Determining whether a foreign alien individual is a resident for federal income tax purposes is crucial to determine how this individual will be taxed in the United States.

In general, foreign nationals who are considered resident aliens for U.S. federal income tax purposes are taxed in the same manner as U.S. citizens – i.e., they are taxed on their worldwide income. Foreign nationals who are considered nonresident aliens for U.S. federal income tax purposes, on the other hand, are subject to U.S. tax only on income derived from sources within the U.S. and/or income that is effectively connected with a U.S. trade or business.

Whether or not a person is considered a U.S. resident is determined by whether they pass the substantial presence test. According to this test, a person is considered a U.S. resident for federal income tax purposes if they are physically present in the U.S. for either:

• 183 days in the current year, OR
• 31 days during the current year and 183 days during a 3-year period that includes the current year and the two years immediately before that, including:
• All the days physically present in the current year
• 1/3 of the days physically present in the first year before the current year
• 1/6 of the days physically present in the second year before the current year

There are a number of exceptions that may be applicable in determining whether one is a U.S. resident, such as the “closer connection” exception or tax treaty benefits, but these exceptions are the subject of a future blog.

A nonresident alien individual is considered a U.S. resident if he or she is not a U.S. citizen or green card holder and if he or she does not meet the substantial presence test.

Once a determination has been made that a foreign alien individual is a nonresident for U.S. federal income tax purposes, the next step is to determine if he or she will be taxed in the U.S.

DETERMINING TAXATION OF U.S. SOURCE INCOME

A nonresident alien individual must first determine whether he or she has income sourced to the U.S. If so, the nonresident alien individual must then determine how that income is treated for U.S. income tax purposes.

Sourcing of Income

Nonresident aliens’ income is either U.S. source or foreign source. The sourcing depends on the type of income. The source of income is determined based on U.S. rules and takes into consideration double tax treaties, if applicable.

Although the table above applies to most cases, treaties may change the sourcing of these types of income. In some cases, an income item that would otherwise be sourced to the under domestic U.S. rules may instead be sourced to the treaty partner and exempt from U.S. taxation.

FDAP Income v. ECI Income

Nonresident alien individuals are subject to tax on their U.S. source income, but the tax rate applicable is determined by whether the income is fixed, determinable, annual, periodic (FDAP) income or effectively connected income (ECI).

FDAP income is one of the following types of income:

• The amounts paid have to be known ahead of time (fixed)
• There is a basis for assessing the amounts to be paid (determined), OR
• The income is paid from time to time (periodic)

Generally, FDAP income refers to passive income.

FDAP income is taxed at a 30-percent flat rate on a gross basis, which means that nonresident alien individuals cannot claim deductions on that income. Tax treaties may lower or eliminate the tax on most FDAP income items.

FDAP includes income items such as compensation, dividends, interests, rents and royalties, unless the income is considered to be ECI.

ECI results from a foreign person being engaged in a trade or business in the U.S. According to the U.S. Tax Code, a U.S. trade or business is only partially defined, but there has been extensive case law that clarifies what is a U.S. trade or business.

Generally, the activity must be “considerable, continuous and regular.” For a nonresident alien individual, a U.S. trade or business generally takes the form of an activity held in the U.S. as a sole proprietor or through a single-member LLC that is disregarded for U.S. income tax purposes. It may also take the form of an interest in a partnership, U.S. or foreign, that has a U.S. trade or business.

The focus for computing ECI is on where the key income-producing activity occurs. Three types of ECI can be derived by a nonresident alien individual that is actually engaged in a U.S. trade or business:

• FDAP income from sources in the U.S. is treated as ECI if the income meets either the “asset use” or a “business activities” test:
  • The asset use test is met if the income is derived from assets used or held for use in the conduct of a U.S. trade or business.
  • The business activities test is met if the activities of the U.S. trade or business were a material factor in the realization of the income.
• All other U.S. source income under the limited force of attraction rule.
• Foreign source income is generally not treated as ECI but there are exceptions for certain types of income that are attributable to a U.S. office or fixed place of business.

ECI is taxed net of deductions and at graduated rates (up to 37 percent for individuals). It is important to note that tax treaties may provide a different definition of whether specific activities rise to the level of having a presence subject to taxation (known as permanent establishment).

REPORTING U.S. SOURCE INCOME

Generally, nonresident alien individuals are subject to withholdings by the payor of the income (withholding agent). Withholdings ensure the collection of the U.S. tax liability of persons over which the U.S. may not have jurisdiction. Withholdings under U.S. tax rules will be subject to a different article.

Nonresident alien individuals are also subject to filing requirements under specific scenarios. If applicable, nonresident alien individuals must file Form 1040-NR, U.S. Nonresident Alien Income Tax Return:

• A nonresident alien engaged in a trade or business in the U.S. during the year must file even if:
• The U.S. trade or business did not generate income
• The U.S. trade or business did not generate U.S. source income
• The U.S. trade or business generated income exempt under a U.S. income tax treaty
• A nonresident alien not engaged in a trade or business in the U.S. during the year,
• Who received passive income from U.S. sources, AND
• Not all the U.S. tax that was owed was withheld from that income, OR
• A refund is being claimed on that withholding

In various areas, U.S. tax filings for nonresidents differ from those of U.S. residents. For instance, married nonresident alien individuals cannot file a joint return, and nonresident alien individuals cannot take a standard deduction. Nonresident alien individuals can only take itemized deductions that are limited as compared to those available for U.S. residents.

Generally, Form 1040NR is due on June 15 (or Dec. 15 when extended) unless the nonresident received wages subject to U.S. income tax withholding. In this case, Form 1040NR is due on April 15 (or Oct. 15 when extended).

Please contact GHJ’s International Tax Services Team for a more comprehensive discussion of the tax implications of being a nonresident alien individual and related tax planning considerations.