in the year the transaction occurred. 70 Similarly, income received in subsequent years is subject to the tax only if the taxpayer meets the 183-day requirement during that subsequent year, even though the taxpayer did meet that requirement in the year of the transaction. 71

The effect of this rule is that a nonresident alien taxpayer who is physically present in the United States for more than 182 days in the year in which a capital gain is realized may elect the installment method of accounting for the gain under I.R.C. Section 453, delay receipt of the sales proceeds until a subsequent year, and avoid U.S. tax by remaining outside of the United States for at least 183 days in the year in which the proceeds are collected.

Capital gains collected by a U.S. resident trustee are not taxable to a nonresident alien beneficiary who remains outside of the United States for at least 183 days. 72

[7] Expatriation to Avoid Tax

The rules discussed above in § 2.05 do not apply to a nonresident alien who expatriated before June 17, 2008–that is, renounced U.S. citizenship or relinquished long-term residency in the United States–and who at the time of the expatriation: (1) has an average tax liability for the prior five years of $124,000 (adjusted for inflation to $151,000 in 2012); (2) has a net worth of $2 million or more, or (3) does not certify under penalty of perjury that he or she had complied with all federal tax obligations for the previous five years. 73 Individuals who expatriate after June 17, 2008 are generally subject to the rules discussed above in this § 2.05 as well as the mark-to-market exit tax on unrealized net gain pursuant to I.R.C. Section 877A, as discussed above in § 1.08[5].

An individual who expatriated before June 17, 2008 to whom the alternative tax regime under I.R.C. Section 877 applies is subject to tax only on his or her U.S.-source gross income and gains on a net basis at the graduated rates applicable to U.S. citizens and resident aliens, rather than the rates applicable to nonresident aliens. However, for this purpose, U.S.-source income has a broader scope than it does for normal U.S. Federal tax purposes for nonresident aliens. For ten years after expatriation, U.S.-source income includes: (1) gains on the sale or exchange of property located in the United States; (2) gains on the sale or exchange of U.S. securities; (3) “portfolio interest” income (such as interest on U.S. Treasury securities) on which nonresident aliens otherwise would not be subject to income tax under I.R.C. Section 871(h); and (4) any income or gain derived from stock in a foreign corporation if the expatriate owned directly, indirectly or constructively, at any time during the two-year period ending on the date of the loss of U.S. citizenship, more than 50 percent of the voting stock or value (but only to the extent such income or gain does not exceed the earnings and profits attributable to such stock which were earned or accumulated before the loss of citizenship during periods such ownership requirements are met). The alternative tax regime applies only if it results in a higher U.S. tax liability than the liability that would result if the individual were taxed as a nonresident alien.

The 1996 amendments to the tax rules applicable to expatriates 74 provide for certain anti-abuse rules to prevent circumvention of the alternative tax regime through conversion of U.S.-source income or property to foreign income or property. In addition, the 1996 amendments extend the scope of the alternative tax regime by including foreign property acquired in nonrecognition transactions, taxing amounts earned by former citizens and long-term residents through controlled foreign corporations, and suspending the 10-year liability period during any time at which a former citizen’s or former long-term resident’s risk of loss with respect to property subject to the alternative tax regime is substantially diminished, among other measures. For reporting requirements applicable to expatriates, see § 1.08[2][d].

§ 2.06 Alien Engaged in U.S. Trade or Business–Effectively Connected Income

Nonresident aliens are taxed at the same rates applicable to U.S. citizens or residents on income effectively connected with the conduct of a trade or business. Interest or dividend income is subject to the asset use test to determine whether the asset is held in a direct relationship to a trade or business. Business activities test determines whether passive income, gain or loss is related to the conduct of a trade or business. Income from U.S. real property is subject to special rules.

A nonresident alien individual engaged in a trade or business is taxed at the same rates applicable to U.S. citizens or residents on income effectively connected with the conduct of such trade or business. 1 All U.S. source income (other than FDAPI) of a nonresident alien individual or foreign corporation engaged in a U.S. trade or business is treated as effectively connected even if the income is not derived from the U.S. trade or business. 2 I.R.C. Section 871(b)(1) was amended by The Small Business Job Protection Act of 1996, effective for tax years beginning after December 31, 1999, to eliminate the reference to I.R.C. Section 402(d)(1) with respect to taxation of lump sum pension distributions from qualified plans. These distributions remain taxable under I.R.C. Section 1.

Example:
Toyco, a foreign corporation which uses the calendar year as its taxable year, is engaged in the business of manufacturing automobiles in its own country. In 1991, Toyco establishes a branch office in the United States, which solicits orders from U.S. customers for Toyco’s cars. All negotiations with respect to such sales were carried on in the United States. By reason of its activity in the United States, Toyco is engaged in business in the United States during 1991. The income or loss from sources within the United States from such sales during 1991 is treated as effectively connected for that year with the conduct of a business in the United States by Toyco. Occasionally during 1991, the U.S. customers write directly to Toyco’s home office and the home office makes sales directly to these customers without routing the transactions through its branch office in the United States. The income or loss from sources within the United States for 1991 from these occasional direct sales by the home office is also treated as effectively connected for that year with the conduct of a business in the United States by Toyco.

U.S. source FDAPI is subject to taxation at graduated rates if effectively connected with the conduct of a U.S. trade or business, 3 and at the 30 percent withholding tax rate if not.4 FDAPI is effectively connected to a U.S. trade or business only if (1) U.S. source FDAPI is derived from assets used in, or held for use in, the conduct of a U.S. trade or business (the asset-use test), or (2) activities of a U.S. trade or business were a material factor in the realization of the income (the business-activities test). 5

A nonresident alien individual who does not engage in a U.S. trade or business during the tax year is treated as having no income, gain or loss effectively connected with the conduct of a U.S. trade or business for that year. 6 However:
(1) Income or gain of a nonresident alien attributable to a transaction that took place in another tax year is treated as income effectively connected with the conduct of a trade or business in the tax year in which it is taken into account, if the income would have been effectively connected with a U.S. trade or business in that other tax year. 7

Example:
A nonresident alien individual, A, performed personal services in the United States during 1991 for a period of 110 days for a foreign corporation. A received $5,000 in January of 1992 for the services performed in 1991. The income received in 1992 is treated as effectively connected with the conduct of a U.S. trade or business thoughA performed no services in the United States in 1992. The performance of the services in 1991 characterized the income.

(2) If property ceases to be used or held for use in connection with the conduct of a U.S. trade or business, and it is disposed of within ten years after U.S. use ceases, the determination of whether gain attributable to the sale or exchange is effectively connected with the conduct of a U.S. trade or business is made as if the sale or exchange occurred immediately before the U.S. use ceased. 8

Example:
B, a nonresident alien individual, conducted a hatmaking business in the United States between 1980 and 1985. He closed the business in December 1985 but did not sell the sewing machines used in connection with the business until 1992. Some gain was made on the sale. Gain attributable to the sale is effectively connected with the conduct of a U.S. trade or business since the sale was made less than ten years after U.S. use ceased.

[1] Asset-Use Test

The asset-use test generally, though not exclusively, applies to determinations of the character of passive income and is of primary significance where, for example, interest or dividend income is derived from sources within the United States by a nonresident alien individual or foreign corporation that is engaged in the business of manufacturing or selling goods in the United States. 9

An asset is treated as used, or held for use, in the conduct of the trade or business in the United States if it is:
(1) held for the principal purpose of promoting the present conduct of the trade or business (e.g., stock acquired and held to assure a constant source of supply);

(2) acquired and held in the ordinary course of the trade or business (e.g., an account or note receivable arising from the trade or business); or

(3) otherwise held in a direct relationship to the trade or business. 10

The most significant factor in whether an asset is held in a direct relationship is whether it is needed in the trade or business. An asset is needed if it is held to meet present needs, such as operating expenses. 11 It is not needed if it is held merely for anticipated future needs such as future diversification, future plant replacement, or future business contingencies, or for expansion of trade or business activities outside the United States. 12

Generally, stock is not an asset held for use in the conduct of a trade or business in the United States, 13 however, portfolio stock investments of a foreign insurance company are excluded from that general rule. 14 Since insurance companies may use stock investments to fund their current obligations to policy holders and to satisfy regulatory capital requirements, such stock meets a present need of the foreign insurance company and so it is an asset used in the company’s U.S. business and produces income subject to U.S. tax.

An asset is presumed to be held in a direct relationship to the trade or business if:
(1) it was acquired with funds generated by a U.S. trade or business;

(2) the income from the asset is retained or reinvested in that trade or business; and

(3) personnel who are present in the United States and actively involved in the conduct of the business exercise significant management and control over the investment of the asset. 15

Example 1:
XYZ, Inc., a foreign corporation which uses the calendar year as its taxable year, is engaged in industrial manufacturing in a foreign country. XYZ maintains a branch in the United States which acts as importer and distributor of the merchandise it manufactures abroad. By reason of these branch activities XYZ is engaged in business in the United States during 1992. The branch in the United States is required to hold a large current cash balance for business purposes, but the amount of the cash balance so required varies because of the fluctuating seasonal nature of the branch’s business. During 1992 at a time when large cash balances are not required, the branch invests the surplus amount in U.S. Treasury bills. Since these Treasury bills are held to meet the present needs of the business conducted in the United States, they are held in a direct relationship to that business, and the interest for 1992 on these bills is effectively connected for that year with the conduct of the business in the United States by XYZ. 16

Example 2:
ABC, Inc., a foreign corporation which uses the calendar year as the taxable year, is engaged in business in the United States during 1992 through its manufacturing branch in the United States. The branch holds on its books stock in domestic D corporation, a wholly owned subsidiary of ABC. There is no relationship between the business of D and the business of ABC ‘s branch in the United States, and the officers of D report to the home office of ABC and not to its U.S. branch. Dividends paid on the stock in D are paid to ABC ‘s branch in the United States and are mingled with its general funds, but the U.S. branch has no present need in its business operations for the cash received. Since the stock in D is not held in a direct relationship to the business conducted in the United States by ABC, any dividends received by ABC during 1992 on such stock are not effectively connected for that year with the conduct of that business.

The direct relationship presumption may be rebutted if the asset is held to meet future business needs. For example, an investment fund set up to carry out a program of future expansion is an asset held to meet future business needs, even if the above-cited criteria otherwise establishing a direct relationship are met. 17

Planning Note

Document Anticipated Use of Funds for Future Purposes. Evidence that funds are to be used for future diversification, plant replacement, or business contingencies should rebut the direct relationship presumption. An alien who does not sink such funds into the trade or business and who desires to avoid the direct relationship test should, therefore, be able to do so by tracking the accumulation of funds and, early on, documenting their anticipated use for future purposes. Nothing in the Code causes the income from the fund to be treated as effectively connected when it finally is used in the business. The character is determined at the time the income arises and such character does not change.

