U.S. Taxation of Foreign Investment James W. Standard, Jr. Hall Booth Smith, P.C. 191 Peachtree Street, Suite 2900 Atlanta, GA 30303 jstandard@hallboothsmith.com (404) 954-6977

Inbound Taxation – In General Inbound transaction – one in which foreign person (FP) earns U.S. connected income FP consists of: Nonresident alien individual (NRA) Foreign corporation (FC) 2 main types of income subject to tax from inbound transactions Income effectively connected with the conduct of a trade or business in the US (ECI) §871(b) (NRA); §882(a) (FC) US-source fixed or determinable annual or periodic income (FDAP income) which is not ECI §871(a) (NRA); §881(a) (FC)

Taxation of ECI and FDAP income Taxed on a net income (TP may deduct expenses and losses from gross income and is only taxed on net income) Taxed at the same rates applicable to US taxpayers §1 (NRA); §11 (FC) FDAP income (which is not ECI) Taxed on a gross income (TP may not deduct expenses and losses from gross income) Taxed at a flat rate of 30% §871(a)(1) (NRA); §881(a) (FC) This tax is required to be withheld by any person having “control, receipt, custody, disposal or payment” of the income §1441(a) (NRA); §1442 (FC)

Who is a nonresident alien? NRA is a person who is not a US citizen or US resident 2 basic tests to determine if FP is a resident alien Green card test - Person has been admitted to US as lawful permanent resident Substantial presence test - Person is resident alien in a particular calendar year if He is present in US for at least 31 during that calendar year, and Weighted count of his days in US for that year and 2 previous years is at least 183 days Current year: Number of days present 1st prior year: Number of days present * 1/3 2nd prior year: Number of days present * 1/6

What is a foreign corporation? Any corporation not organized under the US or under the law of any individual state or District of Columbia

Sourcing of Income - Interest Interest is US source if obligor is US government, US corporation or US non-corporate resident §861(a)(1) US source interest is generally subject to 30% withholding tax §871(a)(1)(A) (NRA); §881(a)(1) (FC) Exception to withholding tax on interest Interest on bank deposits - §871(i)(2) (NRA); §881(d) (FC) Portfolio interest - interest paid on a registered obligation (such as a corporate bond) - §871(h)(1) and (2) (NRA); §881(c)(1) and (2) (FC) Portfolio interest does not include Interest paid to 10% or greater shareholder - §871(h)(3) (NRA); §881(c)(3) (FC) Interest which is dependent on certain contingencies - §871(h)(4) (NRA); §881(c)(4) Interest received by a controlled foreign corporation by a related person - §881(c)(3)(C) (FC)

Sourcing of Income – Dividends Dividend from US corp is US source §861(a)(2)(A) Dividend from FC is US source if: At least 25% of its gross income for the preceding 3 years was ECI, or Dividends paid out of earnings and profits which FC acquired from a domestic corporation, or For purposes of determining the foreign tax credit, dividends were subject to a dividends received deduction §861(a)(2)(B) and (C) US source dividend is generally subject to 30% withholding tax §871(a)(1)(A) (NRA); §881(a)(1) (FC)

Sourcing of Income – Personal Services Income from labor or services performed in US is US source §861(a)(3) Such income may be subject to 30% withholding tax §871(a)(1)(A) (NRA); §881(a)(1) (FC) However, as a practical matter, such income unlikely to be subject to withholding tax Such income is usually ECI Characterization of income can determine whether it is subject to US tax Royalty v. Services Interest v. Services

Sourcing of Income – Rents and Royalties Rents and royalties from property, or interests in property, located in US are US source §861(a)(4) This rule applies equally with respect to tangible and intangible property (e.g. patents, copyrights, trademarks, etc.) Place where IP is used, or where licensee has right to use IP, determines where royalty is sourced Royalty income may be allocated among more than 1 source depending on relative value of use rights Gain from the sale of IP treated as royalties for purpose of determining source if payments contingent upon productivity, use or disposition of IP §865(d)

