Series 103: US International Tax System for Individuals

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Have you ever wondered how the US international tax system works? Well prepare for the ultimate guide on how your income should be reported to the US.

US Citizens and Residents v. Non-Resident Aliens

The way an individual is taxed on offshore income depends on their citizenship or residence status with the US. Simply put, US Citizens and residents are taxed on their worldwide income, no matter where earned. However, non-US citizens and residents, better known as “non-resident aliens”, are only taxed on their investment or trade or business income generated in the US. These two systems of taxation lead to significantly differing tax consequences to the individual taxpayer. That is why it is very important to understand who qualifies as a US Citizen and resident subject to tax on their worldwide income and those who don’t.

So, who qualifies as a US citizen or resident? There are three general categories that meets this test. First, is a US citizen. If you hold US citizenship, you are subject to tax on your worldwide income, even if you do not reside in the US. While it seems unfair that the US government taxes you on foreign income that is also being taxed by another country, the Internal Revenue Code and bi-lateral tax treaties the US enters with other countries provide relief in various forms from double taxation.

The second category of person who qualifies as a US citizen or resident is a person who holds a “green card”. If you hold a “green card” issued by the US government, you too are taxed on your worldwide income. The Internal Revenue Code applies to you as if you were a US citizen. Once again, you will be provided relief from dual taxation on any foreign income earned through various mechanisms in the Internal Revenue Code and various US tax treaties.

The final category of person that qualifies as a US citizen or resident subject to tax on a worldwide basis, is a person who meets the “substantial presence” test in the US. If a person meets the “substantial presence” test in the US, they too are treated just as a normal US citizen is for tax purposes. A person meets this test if they were physically present in the US for at least (1) 31 days during the current tax year, and (2) 183 days during the 3-year period that includes the current year and the 2 years immediately before that. The 183-day count includes the following:

  • All the days you were present in the current year,
  • 1/3 of the days you were present in the first year before the current year, and
  • 1/6 of the days you were present in the second year before the current year.

There are various exceptions to the “substantial presence” test for government officials, teachers, students, and professional athletes who are in the US for a temporary basis. What is important to note about this test for foreigners is the 31 day test for the current year—if you can always remember, as a rule of thumb, to stay in the US less than 31 days, you’re in the clear and will not have to file US taxes as an normal US citizen has to.

So You’re a US Citizen or Qualifying Resident—Worldwide System of Taxation

So you meet the test to be taxed on your worldwide income in the US. What does this really mean? It means that you are subject to tax on all income, no matter if it is earned in or out of the US. For example, lets assume you live in the US and are a US citizen. You earn $100 of income in the US from your normal job, and $100 of interest from a bank account your hold in Country A and another $100 of dividends from a company based in Country B. You will have to report and pay US tax on all $300 of income you earned in the tax year.

Continuing with this example, lets say that both Country A and B have a 10% tax on income earned within their countries. That means you will have paid $20 of foreign tax between Country A and Country B in the tax year–$10 of tax on the $100 of interest earned in Country A and $10 of tax on the $100 of dividends earned in Country B.  Thereafter, assuming your subject to the top marginal rate of 37% on your income earned in the US, you would have to pay total US tax of $111. With that being said, you would be taxed twice on the income earned in Country A and Country B. Most people say that this is not fair, and the US government agrees with you. In order to combat this level of double taxation, the Internal Revenue Code provides you with a dollar-for-dollar tax credit for foreign taxes paid on income subject to US tax. This is better known as the Foreign Tax Credit (“FTC”), and is a very complex, and nuanced are of the law. However, assuming no limitations applied in our example, you would be granted a $20 dollar-for-dollar credit against the $111 of taxes due to the US. Thus, you would only owe an additional $91 to the US government.

Beyond relief from dual taxation provided in the Internal Revenue Code such as the FTC discussed above, dual tax treaties the US entered provides a different type of relief. One of the major provisions in tax treaties is the definition of a resident. Generally, a tax treaty designates which country a dual citizen is subject to tax in as if they were a resident of that country, while providing them treatment as a non-resident in the opposite country. Additionally, treaties cover the taxation between countries on various types of income—dividends, interest, capital gains, royalties, rents from real property, trade, and business income, etc.  Thus, it is very important to consult a tax attorney to see how a tax treaty can provide you relief from dual taxation if you are in a situation where you are subject to taxation in two or more countries on income derived.

Non-Resident Aliens—Only Taxable On Certain US Source Income

If you do not qualify as a US citizen, an “green card” holder, or for the “substantial presence” test, then you are designated as a “non-resident alien” (“NRA”). An NRA is only subject to tax in the US on their US source income. US source income consists of “Fixed, Determinable, Annual, Periodical” (FDAP) income, or income that is effectively connected with a US trade or business. Thus, and NRA is excepted from taxation in the US on their income that is earned offshore.

So, what is FDAP income? FDAP income is defined by exception in the Internal Revenue Code, and generally includes passive income such as rents, royalties, interest, dividends, and other capital gains derived from investments. FDAP income is generally taxed at a 30% flat rate unless a lesser rate applies under a tax treaty. The big problem with earning FDAP income is that it cannot be offset by any applicable deductions. For example, if an NRA earned $100 from investments in the US, and has to pay a US investment broker a $10 management fee, the NRA is subject to a 30% tax (i.e. $30) on the $100 of investment income earned in the US.

We’ve covered FDAP income, but what about effectively connected income with a US trade or business? Well, this is a very technical definition that it defined by years of case law. Essentially, it is income from an ongoing trade or business that is based in the US. For example, if an NRA establishes a retail store through which they sell widgets they produce offshore, and this is done on a continuous and regular basis, the income derived from this will be effectively connected with a US trade or business. In contrast to FDAP income, income that is effectively connected with a US trade or business can be offset by related expenses and deductions. Continuing with our example, if the NRA’s retail store has expenses related to rent, payroll, utilities, etc. all of these expenses can be offset against the income it generates from its sales in the US. Additionally, effectively connected income is not subject to a flat 30% rate. Rather, it is subject to the normal marginal levels of tax in the US, with 37% being the highest for individuals.