[2] Business-Activities Test

The business-activities test examines the activities of the U.S. trade or business and determines if they are a material factor in the realization of the income, gain or loss. 18 The business activities test is usually applied to evaluate passive income, gain, or loss that arises directly from the active conduct of the taxpayer’s trade or business in the United States. 19 This test is applied when:
(1) Dividends or interest are derived by a dealer in stocks or securities;

(2) Gain or loss is derived from the sale or exchange of capital assets in the active conduct of a trade or business by an investment company;

(3) Royalties are derived in the active conduct of a business consisting of the licensing of patents or similar intangible property; or

(4) Service fees are derived in the active conduct of a servicing business. 20

For the purpose of applying the business-activities test, activities that relate to the management of investment portfolios are not treated as activities of the U.S. trade or business unless the principal activity of that trade or business is the maintenance of the investments. 21

Example:
The Opus Corporation, a foreign corporation which uses the calendar year as the taxable year, has a branch in the United States which acts as an importer and distributor of merchandise; by reason of the activities of that branch, Opus is engaged in business in the United States during 1991. Opus also carries on a business in which it licenses patents to unrelated persons in the United States for use in the United States. The businesses of the licensees in which these patents are used have no direct relationship to the business carried on in Opus’s branch in the United States, although the merchandise marketed by the branch is similar in type to that manufactured under the patents. The negotiations and other activities leading up to the consummation of these licenses are conducted by employees of Opus who are not connected with the U.S. branch of that corporation, and the U.S. branch does not otherwise participate in arranging for the licenses. Royalties connected for that year with the conduct of its business in the United States because the activities of that business are not a material factor in the realization of such income. 22

The Treasury Regulations set forth special rules supplementing the asset-use test and the business-activities test for banking, financing, or similar activities by nonresident alien individuals or foreign corporations. 23 The foreign taxpayer will be considered to be engaging in a trade or business in the United States in classic banking activities such as making loans, accepting deposits, or providing trust services. 24 The more difficult issue arises, in modification of the asset-use test and business-activities test, if a foreign person engaged in the banking or financing business in the United States also receives dividends, interest, or capital gains from United States sources during the taxable year. The foreign person will have effectively connected income if he or it receives dividends, interest or gains upon securities used or received in the conduct of the banking or financing business in the United States. 25 In the case of other debt securities, 26 not used or received in the conduct of the banking or financing business in the United States, interest earned upon the securities will be deemed to be effectively connected with the taxpayer’s conduct of a trade or business in the United States if the debt securities have a maturity of no more than one year, 27or are issued by the United States, or any agency or instrumentality thereof, 28 or otherwise is determined by a formula, such that of the entire interest earned on debt securities with United States sourcing, at least 10 percent is deemed effectively connected income but the percentage of income from the debt securities producing U.S. source income which is taxed as effectively connected income will decline from 100 percent as the portion of assets of the foreign taxpayer’s U.S. office which is not debt securities increases. 29 InPrivate Letter Ruling 200811018 , the Service was asked to consider application of the 10 percent rule of Treasury Regulations Section 1.864-4(c)(5)(ii)(b)(3) to a securities account maintained in the United States by a foreign taxpayer engaged in the banking and financing business for trading for its own account. The Service ruled that the Treasury Regulations Section 1.864-4(c)(5)(ii)(b)(3) rule applied to all U.S. debt securities, whether held for investment or trading, which were not used directly in the conduct of the United States banking or financing business.

[3] Election to Treat Income From U.S. Real Property as Effectively Connected

Income (other than capital gains) derived by a nonresident alien from U.S. real property is taxed at the flat 30 percent rate if that income is not effectively connected with a U.S. trade or business. 30 All gain or loss on the disposition of a U.S. real property interest by a nonresident alien or foreign corporation is deemed to be effectively connected with a U.S. trade or business and taxed at the applicable graduated rates. 31

A nonresident alien may elect to treat income derived from U.S. real property as effectively connected with the conduct of a U.S. trade or business. 32 A nonresident alien individual must hold the real property of interest therein for the production of income to qualify for the election. 33 This election is allowed when the taxpayer is not actually engaged in a trade or business during the tax year and the real property income is not effectively connected with a U.S. trade or business. 34

The election may not be made for U.S. source income that would otherwise be treated as effectively connected income, 35 or when the taxpayer has no U.S. real property income that is taxed as fixed or determinable annual or periodical income. 36 The election applies to all classes of income 37 from real property located in the United States, including: 38
(1) gains from the sale or exchange of the property or any interest;

(2) rents or royalties from mines, oil or gas wells, or other natural resources;

(3) gains from dispositions of timber, coal, or iron ore with a retained economic interest; and

(4) income received by the beneficiary of a trust or estate if that income 39 is characterized as real property income in the beneficiaries’ hands. 40

Income from real property, or an interest in real property, does not include: 41
(1) interest on a debt obligation secured by a mortgage of real property;

(2) any portion of a dividend 42 paid by a corporation or trust, including a real estate investment trust, that derives income from real property;

(3) for a nonresident alien individual, income from real property, such as a personal residence, that is not held for the production of income or from any transaction in property that was not entered into for profit;

(4) rentals from personal property or royalties from intangible personal property, when a sales agreement or rental or royalty agreement affects both real and personal property; or

(5) income that is effectively connected without regard to the election.

If a foreign taxpayer derives income from a transaction based upon a sales agreement, or rental or royalty agreement that affects both real and personal property, he must allocate the income between the real property and the personal property. The allocation is made in proportion to the respective fair market values of real and personal property unless otherwise specified in the agreement. For a rental or royalty agreement, the respective fair market values are determined when the agreement is signed. 43

The income to which the election applies is aggregated with all of the foreign taxpayer’s other income that is effectively connected. 44 This aggregated effectively connected income is taxed net of deductions allocable to it, according to the regular graduated U.S. income tax rates. The deductions connected with the real property are treated as effectively connected with the conduct of a U.S. trade or business. 45 Thus, the net income is not subject to the 30 percent withholding tax applied to fixed or determinable annual or periodical income.

The election does not cause a foreign taxpayer who is not actually engaged in a U.S. trade or business to be treated as such for any purpose other than treating the taxpayer’s U.S. real property income as effectively connected income. 46

The real property, or interest therein, is treated as a capital asset that, if allowable, is subject to depreciation. 47 The real property, or interest therein, however, is not treated as property used in a trade or business for the purposes of gain or loss attributable to a trade or business, determining a net operating loss, property not constituting a capital asset, and the special rules for treatment of gains and losses on property used in a trade or business. 48

The election is made by attaching a statement to the taxpayer’s return. The statement must list all the U.S. real property that the taxpayer beneficially owns, and provide each property’s location, the extent of ownership, a description of substantial improvements to the property, and details of any previous elections made regarding the treatment of the taxpayer’s real estate income. 49

Once made, the election remains in effect until revoked, even for years in which there is no income from real estate. The initial election is made without the Service’s consent, and it may be revoked without consent during the period allowed for making the initial election. The initial election may be made within the normal time for filing for a credit or refund, that is, three years from the due date of the tax or two years from the payment of the tax. A revocation of the initial election is made by filing an amended return. To revoke the election for a subsequent year after the time period allowed for making the initial election expires, a taxpayer must obtain the Service’s consent. If an election is revoked, a taxpayer may not make a new election before the fifth tax year after the tax year for which the revocation is effective, unless he obtains the Service’s consent to make a new election. 50

Comment:
In many cases, the election will result in a lower overall tax because of deductions which will result in less net income, even at the normal graduated rate. But the taxpayer needs to consider the possible effect of treaties reducing the withholding rate if the election is not made.

[4] Gain or Loss From Disposition of U.S. Real Property Interest as Effectively Connected (FIRPTA)

Gains and losses realized by foreign investors from the disposition of a U.S. real property interest 51 are treated as effectively connected with a U.S. trade or business. 52 Transferees are required to withhold tax on these transfers. 53 The taxation, withholding and reporting provisions providing for this treatment are collectively known as the Foreign Investment in Real Property Tax Act (FIRPTA). 54 Prior to this legislation, this potential gain generally had escaped U.S. taxation entirely for foreign investors who were not present in the United States for more than 182 days in the year a gain was realized, as remains the case for gains from the sale of other U.S. situs property. At a time of increased foreign investment in U.S. real estate in the late 1970’s, FIRPTA was enacted so as to tax gains from foreign investment in U.S. real estate.

In calculating tax liability, consideration must be given to the alternative minimum tax. The term “alternative minimum taxable income” means the taxpayer’s taxable income for the tax year:
(1) determined with the adjustments provided in I.R.C. Sections 56 and 58; and

(2) increased by the amount of the items of tax preference discussed in I.R.C. Section 57. 55

The alternative minimum tax is imposed on the “taxable excess,” which is the amount of the alternative minimum taxable income for the tax year that exceeds the exemption amount.56 For nonresident aliens, the taxable excess for purposes of I.R.C. Section 55(b)(1)(A) is not less 57 than the lesser of their alternative minimum taxable income 58 or their net U.S. real property gain. 59

The definition of U.S. real property interest includes land located in the United States or the Virgin Islands with attendant improvements and associated personal property. 60 The definition further includes an interest, other than an interest solely as a creditor, in any entity fitting the statutory definition of a U.S. real property holding corporation. 61 A corporation is a U.S. real property holding corporation if, on determination dates, the fair market value of its U.S. real property interests equals or exceeds 50 percent of the aggregate of the fair market value of its U.S. real property interests, its real property interests located outside the United States and any other assets that are held or used in its trade or business. 62

Excluded from the definition of U.S. real property interest are any interest in a domestically controlled real estate investment trust (REIT), 63 any interest in a corporation that has disposed of all its U.S. real property interests in transactions in which gain was fully taxed, 64 interests of no greater than 5 percent in publicly traded corporations 65 or publicly traded partnerships, 66 and any interest held solely as a creditor. 67

An interest in a corporation continues to be a U.S. real property interest for FIRPTA purposes for five years after the corporation ceases to be a U.S. real property holding corporation, but can be purged of its U.S. real property interest characterization earlier if the corporation has completely disposed of all its U.S. real property interests in transactions in which all gain was recognized. 68

The nonrecognition provisions of the Code apply to sale or exchange by a foreign investor of a U.S. real property interest only if the interest that is acquired in the exchange will be fully subject to taxation upon sale. 69

Ownership includes fee ownership or co-ownership, leaseholds, and options. It includes easements, royalties, life estates, remainders, reversions (whether vested or contingent), rights of first refusal and, probably, time shares. 70 It should be noted that the concept of ownership is inclusive, and should encompass contracts of sale, and all types of normal real estate interests. 71 Further, dispositions by sale or exchange of an interest in a partnership, trust or estate is treated under I.R.C. Section 897 as a sale of property by a pass through entity, subjecting the nonresident alien to the FIRPTA tax. 72

I.R.C. Section 121 allows a taxpayer to exclude up to $250,000 ($500,000 for certain joint returns) of gain on the sale of property if, during the five-year period ending on the date of the sale, the property was owned and used as the taxpayer’s principal residence for at least two years. The Service has confirmed that the provisions of I.R.C. Section 121 apply to the sale of a U.S. principal residence by a nonresident alien who is taxable under I.R.C. Section 897, unless the provisions of I.R.C. Section 877(a)(1), pertaining to expatriates, apply to the individual. 73

Treaties that exempt capital gains from income tax have been preempted by FIRPTA unless the treaties have been renegotiated to provide for an additional two-year grace period. 74

The general FIRPTA withholding requirement is that the transferee of any U.S. real property interest transferred by a foreign transferor must withhold a tax equal to 10 percent of the amount realized on the disposition. 75 The amount realized is the total of consideration paid for the interest, generally equal to the contract price. 76 For example, the transferee of an option to acquire U.S. real estate transferred by a nonresident alien was required to deduct and withhold 10 percent of the amount realized by the transferor when the option was sold. 77 The transferee was held liable for the tax because he had failed to comply with the FIRPTA withholding requirements. 78

Withholding is not required if:
The transferor is not a foreign person; 79

The transferred property is not a U.S. real property interest; 80

The transferred property is a residence worth no more than $300,000; 81

A nonrecognition provision applies to the transaction; 82

The transferee receives a withholding certificate that specifically excuses withholding. 83

The transferee is not required to withhold any amount in excess of the transferor’s maximum tax liability. 84

A withholding certificate that reduces or excuses withholding may be obtained when an exemption from the FIRPTA taxation or withholding requirements exists, or when an agreement for the payment of the tax is entered into with the Service. 85

The fact that the transferee has withheld tax does not relieve the transferor from the obligation to file a Form 1040-NR and report the transaction. See § 2.11.

FIRPTA can be an unexpected tax burden upon a nonresident alien individual investing in U.S. enterprises through a partnership, if one or more of the corporations in which the partnership invests is found to be a United States real property holding corporation. This can be the case, for example, with investments in electric or water utilities companies.

[5] Taxation of FDAPI Income to Taxpayers with Effectively Connected Income

The fact that a nonresident alien has effectively connected income in a given year does not mean that all of her income will be taxed as effectively connected income. The Treasury Regulations 86 make clear that the taxpayer is to segregate each class of income collected by her, and distinguish income which is effectively connected with the conduct of a U.S. trade or business from income which is not so connected. Tax will be determined at the flat 30 percent or lower treaty rate on income not effectively connected with the conduct of a trade or business in the same manner as if the taxpayer had no effectively connected income for the year in question. 87 The same principle applies to income received by a nonresident alien taxpayer through a partnership. 88

§ 2.07 Foreign Source Income

Foreign source income is effectively connected with a U.S. trade or business if foreign income is attributable to a taxpayer’s U.S. office. To qualify, an office or fixed place of business must be a material factor in the realization of income and regularly carry on activities that produce income.

