Last week we discussed sourcing of income, when income is from sources within the USA and when income is from sources without the USA. We are going to devote this issue to the taxation of US source income of NRAs.
US tax residents are taxed on their worldwide income, i.e., all of their income irrespective of source; but nonresident aliens, NRAs, are only taxed on income from sources within the USA, or US source income.
One of the reasons I want to touch on NRA taxation at this point, even though our readers are mostly US persons, is because in 2020 a record number of US citizens surrendered their US citizenship.
Close to 6,000 citizenship renunciations were reported by the IRS in the first 2 quarters of 2020. Per IRS records, this number is already higher than the total number of citizenship renunciations in any past complete year.
The IRS does not report the reasons for renunciation, but it is clear that 2020 will be a record year. It already is. This is not a record to brag about.
Despite the reasons not being disclosed, it is generally accepted that one of the main reasons US citizens living abroad decide to renounce US citizenship is the complexity of the citizenship-based taxation rules. Like Snoopy, they want to be removed from the IRS’ mailing list.
When US citizens give up their citizenship, therefore, their expectation is that they won’t need to file a US tax return ever again. The same expectation applies to green card holders who surrender their green cards.
Is this a realistic expectation?
Both former US citizens and green card holders are unlikely to have to file a US resident tax return again, unless they spend too many days in the USA and become tax residents under the SPT (check CBP No. 19 for a refresher on the Substantial Presence Test if you need it), but they may need to file a nonresident tax return, 1040-NR, if they have income from sources within the USA.
Given the larger number of US citizenship renunciations this year, I thought this would be an appropriate time to discuss when these former citizens and green card holders may need to file US 1040-NR nonresident tax returns.
The answer is our Key Tax Insight #6:
“NRAs may need to file US tax returns if they have ECI or FDAP income”, or alternatively:
“If you are an NRA, you better to know your ECI and FDAP income rules!”
What is ECI and what is FDAP income?
ECI and FDAP are the two categories of US source income taxed to a nonresident alien.
ECI stands for EFFECTIVELY CONNECTED INCOME, and
FDAP stands for FIXED or DETERMINABLE, ANNUAL or PERIODICAL income
I know what you are thinking: those words still mean nothing to me. English please!!!
Effectively connected income (ECI) is when an NRA engages in a trade or business in the USA and earns income connected with the conduct of that trade or business. What is key here is that the trade or business be conducted within the US borders, i.e., inside the USA
What are some be some examples of ECI?
- An NRA artist travels to the USA to perform in a movie filmed in California. The compensation the actor receives for their performance is Effective Connected Income in a US trade. The trade being the trade of being an actor.
- An NRA opens a branch of their foreign business in New York, hires US staff and sells products to US clients. The profit from the branch is Effectively Connected Income. The business is a US business and the income it earns was generated within the USA.
- An NRA is a member in a US partnership that conducts US business activities. Similar to the example above, but with multiple business owners.
- An NRA sells their US home, whether that home was a rental property or vacation home. If there is a gain on that sale, that gain is ECI.
- An NRA rents a US home and makes an election to treat the rental activity as a US trade or business. We will see later on, rental income is by default FDAP income. However, an NRA may choose away from FDAP treatment and elect the rental income to be treated as ECI. Why would an NRA want to do that?
Because ECI is taxed at progressive tax rates and deductions are generally allowed against ECI. FDAP instead is taxed at fixed rates, the default is 30%, and it is taxed at the gross level, with no deductions allowed. ECI treatment can therefore result in lower tax imposed on the income.
If there is a choice between ECI treatment or FDAP income treatment, barring a tax treaty, ECI treatment will almost always be better for the NRA taxpayer.
Sometimes, if the NRA is a resident of a country with which the USA has an income tax treaty, the treaty may reduce the rate of tax applicable to the ECI or exempt the ECI from US taxation altogether.
For example, paragraph 1 of Article 17 of the income tax treaty between the USA and France establishes that if a French artist or sportsman comes to the USA for a performance, and receives no more than $10,000 in total compensation, that income is exempted from taxation in the USA.
If the income earned from the performance exceeds $10,000, then the USA has the right to tax the entire amount. If it is $10,000 or less, per the treaty, it can’t tax any of it.
If an NRA has ECI, this will generally result in the requirement to file a US Form 1040-NR tax return.
