Nonresident Alien Taxation
Unlike almost every other country, the United States follows a US Citizenship-based tax model and not a residence-based tax model when it comes to individuals. Technically, even though it is referred to as citizen-based taxation (CBT), it is more accurately defined as US-person-based taxation, because Lawful Permanent Residents and Foreign Nationals who meet the Substantial Presence Test also get roped into the worldwide income tax regime. Even if a person is considered a non-resident alien, they are still subject to US tax on various types of US-sourced income. But, since the person is not technically considered a US person, they are not taxed on their worldwide income or required to file the FBAR or Form 8938. Let’s go through five important tax facts about non-resident aliens in US taxation.
Avoid Substantial Presence
First, it is important for nonresident aliens who are seeking to avoid US taxation on their worldwide income or disclosure of their global assets on international information reporting forms such as FBAR and FATCA, to avoid meeting a Substantial Presence Test. The Substantial Presence Test counts the number of days the person was in the United States over a three-year period using a 1-to-1; 3-to-1; and 6-to-1 ratio. If a person meets the Substantial Presence Test, then they are required to report their worldwide income along with their global assets. But, if for one reason or another a person unintentionally meets the Substantial Presence Test, they may still qualify for an exclusion or an exception such as the Closer Connection Exception to the Substantial Presence Test.
When a person is a nonresident alien, they are still subject to US tax on income that is sourced in the United States, unless an exception applies. An example of an exception is US capital gains: a taxpayer who is a non-resident alien typically does not have to pay US tax on their US capital gains, while dividends are still taxable, along with Social Security and US pension income (although with certain pensions, the taxpayer may qualify to make a treaty election to reduce or eliminate tax and withholding).
FDAP refers to Fixed, Determinable, Annual, and Periodic. Essentially, FDAP refers to passive income. With this type of income category, nonresident aliens may be subject to a 30% withholding, which is significant especially if the nonresident alien would otherwise escape tax in their home country or country of residence on the income. If a person is subject to FDAP withholding, they will want to evaluate any particular tax treaties that may be applicable to see if they can reduce or eliminate withholding.
ECI (Effectively Connected Income)
ECI refers to Effectively Connected Income, which is essentially any income associated with the US trade or business. Unlike FDAP, taxpayers can take deductions with ECI. For example, if a taxpayer makes an election to treat rental income as ECI (which by default is FDAP), then they can take the same type of deductions that they would otherwise take on the US tax return for rental income, such as commissions, maintenance, depreciation, etc. With this category of income, taxpayers are taxed at the same progressive tax rate as their US resident counterparts.
Withholding, Treaties, and Exemptions
Despite the fact that the general baseline rule is that non-residents are taxed on FDAP and ECI — and subject to a 30% withholding rate, there are exceptions, exclusions, and limitations to consider. Presuming that the taxpayer was not a covered expatriate, then as long as they reside in a treaty country, they can still reduce or eliminate withholding. Likewise, depending on the applicable tax treaty, taxpayers may also be able to avoid all taxation on items such as their private pension income. When it comes to applying tax treaties, it is important that the taxpayer evaluate the saving clause and whether the specific article or provision they are relying on is excluded from the savings clause or not.
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