Foreign source income, gain or loss may be treated as effectively connected with a U.S. trade or business if the taxpayer maintains a U.S. office or fixed place of business and the foreign income is attributable to that location. 1

The following three groups of foreign source income may be effectively connected with the conduct of a U.S. trade or business:
(1) rents and royalties for the use of or the privilege of using intangible property (intangible property includes patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises and other like properties); 2

(2) dividends or interest if either is derived in the active conduct of a banking, financing or similar business in the United States or is received by a corporation whose principal business is trading in stocks and securities for its own account; 3 and

(3) income from the sale or exchange of inventory or property held for sale in the ordinary course of business unless the property is sold or exchanged for use outside the United States and an office or other fixed place of business of the taxpayer in a foreign country participates materially in the sale. 4

The rules discussed above do not affect dividends, interest, or royalties paid by related foreign corporations (more than 50 percent owned) and subpart F income of a controlled foreign corporation. The dividends or income are not treated as effectively connected with a U.S. trade or business. 5

[1] Office or Other Fixed Place of Business

Income, gain or loss is not considered attributable to an office or other fixed place of business in the United States unless the office or fixed place of business is a material, though not necessarily major, factor in the realization of the income and regularly carries on activities of the type that produced the income. 6 The office must provide a significant contribution to, by being an essential economic element in, the realization of the income gain or loss. For example, meetings in the United States of the board of directors of a foreign corporation do not of themselves constitute a material factor. An office or other fixed place of business located in the United States at some time during a tax year may be a material factor in the realization of an item of income gain or loss for that year even though the office or other fixed place of business is not present in the United States when the income, gain or loss is realized. 7

An office or other fixed place of business is defined as a place, site, structure, or other similar fixed facility through which a nonresident alien engages in a trade or business. 8 The determination of the existence of an office depends on the facts and circumstances of each case, especially to the nature of the taxpayer’s trade or business and the physical facilities actually required in the ordinary course of that trade or business. 9 Foreign law is not controlling. 10

An office or other fixed place of business includes, but is not limited to, a:
factory;

store or other sales outlet;

workshop; and

mine, quarry or other place of extraction of natural resources. 11

The office of an agent is disregarded in determining if the foreign taxpayer has an office or other fixed place of business in the United States unless the agent:
(1) has the authority to conclude contracts in the name of the alien and regularly exercises that authority or has a stock of merchandise from which it regularly fills orders on behalf of the alien; and

(2) is not a general commission agent, broker or other agent of independent status acting in the ordinary course of his business. 12

An office of a person controlling a foreign corporation from which the general supervision and control over its policies are exercised does not, by itself, cause that corporation to have an office in the country where that person is located. Similarly, a foreign corporation is not deemed to have an office in a country solely because top management decisions are made there. 13

Example:
XYZ Co., a foreign corporation, is engaged in the business of buying and selling tangible personal property. XYZ is a wholly owned subsidiary of ABC Corp., a domestic corporation engaged in the business of buying and selling similar property, which has an office in the United States. Officers of ABC are generally responsible for the policies followed by XYZ and are directors of XYZ but XYZ has an independent group of officers, none of whom are regularly employed in the United States. In addition to this group of officers, XYZ has a chief executive officer, D, who is also an officer of ABC but who is permanently stationed outside the United States. The day-to-day conduct of XYZ’s business is handled by D and the other officers of XYZ, but they regularly confer with the officers of ABC and on occasion temporarily visit ABC’s offices in the United States, at which time they continue to conduct the business of XYZ. XYZ does not have an office or other fixed place of business in the United States for purposes of Treasury Regulations § 1.864-7(c).

Nor is the office of a related person imputed to a nonresident alien (or foreign corporation). 14

Section 865 of the Code governs the taxation of sales of personal property by foreign persons, including inventory property attributable to a U.S. office maintained by such foreign persons. In a recently released Chief Counsel Advice Memorandum, 15 the Service stated that, under I.R.C. Section 865(e)(3), inventory sales by a non-resident attributable to a U.S. office or fixed place of business when production occurred outside the United States would not generate exclusively U.S. source income. The case involved a nonresident alien who raised livestock in Mexico but contracted with a dependant U.S. company to fatten the cattle and sell them to U.S. packing houses or other buyers. According to the Service, Congress intended that where place of production and place of sale were different, the income should be apportioned under I.R.C. Section 865(e)(2) between the appropriate U.S. and foreign sources, allowing for any reasonable apportionment method that the taxpayer can prove fulfills Congressional intent. Such methods, according to the Advice, would include the use of any formula in the regulations promulgated under I.R.C. Section 863, as long the formula chosen sourced some of the income to the United States. Specifically, the Chief Counsel recommended for this factual situation the “50-50 method” contained in Example 2 of Treasury Regulations Section 1.863-3T(b)(2).

It may be desirable for an alien to have certain income characterized as effectively connected. As has been noted, FDAPI and certain U.S. source capital gains are taxed at a flat 30 percent rate with no allowance for expenses while effectively connected income is taxed at graduated rates after permissible deductions. Where the cost of producing the FDAPI is high, the alien may wish to plan so that the income is effectively connected. Moreover, depending on the applicable tax bracket, the graduated income tax rates may make effectively connected status advantageous even where costs are low or nonexistent.

The alien and his counsel must carefully consider the adverse consequences before following such a path, however. For example, it is always better that non-FDAPI not be effectively connected because there is no tax on such income; therefore, an alien who creates effectively connected FDAPI by nominally engaging in a trade or business may be “penny wise and pound foolish.” He may save a few percent by having his FDAPI taxed at graduated rates rather than withholding rates and lose a fortune when all his (otherwise nonincludable) U.S. source non-FDAPI is, by virtue of the force of attraction principle, treated as effectively connected to the conduct of the nominal trade or business and taxed at graduated rates. Indeed, the alien might have avoided most or all of the withholding tax in the first place had he resorted to treaty protection. While planning opportunities exist in using the characterization of income as effectively connected, the disadvantages must be identified and evaluated.

§ 2.08 Treaties

U.S. tax treaties generally contain specific provisions on benefits, source and character for common types of income and taxpayers. They generally give primary right of taxation to the nation of the taxpayer’s domicile, and reduce or eliminate tax by the non-domiciliary nation on most passive income arising in that nation. Even where income is effectively connected to active conduct of a U.S. trade or business, a taxpayer who is entitled to treaty benefits may avoid taxation if he does not have a permanent establishment, i.e., a fixed place of business, in the U.S. through which business of foreign enterprise is carried on. Most treaties also contain provisions on exchanges about information on taxpayers by the taxing authorities.

The U.S. has entered into income tax treaties with most of its major trading partners and many other countries with important economic relationships with the U.S. The Treasury Department in recent years has been continuing to extend and broaden the U.S. tax treaty network by negotiating new agreements with emerging economies, including the entry into force of the treaty with Sri Lanka and Bulgaria, and the signing of a treaty with Bangladesh 1 and ongoing negotiations for an income tax treaty with Brazil. 2 Generally these are bilateral. All are negotiated by the Treasury Department and must be approved by the Senate. 3 A list of those nations with which the United States has bilateral income tax treaties in force, and those with which new treaties are pending, is appended as Appendix A to this section, § 2.08, below. In February 2010, tax treaties with Chile and Hungary were signed and now await ratification by the U.S. Senate. 4 In May 2012, President Obama formally sent the treaty with Chile to the Senate for its advice and consent to ratification. 5 Also in May, Spain and the United States initialed an amending protocol to the 1990 U.S.-Spain Income Tax Treaty; the protocol still awaits official signature. 6 In July 2012, the Senate Foreign Relations Committee favorably voted out of committee the treaty with Hungary and proposed protocols to the tax treaties with Switzerland and Luxembourg. 7 There are ongoing treaty negotiations with South Korea. 8

Treaties and statutes are entitled equal priority under the United States Constitution and in case of conflict between a treaty and a statute, that enacted or ratified most recently prevails. 9 Conflicting provisions in treaties and regulations are not accorded equal treatment. For example, in a decision involving the taxation of the U.S. branch of a foreign banking corporation conducting business in the United States, the Court of Claims held that application of a provision of the Treasury regulations affecting allocation of deductible interest for U.S. operations of a foreign business 10 conflicted with, and was overridden by, the provisions of the (now supplanted) United States-United Kingdom Income Tax Treaty dated December 31, 1975, 11 and that taxpayer was therefore entitled to income tax refunds for the year 1981–once the interest was deducted in accordance with the Treaty. 12

Where a taxpayer takes a position that a treaty under which the taxpayer is entitled to claim benefits overrides the Code in a manner which reduces the taxpayer’s income tax liability, the taxpayer must now attach a statement to his return disclosing his treaty-based return position. 13 See § 1.13[4] for a discussion of similar rules for estate tax liability. Under revised Treasury regulations effective on January 1, 2001, it is specifically required that, among other things, taxpayers report on a return a claim that a treaty’s nondiscrimination provision precludes the application to them of an otherwise controlling Code provision 14 or a treaty reduces or modifies the taxation of gain or loss to the taxpayer from the disposition of a United States real property interest. 15 However, the regulations generally exempt nonresident aliens from reporting to the Service a treaty based claim for reduced withholding upon FDAPI. 16 That treaty position will have been reported to the withholding agent by the taxpayer, and the withholding agent will report the treaty based claim to the Service. 17 The Service has announced an intention to broaden some of the exemptions from reporting treaty positions in connection with withholding tax. 18

Bilateral income tax treaties today are to the fullest extent possible based upon the U.S. and OECD model treaties, as modified from time to time, with specific negotiated variations for historic or other reasons in individual cases. Generally, treaties provide for income tax priority to the nation of the taxpayer’s domicile on most classes of passive income not connected with a trade or business, but do not eliminate a residual right in the United States to tax its citizens on their worldwide income, after credit for taxes paid to the nation of their domicile. 19 The United States is unique among major Western nations in taxing individuals on their worldwide income based upon citizenship, regardless of residency or domicile.

Treaties often reduce the rate of income tax, sometimes to zero, upon passive income (or certain classes of passive income, such as interest income) earned in the United States by foreign nationals, and they provide a framework to determine taxing priority between the two jurisdictions for taxpayers who have connections to both jurisdictions. Generally a taxpayer is entitled to claim the benefits of an income tax treaty only if he or she, as an individual, is a resident of the country whose treaty benefits he or she is claiming, 20 subject to income tax in the other country upon his or her worldwide income. 21 In the case of taxpayers who are not individuals, most modern treaties include a limitation of benefits article that denies the benefit of the treaty to corporations or trusts which are nominally resident in the treaty partner country, but not beneficially owned by individuals resident in that country. 22 For example, in the German protocol entered into force on December 28, 2007, the limitation on benefits provisions for companies were expanded to allow a German corporation with U.S. source income to qualify for the benefits of the Treaty only if: i) its principal class of shares is regularly traded on a recognized stock exchange and primarily traded on such an exchange in Germany, ii) its principal class of shares is regularly traded on a recognized stock exchange and the corporation’s primary management and control are in Germany, iii) shares representing at least 50 percent of the corporation (by vote and value) are owned either directly or indirectly through a chain of U.S. resident or German resident owners, by no more than five corporations that satisfy i) or ii) above, or iv) shares representing at least 95 percent of the corporation (by vote and value) are owned by no more than seven persons who are either individual residents of Germany or the United States, or corporate residents that meet i) above, or residents of an EU member state, or a NAFTA party state entitled to benefits under an applicable income tax treaty and not subject to higher withholding rates under that treaty. These types of limitations are typical in newer treaties, and are being added in other recent Protocols like those with France and Sweden. In addition, I.R.C. Section 894 enacted by Congress in the Taxpayer Relief Act of 1997 and Treasury regulations enacted thereunder in 2000 deny treaty-reduced withholding rates with respect to payments of U.S. source income passing through an intermediate “hybrid” entity that is treated as transparent for U.S. tax purposes (e.g., a partnership or a grantor trust) but treated as a taxable entity in the home country of the entity and the home country of the interest holders. 23 Further complications may arise in the case of persons who may be resident in more than one country. The Service has ruled that a corporation cannot claim the benefits of the United States income tax treaty with Country X, if the corporation is resident in both Country X and Country Y, but for purposes of the bilateral treaty between Country X and Country Y the corporation is treated as a resident of Country Y. 24

Most treaties between the U.S. and other contracting states authorize the competent taxing authorities to enter into mutual agreements with respect to certain cross-border tax issues that may affect treaty interpretations. The Service publishes various pronouncements under the foregoing authority to construe treaty provisions with the mutual agreement of the other contracting state. In some cases such mutual agreement provisions may enable the Service and the competent taxing authorities of the other contracting state to enter into mutual understandings which may deal with issues not specifically contained in the applicable treaty. Oftentimes, such mutual agreements will provide tax benefits to persons in either contracting state based on reciprocity as between the contracting states. For instance, in Notice 99-47 , the Service announced that the American and Canadian tax authorities had entered into certain mutual agreements pursuant to Article XXVI of the United States-Canada Income Tax Convention. 25 Such agreements provide that certain charitable organizations exempt from tax in one jurisdiction will be recognized as exempt from tax in the other jurisdiction without the requirement of an application for tax exemption in such other jurisdiction, simplifying the availability of charitable deductions from income tax for donations by a domiciliary of one state made to organizations recognized as exempt from tax in the other state. (Absent a treaty provision, a U.S. taxpayer cannot obtain an income tax deduction for a gift to a foreign charity. See Chapter 13.)

