Presenting a live 90-minute webinar with interactive Q&A Nonresident Alien Tax Compliance: Challenges and Planning Techniques for Tax Professionals Recent IRS Compliance Campaign, ECI vs. FDAP Income, Reporting Requirements, Exemptions, Deductions and Tax Credits TUESDAY, AUGUST 7, 2018 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Kirsten Burmester, Member, Caplin & Drysdale, Washington, D.C. Chaya Kundra, Atty, Kundra & Associates, Rockville, Md. Lucy S. Lee, Shareholder, Greenberg Traurig, McLean, Va. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 1. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.
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Nonresident Alien Income Tax Compliance Part I: Overview of Rules and Regulations Part II: Determining Status and Filing Obligations AUGUST 7, 2018 Lucy Lee leelu@gtlaw.com 703.903.7584
Part I: Overview of Rules and Regulations
Income Taxes Generally U.S. income tax rules apply differently for U.S. citizens and U.S. residents versus nonresident aliens Residents are subject to U.S. income tax on worldwide income, but foreign tax credits available Nonresidents are subject to U.S. income tax on certain U.S. source income and US business income 2018 Greenberg Traurig, LLP 7
Nonresident Alien Income Taxation Nonresidents are subject to U.S. income tax on certain items of U.S. source income U.S. source fixed, determination annual or periodic ( FDAP ) payments, e.g., rents, royalties, interest, dividends, etc. Income effectively connected ( ECI ) to a US trade or business Capital gains, but only if the nonresident is present in the U.S. for more than 183 days during the year Exceptions for sales of U.S. real property and partnerships that are engaged in a U.S. trade or business Nonresidents should provide proper withholding certificate Generally not subject to additional information reporting applicable to U.S. persons, such as FBAR or Form 8938 2018 Greenberg Traurig, LLP 8
FDAP Income Generally, U.S. source FDAP income is subject to 30% withholding tax Tax may be reduced by an applicable treaty e.g., UK-US treaty reduces interest to 0% FDAP income includes dividends, interest, rents, royalties, annuities, and other payments Exceptions for interest on bank accounts and portfolio income, or income from a registered debt interest (i.e., a bond). Source rules, in general Interest sourced to the residency of the payor Dividends sourced to the residency of the payor Rents and sales of real property sourced to location of property Royalties sourced based on where intangible is exploited Sales of personal property sourced to the tax home of the seller 2018 Greenberg Traurig, LLP 9
Withholding Certificates Withholding certificates provide the payor of income support, as to the payee s eligibility for a reduced withholding rate, and FATCA status Provide withholding certificates to U.S. payors to indicate U.S. tax status: Form W-9 is for U.S. residents Form W-8BEN is for nonresident individual beneficial owners of U.S. source FDAP income Form W-8BEN-E is for nonresident entity beneficial owners of U.S. source FDAP income Form W-8ECI is for nonresidents who are engaged in a U.S. trade or business Form W-8IMY is for nonresident passthrough entities (e.g., foreign grantor trust or foreign disregarded entity) Form W-9 or Form W-8BEN for ultimate beneficial owner of the income should be attached 2018 Greenberg Traurig, LLP 10
U.S. Trade or Business Nonresidents are subject to U.S. net basis tax if engaged in a trade or business within the United States on income that is effectively connected to that trade or business Income for services performed in the U.S. Exception if present in the US for less than 90 days and less $3,000 Income from a U.S. trade or business Income earned by a foreign partner of a US partnership, withholding required Gain on the sale of a US partnership by a foreign partner Reported on Form 1120F (foreign corporations) or Form 1040NR (nonresident aliens) Deductions for nonresidents are limited Personal exemption Charitable deductions Deductions for ordinary and necessary business expenses Casualty losses 2018 Greenberg Traurig, LLP 11
U.S. Trade or Business (cont d) A foreign person is considered to be engaged in a U.S. trade or business if, U.S. activities rise to the level of a business Taxpayer s activity must be regular, continuous and substantial U.S. activities must be central to the derivation of profit, i.e., advance the business purpose of the enterprise However, Mere passive investment or holding property is not enough Isolated (i.e., one off ) or occasional transactions in the U.S. usually not enough Does not include U.S. business activities that are incidental, ministerial, or clerical Activity of an agent Consider implications under treaty 2018 Greenberg Traurig, LLP 12