Sourcing of Income – Real Property Dispositions Gain from sale or other disposition of an interest in US real property is US source §861(a)(5) FP may elect to treat the US real property interest as ECI §871(d) (NRA); §882(d) (FC)

Income Effectively Connected with US Business – In General In order for US source income of FP to be subject to US net basis taxation, 2 requirements generally must be met: FP must be engaged in a US trade or business (ETB requirement) The subject income must be effectively connected to that US trade or business (ECI requirement) If these requirements are met, US source income is taxed on net basis FB may deduct expenses from gross income, and is taxed only on resulting taxable income at regular progressive rates to which US persons are subject If these requirements are not met, US source income taxed on a gross basis 30% flat withholding tax Tax is on gross income, without taking into account expenses incurred in production of income

Engaged in a US Trade or Business (ETB) “Trade or Business” is not defined under the Code or Regs Implies regular, continuous and considerable business activities As distinguished from activities which are sporadic or passive ETB distinguished from pure investment activities E.g. managing investments for one’s own account not ETB If FP is generally ETB, even minimal business activities in US will be subject to US tax But, income from those activities must also be ECI to be subject to US tax Certain ancillary activities conducted in US by FP may not be ETB Investigating business opportunities in US Purchasing products in US for resale abroad without maintaining US office Internet sales to US customers without active solicitation or maintaining US office

ETB – Agency Principles FP may be treated as ETB dues to activities of agent If agent is independent, his activities are generally not imputable to principal If agent is dependent, his activities are generally imputable to principal Factors in making distinction Degree of control principal has over agent Amount of business agent derives from principal Amount of economic risk agent assumes

ETB – Personal Services Performance of personal services in US, to any extent, is generally ETB §864(b) De minimus exception TP not present in US for more than 90 days during taxable year, Aggregate compensation for those services does not exceed $3,000, and TP performs services either for FP which is not ETB, or US person’s office outside of US Exception for foreign government employees §893(a)

ETB – Trading in Stocks, Securities or Commodities Trading in stocks, securities or commodities not ETB if FP trades for his own account, whether through agent or not, OR Trading is conducted through resident broker, commission agent, custodian or other independent agent, AND FP does not have a US office through which such trading is conducted or directed §864(b)(2)

ETB - Real Property Transactions Dispositions of US real property interests Gain or loss treated as if FP ETB and gain or loss is ECI §897(a) Other income from US real property interests Renting real property can be a passive activity which is not ETB Active management of real property can constitute ETB Availability of election FP can elect to treat income as ETB if the investment would not otherwise be ETB §871(d) (NRA); §882(d) (FC) Election allows FP to take advantages of deductions for determining US tax liability

Effectively Connected Income (ECI) Once it is determined that FP is ETB, must then determine whether income is effectively connected (ECI) with the conduct of that trade or business Only ECI is entitled to net basis taxation (taking deductions into account) §871(b); §882(a)(1) US source income which is neither FDAP income nor capital gain is considered ECI §864(c)(3) US source income which is FDAP income or capital gain is ECI if either It was derived from assets used in or held for use in FP’s US business, or The FP’s business were a material factor in the realization of such income §864(c)(2)

ECI – The Force of Attraction Principle IF FP is ETB, US source income which is not FDAP income or capital gain is ECI §864(c)(3) “Residual force of attraction” principal Particularly important where FP’s US source income is derived from sale of inventory

ECI – US Source FDAP Income and Capital Gain: Asset Use Test If US source income derives from asset used or held for use in FP’s US business, it is ECI Asset must be directly related to US business Asset must be needed for present business needs of US business, as opposed to anticipated future needs of US business Treas. Reg. §1.864-4(c)(2) Stock held by a US business not considered to be an asset used in or held for use in conduct of trade or business Treas. Reg. §1.864-4(c)(2)(iii)(a) This test is generally applicable in context of passive income

ECI – US Source FDAP Income and Capital Gain: Business Activities Test If FP’s US business was a material factor in producing the income, the income is ECI This test is generally relevant in the following contexts Dividends or interest derived by dealers in securities Royalties derived from the active conduct of a business licensing IP Fees derived from a service business Treas. Reg. §1.864-4(c)(3)(i)