Finally, treaties provide tie-breaking rules for taxation of income by the two nations and for exchange of information about taxpayers. 26

[1] Income Not Connected with a United States Business

Treaties generally reduce or eliminate any U.S. income tax (imposed as a flat withholding tax) on income not connected with the conduct of a U.S. trade or business earned by a nonresident alien individual or a foreign corporation. The taxation of specific classes of such income is discussed below in § 2.09, below.

An alien who resides in a country that has signed a treaty with the United States typically may dramatically reduce or altogether avoid U.S. tax withholding on interest, 27 royalties,28 pensions, 29 annuities, 30 alimony (but not necessarily child support), 31 gains from the sale of personal property, 32 income from independent (and, occasionally, dependent) personal services, 33 and may greatly reduce his tax on dividends, 34 but only if the income is not attributable to a permanent establishment. 35

The United States-Japan income tax convention greatly reduces, and sometimes eliminates, withholding taxes on the payments of cross-border dividends. 36 Under the U.S.-Japan treaty, withholding is eliminated on payments of cross-border dividends from a subsidiary to its parent company if the parent owns at least 50 percent of the subsidiary. If the parent owns between 10 percent and 50 percent of the subsidiary the rate is 5 percent, and all other dividends are subject to a 10 percent tax rate. Recent agreements with the Netherlands, the U.K., Mexico and Australia and the Protocol with Sweden also eliminate dividend withholding tax, but only if the parent owns at least 80 percent of the subsidiary. 37These recent agreements, along with the Japan treaty, show a trend of reduction of, and even elimination of, mandatory withholding on U.S. source income not connected with a U.S. business. Treaties also provide for relief in some instances from tax imposed by the alien’s state of residence. 38

Under amendments made to I.R.C. Section 894 by the Taxpayer Relief Act of 1997, foreign taxpayers are to be denied reduced rates of withholding of U.S. income tax on FDAPI collected through partnerships or other entities that are transparent for U.S. income tax purposes unless the income is taxable to the taxpayer in his or her country of domicile. I.R.C. Section 894(c) provides that a foreign person shall not be entitled under any income tax treaty of the United States with a foreign country to any reduced rate of U.S. withholding tax on any items of U.S. source income which is derived through a partnership or other fiscally transparent entity if:

(A) such item is not treated for purposes of the taxation laws of such foreign country as an item of income to such person,

(B) the treaty does not contain a provision addressing the applicability of the treaty in the case of an item of income derived through a partnership, and

(C) the foreign country does not impose tax on a distribution of such item of income from such entity to such person.

The provision became effective August 5, 1997.

[2] Income Connected with a Permanent Establishment

Although the term permanent establishment and the term engaged in a trade or business (see § 2.04, above) are not synonymous, both relate to the same concept and imply the same general conditions. Both imply a place for carrying on a trade or business in the United States. 39 The U.S. model treaty defines permanent establishment as a fixed place of business in one country through which the business of an enterprise of a resident of the other country is wholly or partly carried on. 40 This includes a place of management, a branch, an office, a factory, a workshop, and a mine or other place of extraction of natural resources, 41 but generally excludes warehouses, and purchasing or information-gathering facilities. 42 Nor does mere ownership and leasing of property constitute a permanent establishment. A permanent establishment implies the existence of an office, staffed and capable of carrying on business from day to day, or a plant or facility equipped to carry on the ordinary routine of a business activity. 43

The activities of a dependent agent who has and exercises general authority to conclude contracts in the name of the taxpayer are attributed to the taxpayer. For example, a taxpayer had a permanent establishment by virtue of his interest in a limited partnership whose general partner exercised his authority to act on the taxpayer’s behalf. 44

There are differences, however, between engaging in a trade or business and having a permanent establishment. Where the agent is independent, an alien may be engaged in a trade or business for purposes of the Code, yet lack a permanent establishment. 45 For example, a nonresident alien engaged in a trade or business through local real estate agents who negotiated or renewed leases, arranged for repairs, collected rents and paid taxes since the activities were considerable, continuous and regular. The court decided, however, that the taxpayer did not maintain a permanent establishment because the applicable treaty provided that carrying on business dealings through a broker or independent agent acting in the ordinary course of his business as such did not amount to having a permanent establishment. 46

Where a nonresident alien client has income that is subject only to withholding because it is not effectively connected to a U.S. trade or business, the appropriate article of the treaty, applied to the category of income involved, shows the relevant rate of tax (if any). However, even where income is effectively connected to the active conduct of a U.S. trade or business, a taxpayer entitled to the benefits of a treaty may avoid taxation if he can demonstrate that he does not have a permanent establishment. 47 Where there is a permanent establishment, the United States has renounced the right to tax income if it (1) is not effectively connected to the conduct of a U.S. trade or business, and (2) is of a certain type, primarily FDAPI. 48

[3] Appendix A: Status of U.S. Income Tax Treaties
U.S. Income Tax Treaties in Force as of 07/01/12
Treaty    Signed    Amended
__________________________________________
Australia    1982    2001
Austria    1956    1996, 2004
Bangladesh    2004
Barbados    1984    1991, 2004
Belgium    2006
Bermuda 49
1986
Bulgaria    2007    2008
CIS/Former USSR 50
1973
Canada    1980    1983, 1984, 1995, 1997, 2007
China 51
1984    1986, 2008
Cyprus    1984
Czech Republic    1993
Denmark    1999    2006
Egypt    1980
Estonia    1998
Finland    1989    2006
France    1994    2004
Germany    1989    2006
Greece    1950
Iceland 52
2007
India    1989
Indonesia    1988    1996
Ireland    1997    1999
Israel    1975    1980, 1993
Italy    1999
Jamaica    1980    1981
Japan 53
2003
Kazakstan    1993
Korea    1976
Latvia    1998
Lithuania    1998
Luxembourg    1962    1996
Malta    2008
Mexico    1992    1994, 2002
Morocco    1977
Netherlands    1992    1993, 2004
Netherlands Antilles 54
1948    1955, 1963, 1995
New Zealand    1982    2008
Norway    1971    1980
Pakistan    1957
Philippines    1976
Poland    1974
Portugal    1994
Romania    1973
Russia    1992
Slovakia    1993
Slovenia    1999
South Africa    1997
Spain    1990
Sri Lanka    1985    2002
Sweden    1994    2005
Switzerland    1996
Thailand    1996
Trinidad and Tobago    1970
Tunisia    1985    1989
Turkey    1996
Ukraine    1994    2000
United Kingdom    2001    2002
Venezuela    1999

U.S. Income Tax Treaties and Protocols Signed and Awaiting Senate Approval
U.S. Income Tax Treaties and Protocols Not Yet in Force as of 07/01/12
Treaty    Signed    Amended
__________________________________________
Chile    2010
Hungary    2010
Luxembourg    2009
Switzerland    2009

§ 2.09 Determination of the Source of Income (START OF WEEK 3)

Subject to treaty provisions, the source of income determines whether a foreign person’s income is subject to U.S. taxation. U.S. interest is treated as U.S. source income no matter where or how paid. The source of dividend payments is generally wherever the paying corporation is created or incorporated. Source of rental, royalty and real property sales income depends on the location of the property. Personal services income is U.S. source if performed in the United States. Personal property income is sourced to the seller’s residence. Trust or estate income is subject to conduit treatment. Sourcing rules also apply to partnership income, international transportation and communications activities, ocean and space activities and insurance underwriting income.

Because the United States imposes tax (but with few exceptions, see § 2.07, above) only upon U.S. source income, the determination of the source of an item of income as foreign or domestic is important. When a treaty applies, the source-of-income rules contained in the Internal Revenue Code may, however, be trumped by the treaty resourcing provisions. Nevertheless, there are situations when a treaty partner may legitimately impose tax on income that is also domestic-source under the Code. Therefore, most U.S. income tax treaties contain resourcing provisions designed to bridge the gap between the treaty’s allocation of taxing jurisdiction to the other country and Code source rules that treat the income as domestic-source. 1

Different rules for sourcing apply to different types of income so separate discussions of the treatment of each follows.

[1] Interest

Interest from the U.S. or any agency of the U.S. or any state or subdivision thereof and interest on bonds, notes or other interest-bearing obligations of individuals resident in the United States, domestic partnerships engaged in trade or business in the United States, any domestic corporation, or foreign partnerships or corporations engaged in trade or business in the United States, is treated as income from sources within the United States. 2 For example, income from sources within the United States includes interest received on any refund of income tax imposed by the United States or any state. 3 The method by which, or the place where, payment of the interest is made is immaterial in determining whether interest is derived from sources within the United States. 4 Interest paid on foreign government obligations, bonds or notes and interest paid by nonresident individuals to U.S. citizens or resident aliens is foreign source income. 5

For exemption from tax for portfolio interest and interest on deposits paid foreign investors, regardless of U.S. source classification, see § 2.05[3] and [4], above.

Foreign, rather than U.S., source treatment may result due to statutory exception even though the interest arises from within the United States. For example, interest received from a resident alien individual or domestic corporation is foreign source if the individual or corporation meets the 80 percent foreign business requirement. 6 The requirement is met if it is shown to the Secretary’s satisfaction that at least 80 percent of the gross income from all sources of the individual or corporation for the testing period is active foreign business income. 7 The testing period is the three-year period ending with the close of the tax year of the individual or corporation preceding the payment. 8 Active foreign business income is gross income derived from sources outside the United States and attributable to the active conduct of a trade or business in a foreign country or possession of the United States by the individual or corporation. 9 The active conduct test may be met by including the income of foreign or domestic subsidiaries controlled by the U.S. corporation (at least 50 percent owned). 10

Interest paid by an 80/20 payer to a related party is deemed to be partly from United States and partly from foreign sources. The portion of interest treated as foreign source income equals the portion of the payer’s total gross income for the three-year period which is from sources outside the United States. 11 A corporation is related to the payer if it owns, directly or indirectly, at least 10 percent of the total voting power of all voting stock, or 10 percent of the total value of the corporation. A partnership, trust or estate is a related party if the individual owns, directly or indirectly, at least 10 percent (by value) of the beneficial interest in the entity. 12

There is a special rule regarding interest earned on deposits with the foreign branch of a domestic corporation or partnership of a commercial banking enterprise. Such interest is statutorily excluded from U.S. source income. 13 For example, the interest earned from a United Kingdom branch of Bank of America would not be considered U.S. source income. Similarly, interest on deposits with persons carrying on the banking business, certain savings and loans, and certain interest payments from insurance companies are not considered U.S. source income. 14 For example, interest on deposits in general, paid by a U.S. bank or savings and loan, or certain insurance company payments, even though U.S. source income to a nonresident alien, are excluded from U.S. tax. The policy, obviously, is to foster commercial U.S. banking transactions, particularly deposits.