U.S. Taxation of Real Estate Foreign Investment in Real Property Tax Act of 1986 (FIRPTA) Any person who acquires a US real property interest from a foreign person generally must withhold a tax of 15% from the amount realized by the nonresident seller U.S. real property interest means Interest (other than as a creditor) in U.S. real property, or Interest in a U.S. real property holding company 2018 Greenberg Traurig, LLP 13
U.S. Taxation of Real Estate (cont d) IRS Foreign Person U.S. Real Property Interest Withholding $0$ $ $0$ $ Sales Price Less Withholding U.S. or Foreign Person Net gain or loss from disposition of U.S. real property interest treated as ECI Nonresident taxed at regular tax rates Short-term gain, up to 37% Long-term gain, 20% No net investment income tax, 3.8% Transferee is required to withhold, absent any exceptions Transferor must file U.S. return (additional tax or refund) 2018 Greenberg Traurig, LLP 14
Part II: Determining Status and Filing Obligations
Determining Income Tax Residence U.S. income tax residence is determined under any one of three objective tests: Green card test Substantial presence test ( SPT ) An individual who makes an affirmative election to be subject to U.S. federal income tax as a resident Meeting the green card test Lawful permanent resident of the U.S. during the calendar year A lawful permanent resident is one who has applied for and received an immigrant visa, also known as a green card 2018 Greenberg Traurig, LLP 16
Meeting the Substantial Presence Test Physically present in the U.S. for 183 days or more SPT satisfied if: Present in the US at least 31 days during current year, and Present in the US for 183 days or more during the current year and the 2 preceding calendar years, counting days of presence as follows: Include all days in current year 1/3 days in first preceding year 1/6 days in second preceding year Safe harbor: no more than 121 days per year in the current year and prior two years 2018 Greenberg Traurig, LLP 17
Exceptions Exempt visas Form 8843 Medical exception Form 8843 Closer connection exception Form 8840 Treaty tie-breaker election Form 8833 2018 Greenberg Traurig, LLP 18
Treaty Tie-Breaker Election Individual must be a resident of a foreign treaty country to have the treaty tie-break rules available. Common residency tie-break rules are applied in the following order until the tie is broken, but it is always important to check the individual treaty: Location of permanent home Center of vital interests (similar to closer connection test) Location of habitual abode Citizenship Must file Form 8833! 2018 Greenberg Traurig, LLP 19
Cross-border Income Tax Issues U.S. Compliance and Reporting U.S. Citizens and Residents Form 1040 Forms 5471 Form 8865 Form 8858 Form 8621 Form 3520A, 3520 Form 3520 Form 706-NA, 706 Form 709 FinCEN 114 Form 8938 Form 8833 Form 1040NR Form W-8BEN Form 8840 Form 8843 Form 8833 All U.S. citizens and residents income Controlled Foreign Corporation (CFC) Foreign partnerships U.S. owned foreign disregarded entity Passive Foreign Investment Company (PFIC) Foreign trusts and certain individual interests in and transactions with foreign trusts U.S. persons receipt of gifts from foreign sources U.S. estates Gifts and generation skipping transfers Foreign Bank Account Reporting (FBAR) Statement of Specified Foreign Financial Assets Treaty based return position Nonresident Aliens All U.S. nonresident alien income must file to claim deductions Reduced withholding Claim closer connection exception to substantial presence test Exclude days of presence from substantial presence test Treaty based return position 2018 Greenberg Traurig, LLP 20
Income effectively connected with the conduct of a U.S. trade or business in the United States (ECI) Taxed at graduated rates Non US-source income is treated as ECI only in rare circumstances Taxpayer must almost always file a return Fixed or determinable annual or periodical gains, profits, and income (FDAP) Subject to gross basis taxation at flat 30% rate Non US-source income is never treated as FDAP Taxpayer is often exempt from filing a return if tax liability is satisfied through withholding at source Tax treaties narrow the scope of the ECI rules and subject FDAP income to reduced rates 23