Why is this?
Because ECI generally allows deductions from income, and deductions must be reported on a tax return in a certain manner, in order to be allowed. If the NRA wants to make an ECI election, this election needs to be made on a tax return also. If the NRA filed a W8-ECI with the US payor, the income is usually exempt of tax withholding and the tax return is needed to report the income, relevant deductions and pay the resulting tax, if any.
One very common example when NRAs file US tax returns is when they are partners in a US partnership. When a US partnership has foreign partners, the partnership is a withholding agent and it is required to withhold income tax at the highest marginal tax rate (37% in 2020) on the partnership income attributable to the foreign partner. By filing a US tax return, in such cases, the NRA can request the refund for the excess withholding.
Let me give you an example: A foreign partner with $100,000 of income from a US partnership would was withheld $37,000 of US income tax by the partnership and received $63,000 in cash. However, taxed at progressive tax rates, the tax on the $100,000 of partnership income is only $20,000. The NRA files a 1040-NR and claims a refund of the $17,000 withheld in excess ($37,000 withholding – $20,000 tax return tax = $17,000 refund due).
The NRA is not required to file the 1040-NR but it would be silly not to do it in this situation. It would be the equivalent of gifting the $17,000 refund to the US government. Very few NRAs feel that level of generosity towards the US Tresury!
Other than ECI, NRAs are taxed on FDAP.
FDAP income is income that:
- Is fixed or for which the amounts to be paid are known in advance (for example: US rent of $1,800/month)
- Is determinable or there is a basis for figuring the amount to be paid (for example: interest that is paid at a rate of 1.5%/year)
- Is annual or paid yearly (for example a US trust distribution made every March 5th to the foreign beneficiary)
- Is periodic or paid from time to time, in regular or irregular intervals (for example dividends on US stocks)
The most common examples of FDAP income include:
- Prize and awards
FDAP income is generally subject to 30% withholding tax by the US payor. Tax treaties can reduce the rate of tax withholding to 0% to 15%, depending on the payor, the payee and the type of income.
For individual NRAs the most common reduced treaty withholding tax rate is the rate on US dividends, which is 15%. NRAs who are tax residents of treaty countries need to file Form W8-BEN with the payor of the US dividend to claim the reduced rate of withholding under the relevant treaty.
NRAs will want to file a US tax return, Form 1040-NR, when they are entitled to a refund of part of their withholding. For example, if an NRA, who is a Spanish resident, receives $50,000 of US dividends and their broker withholds at the standard rate of 30%, the NRA can file a 1040-NR to claim a refund of 50% of the withholding. This is possible because the treaty rate is 15%, not 30%. This NRA would get $7,500 refunded by the IRS by filing a 1040-NR and claiming the dividend treaty rate.
The best way to avoid having to file a US tax return if you are an NRA with US source income is to ensure the correct rate of tax withholding is applied on that income.
In the example above, if the Spanish resident had filed a W8-BEN to claim the 15% reduced treaty withholding rate, the US broker would have withheld the reduced amount of tax, No 1040-NR would have been needed to be refunded the difference between the default withholding rate and the treaty rate.
Let’s summarize what we learned today:
- NRAs, including former US citizens, foreign spouses of US citizens and former green card holders, pay US tax on their US source income.
- US source income earned by an NRA is classified as either Effectively Connected Income (ECI) or Fixed or Determinable, Annual or Periodic (FDAP) income
- ECI is taxed at progressive rates and allows deductions, there may or may not be tax withholding (Form W8-ECI) and generally results in having to file a US tax return, Form 1040-NR
- FDAP income is generally taxed at a 30% rate on gross income with no deductions unless a lower treaty rate applies. Form 1040-NR can be filed to claim a refund of excess tax withholding.
- If the NRA claims the relevant treaty withholding rate using Form W8-BEN, the US Form 1040-NR is generally not needed.
- NRAs can make their lives easier by making sure they are filing the right W8 forms to avoid excess tax withholding.
- When an NRA does not live in a treaty country, the default withholding tax rates apply and no 1040-NR would be required by the non-treaty country NRA.
So NRAs, don’t forget:
“If you are an NRA, know your FDAP and ECI rules” and
“File your W8 Form to avoid having to file a US tax return”
With this, I leave you until next week.