Planning Note

Monies on Deposit. It is advisable to make sure that significant monies on deposit not be held by a brokerage firm, or in certain money market accounts, but rather with a bank or savings and loan.

The allocation of interest between U.S. and foreign sources applies to interest payments after December 31, 1986 unless paid pursuant to obligations outstanding on December 31, 1985. There is no grandfathering, though, of payments made pursuant to an extension or renewal of an obligation to which the parties agreed after 1985. 15

In the case of interest paid to a related person benefiting from this grandfather rule, the payments are treated as payments from a controlled foreign corporation for foreign tax credit purpose. As such they retain their character and source. 16 There would be no allocation of interest paid on obligations outstanding pre-December 31, 1985, that have not been extended or renewed, and the old law would apply, even if 20 percent or more of the gross income from all sources are derived from U.S. sources for the three-year measuring period.17

Under the Model Treaty, 18 and most treaties, interest collected by a taxpayer domiciled in a foreign country from a U.S. payor is not taxed by the United States.

[2] Dividends

The source of dividend payments is generally the jurisdiction in which the paying corporation is created or incorporated. Dividends paid by U.S. corporations are U.S. source income unless the corporation has elected to be treated as a possessions corporation. 19 For exemption from tax of a portion of dividends when received by a foreign person from a U.S. corporation that earns more than 80 percent of its income from active foreign business, see § 2.05[1], above.

Dividends from foreign corporations also are U.S. source unless less than 25 percent of gross income over a three-year period is effectively connected to the conduct of a U.S. trade or business. 20 If 25 percent or more of gross income is effectively connected then U.S. source characterization attaches, but only in proportion to the ratio of effectively connected income to noneffectively connected gross income. 21

Dividends received from a domestic international sales corporation (DISC) or former DISC are treated as U.S. source income except to the extent attributable to qualified exports receipts of the DISC. 22

Under the Model Treaty, 23 dividends collected by a foreign taxpayer from U.S. payors are primarily taxed in the jurisdiction in which the payee is domiciled, but remain subject to tax by the United States, at reduced rates.

[3] Rentals and Royalties

The source of rental or royalty income depends on the location of the property giving rise to the income. 24 U.S. source income includes rentals and royalties from property located in the United States or from any interest in such property, including rentals or royalties for use of, or for the privilege of using, in the United States, patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises and other similar property. 25

For example, in a Chief Counsel Advice Memorandum released in 2005, the Service determined that income paid to a nonresident alien (a Brazilian citizen neither present in the United States for 183 days nor engaged in a trade or business in the United States) by a United States publishing company for the right to copy and distribute musical works owned by a nonresident alien was royalty income from sources within the United States and subject to the 30 percent withholding tax. 26 The taxpayer tried to analogize his situation to Boulez v. Commissioner, 27 in which CBS contracted with a conductor to make recordings for CBS records. In that case the Tax Court determined that the contract was a contract for personal services and payments made to the conductor were not royalty payments because the conductor was not conveying pre-existing property, and the recordings would be solely the property of CBS records. The Chief Counsel distinguished Boulez because the Brazilian musician had composed and copyrighted the music prior to his connection with the U.S. publisher, who, unlike CBS in Boulez, did not have any involvement in the writing or production of the final product. The payments made to the Brazilian musician were therefore royalties with a U.S. source and subject to the 30 percent withholding tax.

Moreover, gains from the sale or exchange of such property are U.S. source to the extent that they are from payments for use of property in the United States that are contingent upon productivity, use, or disposition of the property sold or exchanged. 28

Under the Model Treaty, 29 royalties may only be taxed in the nation in which the payee is resident.

[4] Personal Services Income

Compensation for labor or personal services is U.S. source income if performed in the United States 30 and foreign source income if performed outside the United States. 31 Other factors, such as whether the person is an individual, corporation or partnership, the nationality or residence of the performer or the recipient of the services, the place where the contract was negotiated or signed, and the time, place or currency of payment, are irrelevant. 32

A nonresident alien individual’s income from labor or personal services performed in the United States is not U.S. source income if:
(1) He is not present in the United States for an aggregate of more than ninety days during a tax year;

(2) He earns, in the aggregate, less than $3,000 per tax year for services performed in the United States; and

(3) He is an employee of, or under a contract with:
(a) a foreign person not engaged in a trade or business in the United States,

(b) a U.S. person if the services are performed for the U.S. person’s office located in a foreign country or U.S. possession, 33 or

(c) a foreign office of a U.S. government agency. 34

Treasury Regulations Section 1.861-4(b) provides rules for determining source when services are performed by either individuals or non-individuals partly within and partly without the United States. 35 In that case, the amount to be included in gross income is determined on the basis that reflects the most proper source of the income under the facts and circumstances of the particular case, which the regulations conclude is an apportionment on a time basis. 36

An individual may determine the source of compensation under an alternative basis, other than a time basis, if the individual can establish to the Commissioner’s satisfaction that the alternative basis is the more appropriate and more accurate way to source the income under the facts and circumstances of the particular case. 37 The regulations also require that the taxpayer source certain fringe benefits, including housing stipends, payment of qualified tuition expenses, transportation fringes and moving expense benefits, on a geographical basis. 38

Employer contributions to an annuity or pension plan also constitute personal services income. 39 For an employee who performed personal services both inside and outside the United States, the Service determines the source of the pension or annuity payments similarly to the way it determines the source of current compensation. The portion of the annuity or pension payments attributable to employee contributions for services rendered in the United States is income from U.S. sources, the portion attributable to services performed outside the United States is treated as income from non-U.S. sources, and any earnings or accretions to the contributions of either the employer or the employee is treated as income from sources within the United States. 40 If the actual amount of the employer contributions is unknown, the regulations provide a formula to determine that amount, and then allocate the employer contributions based on the employee’s time worked either inside or outside the United States. 41

An applicable tax treaty may alter whether pension or annuity payments are determined to be U.S. source or foreign source income as discussed above. 42 In Private Letter Ruling 200416008 the Service determined that under the U.S.-Australia Income Tax Treaty, distributions from a retirement plan for a nonresident alien who had worked both inside and outside the United States were exempt from U.S. income tax. Under Article 18 of the Treaty, pension payments and other periodic payments made by reason of retirement or death are taxable only in the contracting state in which the recipient resides. The nonresident alien lived in Australia, so his payments were taxable there and not in the United States.

[5] Income from Sales of Real Property Interests

Income from the disposition of a U.S. real property interest is treated as income from sources within the United States. 43 However, income from the sale of a U.S. real property interest located in the Virgin Islands is foreign source income. 44 Income from the sale or exchange of real property located without the United States is foreign source income. 45

For the definition of a U.S. real property interest and the treatment of gain or losses from the disposition of a U.S. real property interest as effectively connected with the seller’s trade or business, see § 2.06[4], above.

[6] Income from Sales of Personal Property

The source of income from the sale of personal property generally follows the residence of the seller. Thus, income from sales by a U.S. resident is sourced in the United States and from a nonresident is sourced outside the United States. 46

Basing source on residency of the seller generally could help nonresident aliens. A special definition, applicable only for purposes of I.R.C. Section 865, is provided for distinguishing between resident and nonresident. See § 2.03, above, for the general rules for determining residency. A U.S. resident is a U.S. citizen or a resident alien if he does not have a tax home in a foreign country or a nonresident alien who has a tax home in the United States. 47 Generally, an individual’s tax home is defined for purposes of I.R.C. Section 865, as it is for purposes of I.R.C. Section 7701(b)(3)(B)(ii) (the so-called “closer connection” test), by reference to the code provisions defining “tax home” for purposes of allowing an income tax deduction for travel expenses while away from “home.” 48 These rules deny an income tax deduction for commutation expenses, 49 and define “home” generally based upon all of the facts and circumstances of an individual’s center of interests.

Exceptions to the source of income following the residence of the seller exist for inventory, 50 depreciable property 51 and intangibles. 52

All gain attributable to U.S. depreciation is U.S. source and the excess is sourced as though the property is inventory property, although there is an exception for allocation of depreciation deductions where the property is used predominantly either inside the United States or out. 53 To the extent that payments for intangible property are contingent, the payments are sourced as though they are royalties. 54 See § 2.09[3], above.

Income from the sale of personal property, including inventory, attributable to a nonresident’s office or fixed place of business in the United States is U.S. source income. However, it remains foreign source income if it is attributable to the sale of inventory for use, consumption, or disposition outside the United States and an office of the nonresident outside the United States materially participates in the sale. 55

For transactions entered into before March 19, 1986, income from personal property sales was sourced under the passage of title test. 56 Gains from the sale or exchange of personal property were treated as derived from the country in which the property was sold, 57 a determination turning on where title passed. 58 This rule was subject to manipulation. Those desirous of having foreign source income from sales of personal property to those abroad merely specified in the sales agreement that title (and risk of loss) passed at the time that the property reached foreign shores. A foreign person sources all income from an installment sale executed before March 19, 1986, under the old rules, regardless of when received. Income from installment sales executed after March 18, 1986, are sourced under the current rules. 59

[7] Income from a U.S. Trust or Estate

The character of income distributed by a simple or complex trust or estate is determined by application of the “conduit theory” which provides that the income has the same character in the hands of the beneficiary as it would have had if paid in the first instance to the beneficiary rather than to the trust or estate and then to the beneficiary. 60 For example, interest earned by a simple trust on a deposit in a U.S. bank and distributed to nonresident aliens is foreign source income. 61

However, conduit treatment is inappropriate for income not currently distributed. For example, if a complex trust accumulates and distributes income in a later year, the income loses its original source and is sourced according to the residence of the trust. 62

[8] Income from Partnerships

The character of any item of income included in a partner’s distributive share is determined as if the item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership. 63 Therefore, a distribution received by a foreign-based partner from a partnership having U.S. source income retains the same character when received by the partner. 64 The conduit theory may produce results amenable to the taxpayer: Payments from a U.S. partnership that derive from foreign sources should retain their foreign character in the hands of the nonresident alien. Similarly, income of a foreign partnership from U.S. services that is allocable to foreign partners will be taxable to them as U.S. source income. In a private letter ruling, the Service has said that where a German law firm practicing as a partnership has a U.S. office and allocates all profits of the U.S. branch to the U.S. partners, the U.S. partners will have solely U.S. source income and report the same on their returns, but if any residual income is allocated to the German partners, they will also have U.S. source income. 65

The entity approach supplants the conduit theory if the payments are paid to the partner for services or the use of capital, for such payments are considered made to one who is not a member of the partnership. 66 The source of these “guaranteed payments” turns on the nature of and the reason for the payment to the parties who, therefore, may acquire foreign source income though paid from funds that originally were U.S. source. Payments for use of capital should constitute interest and the determination of source made pursuant to rules governing source of interest income: Interest paid by a foreign partnership should be foreign source. See § 2.08[1], above. Similarly, the source of payments for services should be determined in accordance with the proper method for characterizing source of income paid for provision of services. See § 2.08[4], above. The guaranteed payments exception to the conduit theory allows taxpayers to transform distributions of effectively connected U.S. source income taxable at graduated rates into compensation deductible from partnership gross income by, for example, maximizing guaranteed payments to partners for services to the partnership rendered abroad. Variations on this planning theme certainly exist, as well.

Example:
A is a Swiss citizen and resident, and a partner in a domestic U.S. partnership engaging in the management and operation of a shopping center. The partnership has an investment portfolio in the United Kingdom that is not effectively connected with its shopping center operation in the United States. A’s distributive share of income from the investment portfolio is not U.S. source income, although obviously his shopping center derived income does have a U.S. source.