Two steps: 1) Taxpayer must be engaged in a trade or business within the United States (ETBUS) Law developed largely in case law; requires continuous business contacts with the United States Certain safe harbors apply Taxpayer can be deemed to be ETBUS (e.g., real estate) 2) Determine what income is effectively connected with the US trade or business 24
Employees performing personal services in the US are generally ETBUS Extremely limited safe harbor: Work is performed for NRA, foreign partnership, or foreign corporation not ETBUS or an office of fixed place of business maintained in foreign country; Employee spends no more than 90 days in the US in the calendar year; and Compensation for all work in the US does not exceed $3,000 Potential treaty override 25
Self-employed services provider will generally be considered ETBUS Same safe harbor as for employees Potential treaty override 26
Code provides broad exemption from ETBUS status for trading in stocks, securities or commodities, for the taxpayer s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any employee or agent has discretionary authority to make decisions effective transactions Not available for dealers More limited exception with respect to trading in stocks, securities, or commodities through a resident broker, commission agent, custodian or other independent agent Does not apply if taxpayer has office or other fixed place of business in US through which or by the direction of which transactions are effected 27
Note that if investment is in a partnership interest, the taxpayer is treated as ETBUS if the partnership is ETBUS 28
FIRPTA (section 897 and 1445) Payments deferred into non-etbus year (864(c)(6)) Sale of ETBUS Assets in Later Year (864(c)(7)) Real Property Net Election under 871(d) 29
IRC 864(c) provides rules for treating gross income as ECI US-source FDAP income treated as ECI if it meets one of the following tests Asset use test: income is ECI if derived from assets used in or held for use in the conduct of the U.S. trade or business Business activities test: income is ECI activities of the U.S. trade or business were a material factor in its realization All other US-source income is treated as ECI Foreign-source income is treated as ECI only under rare circumstances Income for personal services is treated as ECI based on workdays spent within and without the US during the year 30
Expenses Connected with ECI Expenses allocable to ECI is a somewhat subjective analysis Apply the rules of Treas. Reg. 1.861-8 Where taxpayer is employee working in the US, deductions allocable to ECI will include state and local income taxes, tax preparation fees and unreimbursed employee expenses Deductions Not Connected with ECI Casualty losses to the extent otherwise allowable under 165(c )(3) with respect to property located within US Charitable contributions to US charities under 170 One personal exemption under section 151 Dependency exemption if alien is resident of Canada or Mexico No standard deduction allowed 31
Subject to gross basis taxation at 30%, largely collected through withholding under section 1441 FDAP generally includes interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income Other limited categories can capture certain gains from the disposition of certain natural resources, OID, and certain IP sales Important exception is interest on qualifying US bank accounts and portfolio debt that is not ECI 32
871(i) exempts deposits at US bank from tax if non-eci Portfolio debt exception applies to interest on obligations if: Obligation is in registered form Beneficial owner statement is received or requirement for statement is waived by secretary Exceptions to portfolio debt exceptions: Where lender is a 10% shareholder or partner For certain contingent interest 33
871(a)(2) imposes tax at the rate of 30% on net USsource capital gains realized if NRA is present for 183 days or more in the taxable year Unlikely to apply, since a person present in the US for more than 183 days is unlikely to qualify as an NRA Whether capital gains are US-source is determined under section 865 Capital gains sourced generally sourced to residence of seller For NRAs, tax home determines residence Note gain from US real property is dealt with separately under the FIRPTA rules of section 897 34
Article 7 of most treaties limits the taxation of business profits to income attributable to a permanent establishment Permanent Establishment includes: 1) place of management, 2) branch, 3) office, 4) factory, 5) workshop, and 6) mine, oil or gas well, quarry or any other place for extracting natural resources 36