In Private Letter Ruling 200811019 , 67 the Service considered the U.S. federal income taxation of income derived from a U.S. partnership by a foreign corporation that was in fact engaged in the banking and financing business within the United States, within the meaning of Treasury Regulations Section 1.864-4(c)(5). The taxpayer had sold U.S. securities to a partnership for cash which it had contributed to the partnership with other investors. The partnership was a true partnership, holding its assets for investment. The taxpayer represented that the securities in question had been held in a trading account by the taxpayer, but were now held for investment by the partnership. The Service ruled that that change was possible. However, as to whether the entity approach should be applied to the partnership, or the aggregate (conduit) approach, the Service ruled that the taxpayer had transferred the securities to the partnership and managed the partnership. The Service ruled that the income produced by the securities should be taxed as effectively connected income based upon application of the 10 percent test of Treasury Regulations Section 1.864-4(c)(5)(ii)(b)(3), as if taxpayer held them directly.

Tax treaties may provide for different sourcing rules for partnership income. In the tax treaty between the U.S. and Germany, Article 14 provides that income derived by a resident of one contracting state from the performance of services shall be taxable only in that state, unless such services are performed in the other contracting state and the income is attributed to a fixed base regularly available to the individual in that other state. 68 In Revenue Ruling 2004-3 , a nonresident partner in a service partnership with a fixed base in the United States was subject to U.S. tax on income attributable to that fixed base even though the partner never performed services in the United States. 69 As interpreted in the partnership context, because the fixed base is attributed to all partners for the purposes of applying Article 14, the Service stated it did not matter that the partner had never performed services in the United States. The ruling also stated that provisions similar to Article 14 in other treaties would also be interpreted the same way.

I.R.C. Section 894(c) denies treaty benefits to nonresident aliens otherwise entitled to reduction of income tax upon covered classes of income earned through certain “hybrid entities.” The Code provision makes clear that in order to claim treaty protection the entity must be treated similarly (i.e., either as a taxable entity or as tax transparent) both for purposes of U.S. income tax law and for purposes of income tax law of the treaty partner. The regulations 70 make clear that a hybrid entity must be treated identically by both treaty partners, so that an individual nonresident alien taxpayer who is a partner of a United States partnership may not claim treaty benefits upon income from that partnership if the income from that partnership is taxable in her country of residence under the treaty to the entity, rather than to her.

Planning Note

Structure Payments of Sheltered Income to Reduce Taxes. If a principal partner of a partnership can personally shelter compensation by the appropriate deductions in the United States, the careful planner may be able to structure the overall payments so that less tax will be paid, assuming a legitimate compensation arrangement. The overall tax impact, of course, needs to be considered, but often in a partnership arrangement a guaranteed payment structure can be optional, depending upon the economics of each circumstance.

[9] Income from International Transportation and Communication Activities

Income from transportation either beginning or ending in the United States is one-half U.S. source and one-half foreign source. 71 A 4 percent tax is imposed on a foreign person’s gross U.S. transportation income, 72 unless the foreign person is a qualifying resident of a country that grants an equivalent exemption to U.S. persons. 73

A similar sourcing rule applies to communications income for U.S. persons. 74 A foreign person’s communications income is foreign source, unless it maintains a fixed place of business in the United States. The communications income attributable to the fixed place of business is U.S. source. Transportation or communications between different points within the United States is U.S. source even if transportation or communications go beyond the country’s boundaries. 75 Income from vessels or craft leased before January 1, 1986, is also U.S. source. 76

Example 1:
A cruise line carrying A, B and C departs Maine for Europe but stops in Florida and discharges A before crossing the Atlantic. B disembarks in Europe while C returns home to the United States with the ship. Transportation of A began and ended in the United States and all income attributable to his transport is U.S. source. The transport ofB and C is deemed not to have begun and ended in the United States. Only half the income attributable to their transport is deemed U.S. source income. 77

Example 2:
D travels from Canada to Mexico, stopping in New York, but continuing on to Mexico on the same Canadian Airways plane. Cargo on the Canadian flight is removed from the plane in New York and loaded onto another Canadian Airways plane for transport to Mexico, but only after the cargo passes through U.S. customs. D has not been involved in U.S. transportation, but the cargo has. It has ended a Canadian flight in the United States and begun a trip to Mexico in the United States. Half the income attributable to each leg is U.S. source income.

Nonresident aliens and foreign corporations are subject to a 4 percent tax on U.S. source gross transportation income. 78

[10] Income from Ocean and Space Activities

Income derived from space and ocean activities is U.S. source income if derived by a U.S. person, and foreign source income if derived by a foreign person. 79 I.R.C. Section 863defines space activity to include any activity conducted in space, and ocean activity to include any activity conducted on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, the United States or a U.S. possession. 80 Activities covered include the performance and provision of services, leasing of equipment, licensing of technology or other intangibles, manufacturing of property, and the leasing of a vessel so long as the vessel does not transport cargo or persons for hire between ports of call. 81

Space and ocean activities do not include the sale of property on the high seas, activities generating transportation income, activities involving mines, oil and gas wells, or other natural deposits located within the jurisdiction of any country, or activities giving rise to international communications income. 82 In 1986, Congress directed that regulations be issued further defining ocean and space activities. 83 Regulations were proposed in 2001 and received much comment, but were never adopted. In September of 2005, the 2001 regulations were withdrawn and new regulations under I.R.C. Section 863(d) and (e) were proposed. The notice accompanying the new regulations claimed that the initial regulations were withdrawn because technological advancements in the aerospace, telecommunications and related industries, and material changes brought about by the American Jobs Creation Act of 2004, made the 2001 regulations obsolete. 84 Final regulations were issued on December 27, 2006. 85

The regulations provide that a U.S. person’s space and ocean income will be sourced outside the United States only to the extent that such income, based on all facts and circumstances, is attributable to functions performed, resources employed or risks assumed in a foreign country. 86 Otherwise, all space and ocean income will be U.S. source income.87 For purposes of determining the source of the space and ocean income of controlled foreign corporations (see § 4.10[1]), the Service will treat such corporations as U.S. persons.88 For foreign persons, space and ocean income will be foreign source income unless it is attributable to functions performed, resources employed or risks assumed within the United States. 89 The 2001 regulations included a presumption that the space and ocean income of foreign persons engaged in a trade or business within the United States was U.S. source income, but this was removed from the final regulations. 90

Under the final regulations, income from the sale of property in space or international water is included in the definition of space and ocean activity, and therefore is sourced underI.R.C. Section 863. 91 This definition excludes sales of inventory property in space or international water for use, consumption or disposition outside space or international water, which is sourced under Treasury Regulations Section 1.861-7(c). 92

The definition of space is also clarified by the final regulations to include the entire area outside the jurisdiction of any country or U.S. possession, extending from just above the surface of international water, through, and beyond the Earth’s atmosphere. 93 This definition was part of the 2001 regulations, but some commentators had proposed that the definition of space should be limited to areas beyond the Earth’s atmosphere. The Service rejected such comments and retained the definition in the final regulations, including international airspace in the definition of space.

For tax years beginning before January 1, 1987, ocean and space activities generated foreign source income. 94

[11] Insurance Underwriting Income

Amounts received as underwriting income from the insurance or reinsurance of U.S. risks is U.S. source income. 95 Other underwriting income is foreign source income. 96 Underwriting income includes premiums earned on insurance contracts less losses and expenses incurred. 97 U.S. risks are risks in connection with property in the United States, liability arising from an activity in the United States, or in connection with the lives or health of U.S. residents, or as a result of an arrangement in which another corporation receives a substantially equal amount for insuring or reinsuring U.S. risks. 98

Premiums received by foreign insurers and reinsurers of hazards, risks, losses, or liabilities within the United States are subject to an excise tax, unless the foreign insurer or reinsurer is authorized to do business in the United States. Its income is then subject to taxation at regular corporate tax rates. 99 A special exemption from the excise tax was allowed for life, sickness, and accident insurance and annuity contract premiums for insurance and annuity contracts for U.S. citizens and residents. The exemption applied if the foreign insurer was subject to tax under the rules determining the minimum amount of net investment income treated as effectively connected with the conduct of a trade or business in the United States. The exemption was repealed effective for premiums paid after December 10, 1988. 100 However, the general exemption for premiums effectively connected with the conduct of a trade or business in the United States (effective for premiums paid after December 10, 1988) applies to these insurance and annuity contracts. 101

The excise tax is in lieu of the tax on gross income and not subject to withholding. Thus, insurance premiums derived by a foreign insurer or reinsurer not engaged in a trade or business in the United States are not considered fixed or determinable annual or periodic income. 102 Exemption from excise tax on premiums on insurance policies may be granted under some tax treaties. 103

§ 2.10 Deductions and Credits

Business costs, losses and expenses may be deducted from nonresident alien’s income effectively connected with a U.S. trade or business. A deduction or credit for foreign taxes paid on this income is also allowed. Generally, no deductions are allowed for income not effectively connected with a U.S. trade or business. Exceptions include theft or casualty losses, charitable contributions and personal exemptions.

A nonresident alien’s income that is effectively connected with a trade or business in the United States is taxable under the same rules as those that apply to domestic taxpayers. 1 A nonresident alien, however, is disallowed deductions and credits if he or she fails to file a timely U.S. income tax returns, unless the Commissioner waives the filing deadlines. 2 The Service may waive a filing deadline unless the non-filer either (1) knew the return had to be filed and chose not to file such return or (2) does not cooperate in the process of determining its income tax liability for the tax year for which it did not file a return. 3 Foreign persons who are subject to a flat 30 percent tax (or lower applicable treaty rate) on certain U.S. source income that is not effectively connected with the conduct of a U.S. trade or business are generally not entitled to any deductions from their gross income in computing U.S. taxable income. 4

[1] Income Effectively Connected with U.S. Trade or Business

A foreign person engaged in a U.S. trade or business may deduct the business’s costs, losses, and expenses against gross income effectively connected with a U.S. trade or business.5 The deductions may not be offset against other U.S. source income. Expenses relating to both U.S. source and foreign source income must be apportioned between those sources.6 A foreign person cannot elect to capitalize real estate taxes, mortgage interest and other carrying charges incurred on unproductive U.S. real property, 7 if during the tax year in which the expenses are incurred, they are not deductible. 8

The allocation of interest expense by a foreign corporation is determined by a three-step process outlined in Treasury Regulations Section 1.882-5. Step one determines the total value of the foreign corporation’s U.S. assets, which generally are those that produce income effectively connected with the foreign corporation’s U.S. trade or business. 9 Step two determines the total amount of U.S. connected liabilities for the taxable year. The corporation can multiply the value of the U.S. assets determined under step one by an actual ratio of worldwide liabilities to worldwide assets, or the corporation can elect to use a fixed ratio. 10 Step three determines the amount of interest expenses that are allocable to U.S. effectively connected income under the U.S. booked liabilities method or the separate currency pools method. Under the U.S. booked liabilities method, the corporation looks to the interest expense on the foreign corporation’s U.S. books and it adjusts that booked interest expense up or down depending on the figure determined under step two. 11 The corporation can also elect to determine the interest allocation under the separate currency pools method. Here, the interest expense allocated to effectively connected income is the sum of the separate interest deductions for each of the currencies in which the foreign corporation has U.S. assets, multiplied by the corporation’s worldwide rate for liabilities in such currency. 12

The provisions of Treasury Regulations Section 1.882-5, discussed above, no longer provide the exclusive rules for determining the interest expense attributable to the business profits of a permanent establishment under any U.S. income tax treaty. Treaties have been entered into with the United Kingdom and Japan which permit United Kingdom and Japanese resident financial institutions to use an alternative method to determine taxable income without using the steps outlined in Treasury Regulations Section 1.882-5 for interest allocation. The IRS temporary regulations allow taxpayers to use alternative approaches for allocating interest deductions under tax treaties. 13 Taxpayers with the opportunity to use a different method under a tax treaty may continue to use the Treasury Regulations Section 1.882-5 method if they so choose provided they apply either the domestic law or the alternative rules expressly provided in the treaty in their entirety.

A foreign person may deduct or receive a credit for foreign taxes paid on income effectively connected with that person’s U.S. trade or business. However, a deduction or a credit is not allowed for foreign taxes paid on U.S. source effectively connected U.S. trade or business income if the taxes are imposed solely because the taxpayer is a resident of, or created or organized in, the jurisdiction imposing the tax. 14

As a pre-requisite to claiming allowable deductions and credits, a nonresident alien individual must file an accurate and timely return of the taxpayer’s effectively connected income.15 In addition, the taxpayer must be able to substantiate any deductions taken on the filed return. 16 For income tax return filing requirements for nonresident aliens, see Chapter 10.

The return filing requirement does not prevent a nonresident alien individual from claiming credits for: 17
(1) amounts withheld from wages; 18

(2) earned income; 19

(3) amounts withheld at source on nonresident aliens; 20

(4) use of gasoline and special fuels; 21 and

(5) tax on net capital gain deemed paid by shareholders of regulated investment companies. 22

In a recent Tax Court case, the deduction taken by a Canadian citizen on Form 1040NR for medical expenses was denied because the expenses were not effectively connected with a U.S. trade or business. 23

[2] Income Not Effectively Connected with U.S. Trade or Business

Generally, foreign taxpayers are not allowed deductions in determining the amount of their U.S. source noneffectively connected income that is subject to U.S. tax. There are, however, some exceptions. 24

The following deductions are allowed against income not effectively connected with a U.S. trade or business:
(1) losses for theft or casualty, subject to the general limitations on the deductibility of theft or casualty losses 25 and only if the loss is to property located in the United States and to the extent not compensated by insurance; 26

(2) charitable contributions to domestic corporations or other charitable organizations created in the U.S.; 27 and

(3) personal exemptions allowable to, and on the same terms as, U.S. residents 28 but taxpayers not residents of Canada or Mexico, or U.S. nationals are allowed only one exemption. 29

Deductions for losses on the sale or exchange of capital assets are allowed only against gain on the sale or exchange of capital assets.

To claim the allowable deductions and credits, a foreign person must file a timely and accurate return under the general rules for filing returns. 30 For income tax return filing requirements, see Chapter 10.

Regardless of whether a return is filed, a nonresident is entitled to credits for: 31
amounts withheld from wages; 32

earned income; 33

amounts withheld at the source by the payer; 34

taxes paid for the use of gasoline and special fuels; 35 and

the credit for taxes deemed paid by stockholder in a regulated investment company. 36

§ 2.11 Return Requirements

Generally, a nonresident alien individual with income which is effectively connected with the conduct of a U.S. trade or business must file an income tax return on Form 1040NR and pay the tax.

While income tax on fixed or determinable annual or periodic income is generally collected through withholding at the source (see discussion at § 2.12, below), income tax on effectively connected income is to be remitted by the taxpayer and reported on a timely filed Form 1040NR. 1 A nonresident alien individual whose tax has been fully paid at the source and who has no effectively connected income need not file a return, unless he seeks a refund of overpaid taxes. But if the nonresident alien has any gross income, from any source, and is engaged in a trade or business in the United States, even one which has produced no income, he must file a Form 1040NR. 2 The IRS has announced an intention to amend Treasury Regulations Section 1.6012-1(b)(2) to except from the obligation to file a Form 1040NR a nonresident alien whose only U.S. source income is wages in an amount less than one personal exemption for United States income tax purposes. 3 Because income collected by a nonresident alien from disposition of an investment in U.S. real property is treated under I.R.C. Section 897 as income which is effectively connected with a U.S. trade or business, the taxpayer must report the gain on a Form 1040NR even if she believes the tax was fully withheld. 4

§ 2.12 Withholding Requirements

A nonresident alien’s U.S. source income not effectively connected with a U.S. trade or business is subject to 30 percent withholding tax at the source. Normal graduated withholding rates apply to a foreign taxpayer’s U.S. source compensation for personal services (other than self-employment income). A withholding agent withholds and pays over the tax. Taxpayers eligible for the benefits of a tax treaty may be subject to partial or full exemption from withholding on income specified in the treaty.

A nonresident alien’s U.S. source income that is not effectively connected with a U.S. trade or business is subject to tax at a flat 30 percent rate unless otherwise provided by treaty. 1

A withholding agent is the person required to deduct, withhold and pay the tax of a nonresident alien. This duty is imposed on all persons, acting in whatever capacity, that have the control, receipt, custody, disposal or payment of any of the items subject to withholding. 2 Withholding agents specifically include lessees and mortgagors of realty or personalty, fiduciaries, employers, and officers and employees of the United States. 3

A withholding agent may be a foreign person.

A withholding agent is both liable for the tax withheld and indemnified against any person claiming any tax properly withheld and paid over to the U.S. Treasury. 4 Tax withheld at the source upon income paid to a fiduciary is deemed to have been paid by the taxpayer (i.e., beneficiary) ultimately liable for the tax upon the income. 5 Thus, U.S. income tax withheld at the source upon dividends paid to a trustee may be claimed as a credit against tax by a trust beneficiary, but may not be claimed as a credit against tax by the shareholder of a foreign holding company.

A nonresident alien who has U.S. source income must generally file an income tax return. However, a foreign person is not required to file a return if his tax liability is fully satisfied by the withholding provisions, provided the foreign person is not engaged in a U.S. trade or business during the tax year. 6

[1] Income Subject to Withholding

Withholding applies to any U.S. source fixed or determinable annual or periodical income and certain other gains from disposition of property paid to a nonresident alien that is not effectively connected with a U.S. trade or business. 7

Fixed or determinable annual or periodical income includes:
(1) interest (except original issue discount);

(2) certain payments of original issue discount by the original issuer or a related obligor, as defined in regulations;

(3) dividends;

(4) rent;

(5) royalties;

(6) salaries;

(7) alimony;

(8) wages;

(9) premiums;

(10) annuities;

(11) compensations;

(12) remunerations;

(13) gains from timber, coal and domestic iron ore;

(14) qualified scholarships and fellowships; and

(15) distributive shares from U.S. partnerships to the extent they include the foregoing. 8

[2] Income Not Subject to Withholding

The following categories of income are not subject to withholding:
(1) income (other than compensation for personal services) effectively connected with a U.S. trade or business; 9

(2) foreign source income; 10

(3) portfolio interest paid on bearer obligations that are described in I.R.C. Section 871(h)(2)(A) or 881(c)(2)(A) and Treasury Regulations Section 1.871-14(b); 11

(4) interest received by foreign central banks of issue and the Bank for International Settlement; 12

(5) passive income paid from U.S. sources to a U.S. possessions corporation; 13

(6) compensation of nonresident aliens engaged in a U.S. trade or business; 14

(7) per diem subsistence payments to military trainees; 15

(8) annuities received under qualified plans for services performed outside the United States or if received from plan satisfying 90 percent U.S. employee test; 16

(9) income exempt under a tax treaty between the United States and a foreign country;

(10) dividends from domestic corporations satisfying the foreign active business requirement test; 17 and

(11) salary and wages otherwise subject to withholding by the employer. 18

[3] Treasury Regulations

On April 15, 1996, the Treasury Department proposed the first comprehensive revisions to the withholding regulations under I.R.C. Section 1441 in 40 years. 19 These broad provisions were then subjected to extensive debate, and, in substantially revised form, were reissued and made final on October 6, 1997. 20 Generally, the new regulations were to become effective for withholding agents with respect to any payments made to foreign taxpayers after December 31, 1999. The effective date was then extended by the Service to payments made after December 31, 2000, and the Service announced that it would treat 2001 as part of the base audit period for paying agents and not demand absolute compliance for those financial institutions that wished the benefit of an additional transition year. But as of January 1, 2002, the new regulations apply to all payments made to foreign persons of U.S. source interest, dividends, and other fixed and determinable annual or periodic income payments. The regulations are over 100 single-spaced pages in length, and are extremely detailed.

The final regulations significantly revise the U.S. withholding tax and information reporting rules, including the rules for withholding on dividends, the rules regarding eligibility for tax treaty benefits, the withholding tax exemption for payments that are effectively connected with the conduct of a U.S. business of a foreign person, and the treatment of payments to intermediaries and foreign partnerships.

The 1997 rules were criticized by practitioners for their complexity. In response to those criticisms, and to effectuate the government’s broad policy goals of identifying U.S. taxpayers who put assets into foreign bank accounts and to ensure that treaty benefits are granted only to residents of treaty countries, the Service issued final regulations underI.R.C. Section 1441 on May 15, 2000 dealing with the withholding obligations of both qualified and non-qualified intermediaries, which regulations modify the 1997 regulations and are effective January 1, 2001. 21 In general, the balance of the Section 1441 regulations not covered in the final regulations remain effective. Although many of the provisions are beyond the scope of this text, certain provisions warrant attention.

First, Treasury Regulations Section 1.1441-1(c)(6) now provides that for withholding purposes, the beneficial owners of a payment to a foreign simple trust are the trust beneficiaries. The beneficial owners of a payment to a foreign grantor trust are the owners of the trust, and foreign complex trusts and estates are considered to be the beneficial owners of income paid to such entities. Simple trusts and grantor trusts are defined by reference to the applicable provisions of Subchapter J of the Internal Revenue Code. 22 Whether a foreign complex trust or estate can claim a reduced rate of withholding under a treaty depends on the country of residence, the application of any treaty benefits limitation provision and whether such trust or estate derives income under I.R.C. Section 894.

Second, Treasury Regulations Section 1.1441-5(b) now provides that a U.S. simple trust is a withholding agent for the distributable net income (DNI) includible in the gross income of a foreign beneficiary to the extent the DNI consists of an amount subject to withholding. Similarly, a U.S. complex trust is a withholding agent on DNI includible in the gross income of a foreign beneficiary to the extent the DNI consists of an amount subject to withholding that is, or is required to be, distributed currently. U.S. simple trusts and complex trusts are permitted to make reasonable estimates of the portion of a distribution that constitute DNI consisting of amounts subject to withholding. A U.S. grantor trust must withhold on any income includible in the taxable income of a foreign person that is treated as an owner to the extent the amount includible consists of an amount subject to withholding.

Third, interest or original issue discount (“OID”) realized on the sale or exchange (but not redemption) of a short-term OID instrument is no longer required to be reported to a withholding agent (provided such sale or exchange is not undertaken with the principal purpose of avoiding tax and that the withholding agent does not know and has reason to know of any such tax-avoidance plan).

Fourth, amounts that would be excluded from gross income without regard to whether the recipient of such amounts is a U.S. or non-U.S. person are not treated as FDAPI. However, income under I.R.C. Section 892 or 115 is reportable as FDAPI and is subject to withholding.

Fifth, income from notional principal contracts is no longer treated as effectively connected income unless paid to a U.S. Qualified Business Unit of a foreign person or the withholding agent knows (or has reason to know) that the payment is effectively connected income. The preamble to the regulations indicates that it is not expected that a withholding agent will be considered to have reason to know that a notional principal contract is effectively connected income merely because the foreign payee has a U.S. Qualified Business Unit to which a portion of the payment may be allocated pursuant to the regulations on global dealing. Specific provisions of the final regulations include the items below.

[a] Portfolio Interest

The final regulations provide that U.S. tax is not required to be withheld from “portfolio interest” paid on a registered form debt obligation if the beneficial owner 23 of the obligation provides the withholding agent with an Internal Revenue Service Form W-8 (“Form W-8”). The Form W-8 must (i) be signed by the beneficial owner under penalties of perjury, (ii) certify that the owner is not a United States person, or in the case of an individual, that the owner is neither a citizen nor a resident of the United States, and (iii) provide the beneficial owner’s name, permanent residence address and, in the case of an entity, country of organization and classification. 24

[b] Dividends

Under the final regulations, a foreign beneficial owner must furnish the withholding agent with a Form W-8 in order to obtain a reduced rate of withholding under a tax treaty. 25 The beneficial owner will generally be required to provide a taxpayer identification number (or “TIN”) on the Form W-8, except that a TIN will not be required in the case of (i) dividends on stock that is actively traded on a U.S. national securities exchange or NASDAQ, 26 (ii) dividends on any redeemable security issued by an investment company registered under the Investment Company Act of 1940, that is, mutual fund shares, and (iii) dividends from units of beneficial interest in publicly-offered SEC-registered unit investment trusts. The final regulations eliminate the so-called “address rule” which had permitted a withholding agent to generally assume that dividends paid to an address in a foreign country which has a treaty with the United States permitting withholding at a reduced rate were entitled to that reduced rate. Now the recipient must file a Form W-8 in order to obtain the reduced rate.