Exceptions for the use of facilities solely for: Storage, display or delivery of goods or merchandise Maintenance of stock of goods or merchandise for purpose of storage, display, or delivery Maintenance of stock of goods or merchandise for purposes of processing by another enterprise Maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or collecting information; Maintenance of a fixed place of business solely for the purpose of carrying on activities of preparatory or auxiliary nature Any combination of the above 37
Most treaties exempt income from employment of an resident of the other contracting state if: Employee is in the US less than 183 days in a 12 month period, Remuneration is paid by or on behalf of an employer not resident in the US, and Remuneration is not borne by a US PE 38
Withholding on dividends generally reduced to 15% Withholding on interest and royalties generally eliminated Capital gain on property other than real estate generally taxed to residence of seller as determined under the treaty 39
Disclaimer This communication does not provide legal advice, nor does it create an attorney-client relationship with you or any other reader. If you require legal guidance in any specific situation, you should engage a qualified lawyer for that purpose. Prior results do not guarantee a similar outcome. Attorney Advertising It is possible that under the laws, rules, or regulations of certain jurisdictions, this may be construed as an advertisement or solicitation. 2018 Caplin & Drysdale, Chartered All Rights Reserved. 40
NON-RESIDENT ALIENS TAX PLANNING Presented by: Chaya Kundra, Esq. (Kundra & Associates PC, Rockville, MD) ckundra@kundrataxlaw.com 42
I. DEFINITION OF NON- RESIDENT ALIENS (NRA) A nonresident alien is an alien who has not passed the green card test or the substantial presence test. 43
I. DEFINITION OF NON-RESIDENT ALIENS (NRA) A. Green Card Test The green card test if the taxpayer is a Lawful Permanent Resident of the United States at any time during the calendar year B. Substantial Presence Substantial presence test for the calendar year. To meet this test, the taxpayer must be physically present in the United States (U.S.) on at least: 44
I. DEFINITION OF NON-RESIDENT ALIENS (NRA) CONT. A. 31 days during the current year, and B. 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting: 1) All the days you were present in the current year, and 2) 1/3 of the days you were present in the first year before the current year, and 3) 1/6 of the days you were present in the second year before the current year. 45
II. NRA- ITEMS SUBJECT TO U.S TAXATION A nonresident alien's income that is subject to U.S. income tax is generally divided into two categories: A. Income that is Effectively Connected (ECI) with a trade or business in the United States B. U.S. source income that is Fixed, Determinable, Annual, or Periodical (FDAP) 46
A. EFFECTIVELY CONNECTED INCOME Effectively Connected Income, after allowable deductions, is taxed at graduated rates. These are the same rates that apply to U.S. citizens and residents. This income is to be reported on page one of Form 1040NR, U.S. Nonresident Alien Income Tax Return. 47
A. FDAP INCOME A. FDAP income generally consists of passive investment income; however, in theory, it could consist of almost any sort of income. B. FDAP income is taxed at a flat 30 percent (or lower treaty rate, if qualify) and no deductions are allowed against such income. FDAP income should be reported on page four of Form 1040NR. 48
II. IRS RECENT COMPLIANCE CAMPAIGN AND HANDLING ISSUE- BASED EXAMINATION AND AUDITS FOR NRAS A. The IRS implemented campaigns specifically focused on nonresident alien taxpayer compliance with tax treaty exemption claims, proper deduction of expenses and claiming tax credits. B. This campaign will address noncompliance through a variety of treatment streams including outreach/education and traditional examinations. 49
A. NON-RESIDENT ALIEN TAX TREATY EXEMPTIONS 1. Purpose is to increase compliance in nonresident alien (NRA) individual tax treaty exemption claims related to both effectively connected income and Fixed, Determinable, Annual Periodical (FDAP) income. 2. Concerns have been some NRA taxpayers may either: i. misunderstand or misinterpret applicable treaty articles ii. iii. provide incorrect or incomplete forms to the withholding agents rely on incorrect information returns provided by U.S. payors and improperly claim treaty benefits and exempt U.S. source income from taxation. 50
B. NON-RESIDENT ALIEN SCHEDULE A AND OTHER DEDUCTIONS 1. Purpose: is the proper deduction of eligible expenses by nonresident alien (NRA) individuals on Form 1040NR Schedule A. 2. Concerns: i. NRA taxpayers may either misunderstand or misinterpret the rules for allowable deductions under the previous and new Internal Revenue Code provisions ii. iii. Do not meet all the qualifications for claiming the deduction Not maintain proper records to substantiate the expenses claimed. 51
C. NRA TAX CREDITS Purpose: increase compliance as to: A. NRAs who either have no qualifying earned income, do not provide substantiation/proper documentation, or do not have qualifying dependents may erroneously claim certain dependent related tax credits. B. In addition, some NRA taxpayers may also claim education credits (which are only available to U.S. persons) by improperly filing Form 1040 tax returns. 52
III. PRACTICES FOR COMPLIANCE AND TAX PLANNING TECHNIQUES FOR U.S NON-RESIDENT ALIENS (NRA) A. Deduction from Income 1. The deductions that can be taken against effectively connected income are limited to: i. personal exemptions ii. iii. iv. contributions to US charities casualty and theft losses other expenses that are related to the earning of effectively connected income. 2. Examples of such related expenses are: i. travel expenses incurred in performing services in the United States while temporarily away from home ii. iii. contributions to individual retirement accounts state and local income taxes imposed on effectively connected income. 53
A. DEDUCTION FROM INCOME C O N T. 3. The standard deduction is not allowed to nonresident aliens. 4. Available deductions may be disallowed if tax returns are not filed on a timely basis. 5. Unless the alien is a resident of Canada or Mexico, nonresident alien can deduct only one personal exemption. However, certain treaties allow additional exemptions to be claimed for the spouse and children residing with the alien in the United States (for example, the treaty with the Republic of Korea). 54
B. FILING STATUS A. Individuals who are nonresident aliens at any time during the tax year normally are not eligible to claim head-of-household status and generally may not file a joint tax return. They must use the single filing status or, if married, must file separate tax returns. B. An exception is when a nonresident alien is married to a citizen or resident of the United States. 55
C. TAX TREATIES 1. Most tax treaties will either eliminate or reduce withholding requirements on US income, such as dividends, interest and royalties received by nonresident aliens. i. The applicable treaty, should be reviewed to determine whether the flat 30% tax rate is reduced for the specific type of income. ii. Establish that the recipient is a qualified resident of the treaty partner country. 56
C. TAX TREATIES CONT. 2. Tax treaties may exempt nonresident aliens from US taxation on the following types of income: i. Compensation received from a foreign employer that is not engaged in a US trade or business if the employee is in the United States for fewer than 183 days. Some treaties also contain a dollar threshold for tax exemption; ii. iii. iv. Pensions from former foreign employers; Compensation and pensions received by teachers who are temporarily in the United States; Foreign income received by students and trainees who are in the United States for maintenance, training and education. 57
C. TAX TREATIES CONT. 3. Under many treaties, the foreign national must receive his or her compensation from a foreign employer in order to receive treaty exemptions. Therefore, tax planning must involve consideration of the employee s payroll arrangement. Commonly used treaty benefits are: i. Tax exemption for compensation earned under certain dollar limits or during limited periods of time; ii. iii. iv. Lower rates of withholding for interest and dividend income;. Exemption from social security withholding (under social security totalization agreements); Preferential treatment for capital gains and pension income. 58
C. TAX TREATIES CONT. 4. Planning the timing of income recognition could possibly include: i. Exercising stock options before US residency begins. ii. iii. iv. Accelerating receipt of bonuses or other deferred compensation to a point before or deferring it until after the period of US residency. Deferring recognition of losses until the period when US residency begins, and paying deductible expenses when a US resident. Accelerating recognition of income so as to receive it as a nonresident, before US residency begins. v. Obtaining a step-up in basis before US residency begins by selling and reacquiring appreciated assets. vi. Selling a foreign residence before US residency begins, to avoid US tax on any gain. 59