[c] Other Income Eligible for Treaty Benefits

Under the final regulations, a foreign beneficial owner claiming tax treaty benefits with respect to other types of income (including royalties and interest that is not eligible for the portfolio interest exemption) must provide the withholding agent with a Form W-8 (containing the information listed above under ” Portfolio Interest”) that generally includes the TIN of the beneficial owner. A withholding agent may withhold at a reduced rate without having a completed Form W-8 if the withholding agent has personal knowledge of the alien’s eligibility for the treaty rate, but such knowledge will be rare. In 2003, the Service adopted further regulations covering special situations in which a withholding agent who is also an acceptance agent authorized to act on behalf of taxpayers seeking taxpayer identification numbers 27 may remit an “unexpected payment,” such as a death benefit or casino winnings, without having a TIN or a completed Form W-8, because the taxpayer has not had time to obtain a TIN. 28

[d] Effectively Connected Income

Under the final regulations, a foreign beneficial owner claiming an exemption from withholding for income that is effectively connected with a U.S. trade or business must furnish to the withholding agent a Form W-8 (containing the information listed above under ” Portfolio Interest”) that includes the TIN of the beneficial owner. This rule is similar to that of the existing regulations. 29 Under the final regulations, the existing IRS Forms W-8, 1001 (relating to treaty benefits) and 4224 (relating to income effectively connected with a U.S. trade or business) are all combined in a new Form W-8 containing all of the required information, which must be signed under penalties of perjury. A Form W-8 will now generally remain valid for 3 years, except that a Form W-8 which contains the beneficial owner’s TIN will remain valid for an indefinite time.

[e] U.S. Source Bank Deposit Interest and Short-Term Original Issue Discount (“OID”) 30

Payments of these types of income to foreign persons are generally not subject to withholding tax. A beneficial owner is not required to furnish documentation establishing foreign status to a withholding agent in order to obtain the withholding tax exemption. Documentation of the beneficial owner’s status may be necessary, however, in order to establish exemption from backup withholding and information reporting.

[f] Notional Principal Contracts

Payments made pursuant to notional principal contracts (including foreign currency notional principal contracts) are not subject to withholding. 31 If paid to a U.S. Qualified Business Unit of a foreign person, however, they are presumed to be effectively connected income and, as such, are required to be reported by a withholding agent on Forms 1042 and 1042-S. In the event that the withholding agent knows or has reason to know that the notional principal contract payments are effectively connected income, then the payments will be treated as such and subject to withholding accordingly.

[g] Payments to Intermediaries

In a case where a withholding agent makes a payment of interest, dividends or similar income to a person acting as an intermediary (e.g., a financial institution that receives payments on behalf of its customers), the final regulations would permit the withholding agent to rely upon an “intermediary withholding certificate” furnished by the intermediary to establish the foreign status of the beneficial owner(s) of the payment and the applicability of an exemption from, or reduced rate of, withholding. 32

[h] Payments to Domestic Trusts and Partnerships

Because no withholding is required for a payment to a U.S. payee, a withholding agent is not required to withhold taxes upon payments which the withholding agent may “reliably associate” with a U.S. domestic partnership or trust. 33 The U.S. partnership 34 or trust 35 is then required to withhold tax when remitting payments to foreign owners: the partners or beneficiaries.

[i] Payments to Foreign Partnerships

The final regulations adopt a look through approach for payments to foreign partnerships. Under the final regulations, a payment made to a foreign partnership is generally treated as made to the partners, rather than to the partnership, and the determination of whether (and how much) to withhold is therefore based upon the status of the individual partners. 36In the case of tiered foreign partnerships, the withholding agent is required to look through all tiers of foreign partnerships until it reaches a partner (or partners) that is not subject to the look-through rule.

A foreign partnership that is acting for its own account generally must furnish to a withholding agent a Form W-8 attaching appropriate withholding certificates (e.g., Forms W-8 or W-9, or an applicable intermediary withholding certificate) for each of its partners and including information on each partner’s distributive share of a payment. The final regulations provide certain exceptions to this general rule.

[j] Payments of Foreign Partners’ Shares of Effectively Connected Income

I.R.C. Section 1446 governs withholding upon a foreign partner’s share of the income of a partnership (whether domestic or foreign) that is effectively connected with the conduct of a U.S. trade or business. Treasury proposed regulations under I.R.C. Section 1446 37 on September 3, 2003 which, in modified form, became final on May 18, 2005. 38

I.R.C. Section 1446 generally requires a partnership, whether domestic or foreign, which has income that is effectively connected with the conduct of a trade or business in the United States, to withhold and pay U.S. income tax on a quarterly basis on such income allocable to a foreign partner, whether or not it is paid to him or her. Withholding under the statute is at the highest marginal tax rate applicable to individuals or corporations, as the case may be, 39 but the regulations provide relief for foreign partners who file certificates with the Service setting forth deductions and credits to which the partner is entitled. 40 The partnership is to file the foreign partners certificate with the Form 8813, or Forms 8804 or 8805, whichever is applicable. In meeting its withholding obligations for a foreign partner under I.R.C. Section 1446, the partnership may determine the status of a foreign partner by reference to the Form W-9, W-8 BEN, or another form completed by the partner for purposes of withholding under I.R.C. Section 1441.

[k] Payments to Foreign Trusts

Payments made to a foreign complex trust will be treated as made to the trust so that any eligibility for treaty relief depends upon the status of the foreign trust. 41 Payments made to a foreign simple trust are subject to withholding based upon the status of the income beneficiary, and the withholding agent must receive a valid and complete Form W-9 containing all relevant data regarding the income beneficiaries. 42 Similarly, payments made to a foreign grantor trust are subject to withholding based upon the status of the owner, and the withholding agent must receive a valid and complete Form W-9 containing all relevant data regarding the trust’s owner. 43

[l] Payments to Qualified Intermediaries

An important new feature of the withholding regulations, as proposed and then, in modified form, adopted as final, is the concept of a qualified intermediary. A “qualified intermediary,” or “QI,” is defined in the final regulations 44 as a foreign financial institution or a foreign clearing organization, or a foreign branch or office of a U.S. financial institution, or a foreign corporation for purposes of presenting claims of benefits under an income tax treaty on behalf of its shareholders, or “any other person acceptable to the IRS,” “that is a party to a withholding agreement with the Internal Revenue Service.” That is, a QI is a foreign person, acting on its own behalf or on behalf of others, that effectively agrees to withhold taxes due to the United States upon payments remitted abroad, so that the U.S. payor shall not have to withhold the tax. Under the terms of the withholding agreement, the QI becomes subject to the applicable withholding and reporting provisions which would otherwise have applied to the U.S. withholding agent paying the amounts abroad. 45 The QI must obtain the documentation from ultimate beneficial owners which otherwise would have had to be furnished on a Form W-8 to the U.S. paying agents, and itself make determinations of applicable withholding rates for each payee. The QI will then, under the terms of its withholding agreement with the Service, withhold and remit the taxes due. Alternatively, the QI can act as a compiler of information which it furnishes to the U.S. paying agent, advising the paying agent on an aggregate basis of the applicable withholding rate for payments being remitted to the QI on behalf of all of its customers, and the U.S. paying agent will withhold the tax, while the QI will compile the information and have it available to the Service.

The result of such an arrangement is that foreign banks and brokerage houses can themselves act as withholding agents, relieving their customers of filing requirements in the United States with respect to their U.S. investment securities, and alleviating the need that information be on hand in the United States concerning the investor. However, under the terms of the withholding agreement between the QI and the Service, that information will be available to the Service upon request. The United States Senate recently published a report investigating the degree to which foreign banks have been manipulating their reporting obligations under the QI reporting program. In particular, the Senate report found that UBS AG of Switzerland engaged in practices, as part of its efforts to open accounts in Switzerland for high net worth U.S. clients, that could and did facilitate tax evasion by allowing the U.S. clients to structure their accounts so as to avoid the QI reporting requirements. Based on its findings, the Senate report recommends that the QI reporting program be strengthened by, in addition to stepping up enforcement of existing law, requiring QI participants to file an IRS Form 1099 for all U.S. persons who are either the direct or beneficial owners of an account (whether or not the U.S. client has U.S. securities or receives U.S. source income, and whether or not the account is held in the name of a foreign corporation, foundation, trust, or other entity). 46

The Service published a model withholding agreement for QIs on January 7, 2000 47 and explained its approach to QIs. An institution wishing to qualify as a QI must file a detailed application with the Service which sets forth information on its account opening procedures, types of account holders, types of U.S. investment assets its account holders own, and establishing that it has the resources to “know its customers” and their accounts, and comply with the requirements of its withholding agreement with the Service. The Service has discretion to enter into a withholding agreement with an applicant, and thereby constitute the applicant as a QI, or to decline to enter into the agreement. Generally, its has been found desirable by foreign financial institutions for competitive reasons that they qualify as QIs, and many have done so. For examples, Article 4 of the U.S.-Bahamas Information Exchange Agreement signed on January 25, 2002, includes a provision intended to facilitate a Bahamian financial institution’s achieving QI status.

In Revenue Procedure 2005-77 , 48 the Service published amended forms of withholding foreign partnership and foreign trust agreements. A qualifying foreign trust is one which enters into a withholding agreement with the Service. 49 A series of amendments to the final regulations were adopted in March 2006. 50 These amendments do not alter significantly any of the substantive provisions of the final regulations, but rather, in response to comments from various taxpayers, provide relief from various reporting and other requirements. 51

[m] Payments to Foreign Financial Institutions with United States Accounts

The Service has indicated that it is re-examining its policies with respect to withholding on payments to qualified intermediaries in the light of scandals involving foreign bank accounts held by U.S. persons.

The Foreign Account Tax Compliance Act (“FATCA”), first introduced as legislation in Congress on October 29, 2009, 52 was enacted into law on March 18, 2010 as Title V, Subtitle A of the Hiring Incentives to Restore Employment (“HIRE”) Act. Included among its provisions, in Section 501 of the Act, are new I.R.C. Sections 1471 through 1474 imposing new withholding tax obligations on U.S. payors. The new provisions are effective for payments made to foreign accounts after December 31, 2012. 53

New I.R.C. Section 1471 provides for a 30 percent tax withholding on the amount of any payment made by a U.S. payor to a foreign financial institution which is a “withholdable payment,” absent an agreement of the payee with the U.S. Treasury that payments to that payee are not to be withheld on. “Withholdable payment” is defined by new I.R.C. Section 1473(1) as any payment of fixed or determinable annual or periodic income made to a foreign financial institution or other foreign entity. Payments of income which are effectively connected with the conduct of a U.S. trade or business are not subject to withholding.

With respect to payments made to foreign financial institutions, new I.R.C. Section 1471 provides that a U.S. payor must withhold 30 percent upon any payment of FDAP income unless, prior to December 31, 2012, the payee financial institution has entered into an agreement with the U.S. Treasury by which the foreign financial institution agrees to determine which of its accounts are “United States accounts,” defined as accounts in which one or more U.S. persons have interests valued at $50,000 or more (per U.S. person for all accounts at the foreign financial institution). 54 In order to avoid the 30 percent withholding, the foreign financial institution must agree to provide to the Internal Revenue Service the name, address, taxpayer identification number and full account asset, income and withdrawal information on all U.S. account holders, and to withhold at a 30 percent rate on the interests of all “recalcitrant” account holders who refuse to allow the foreign financial institution to provide the required information. 55

With respect to payments made by United States payors to foreign entities which are not foreign financial entities, new I.R.C. Section 1472 requires the same 30 percent withholding unless, prior to December 31, 2012, the foreign entity provides the payor with a certification that it has no substantial United States beneficial owners 56 or provides full taxpayer information on all U.S. owners. Publicly traded companies are not included in the reach of new I.R.C. Section 1472.

These new provisions are intended to reach payments of income to foreign accounts which directly or indirectly benefit U.S. persons and are not being reported as income by the U.S. owner beneficiaries.

PLACE THIS ORDER OR A SIMILAR ORDER WITH US TODAY AND GET AN AMAZING DISCOUNT 🙂