D. SALE OF PROPERTY BY NON- RESIDENT ALIENS 1. In general, a gain or loss from a sale or other disposition of US real property interests (USRPIs) by a nonresident alien is treated as if it were effectively connected with a trade or business within the United States, regardless of the property s actual use. 2. All nonresident alien individuals regardless of whether they engaged in a trade or business or elected to treat real property income as effectively connected with a trade or business will be treated alike when taxed on gains from sales of real property. Real property may consist of undeveloped land, buildings, residential dwellings, options on land and real estate partnerships. 3. Taxable US real property interests also include stock and other equity interests in certain US corporations that own real property. 60
D. SALE OF PROPERTY BY NON- RESIDENT ALIENS CONT. 4. Any gain from the disposition of a USRPI will be taxed at the graduated rates, limited to a maximum tax of 15% or 20% if the USRPI is a capital asset and the gain is long-term. The higher 20% maximum tax rate applies to individuals falling in the highest graduated income tax bracket (i.e., 39.6%). 5. As with resident aliens, losses can be offset against gains only if the property was actually used in a business or income-producing property 6. Personal-use property does not generate a deductible loss. 61
D. SALE OF PROPERTY BY NON- RESIDENT ALIENS CONT. 7. Upon purchasing a USRPI from a nonresident alien, the purchaser may be required to withhold 10% of the proceeds, to be applied against the seller s tax on the gain. 8. The IRS may agree to lower the rate of withholding if the expected tax would be less than the otherwise required 10%. Withholding does not apply if the sale or exchange falls within a few narrowly defined tax-free exchanges or if the purchaser acquires the property for use as his or her residence and the purchase price does not exceed $300,000. 62
D. SALE OF PROPERTY BY NON- RESIDENT ALIENS CONT. 9. A nonresident alien disposing of his or her US real estate investment should consider a number of other special rules. For example, if the property is sold on an installment basis, the IRS will not generally refund any portion of the 10% tax withheld until the gain is reported in full. 10. Also, if the nonresident alien holds the US real estate in a US partnership, the purchaser will not be required to withhold the 10% tax on the disposition. However, the managing partner of the partnership will be required to withhold 20% of the gain allocable to the nonresident alien partner, regardless of whether any cash is distributed from the partnership. 63
E. ESTATE AND GIFT TAX A. Non-resident aliens can transfer and receive and unlimited amount of intangible personal property The $15,000 annual gift tax exclusion applies to everyone. Non-resident alien can inherit/receive and can then bequeath/transfer any amount of almost every asset type with the exception of real estate, cash, artwork and jewelry. There are no gift taxes and no estate taxes owed on transfers of securities (equities, bonds and business interests), intellectual property and life insurance. Additionally, cash drawn on a foreign bank account in the non-resident alien's sole name but payable by a domestic bank is not subject to gift tax as it is considered a non-u.s. sitused asset (if for more than $100,000, Form 3520 must be filed). 64
ESTATE AND GIFT TAX CONT. Once a visa is secured, one can instantly become a U.S. taxpayer and be required to disclose worldwide assets under the FBAR (reporting signatory authority over or interests in foreign accounts), Form 8938 (reporting foreign assets, including all real estate owned by an entity or a trust) and Form 3520 (reporting foreign trusts and gifts) even if they are a non-resident alien and certainly if they are a resident. Most likely the non-resident alien is going to elect to be treated as a resident for tax purposes to avoid the thirty percent mandatory withholding on U.S. derived income. 65
ESTATE AND GIFT TAX CONT. Once they obtain their visa, many of these clients are likely going to become nonresident aliens (as they may intend to return or in fact do return to their home country), some have no plans to become permanent residents and they are going to have to pay hefty taxes once they transfer their U.S. investment asset upon their death or otherwise. 66
CITATIONS 26 CRF-2.2104-1 26 CRF-2.2105-1 67