Bus 225D – International Transactions II Instructor: Carol Rutlen, CPA

2 Key Points Taxation of nonresident alien (and foreign corporation) –US source –Effectively Connected Income (ECI) –Non ECI Foreign currency translation –Qualified business unit –Foreign income taxes

3 Nonresident Alien - Income Effectively connected (ECI) –Connected to a US trade or business Compensation for personal services (sourced based on where services are performed) Profits from operation of business in US Income from partnership doing business in US Income from real property (if election is made to treat as effectively connected) Sale of US real property Sale of business-related capital assets Interest, dividends, etc. from assets or activities of US trade or business –Taxed at regular graduated rates

4 Nonresident Aliens – Deferred Payments §864(c)(6) – Treatment of Certain Deferred Payments, Etc. – Income or gain of a NRA or foreign corporation which (A) is taken into account for any taxable year, but (B) is attributable to a sale or exchange of property or the performance of services in any other taxable year Shall be made as if such income or gain were taken into account in such other taxable year

5 Nonresident Alien - Income Not effectively connected –Investment income –Passive income –Examples Dividends Interest Rents and royalties Alimony Limited capital gain –Taxed at flat 30% rate or lower treaty rate Exempt from US taxation –Interest on deposits with banks §871(h) and (i) –Certain portfolio obligations –Most capital gains

6 Nonresident Alien – Capital Gain §871(a)(2) – interaction with §7701(b)(2) –If NRA is in US 183 days, all US source capital gains are taxable –If NRA is in US < 183 days, no US source capital gains are taxable Exception –Gain on sale of US real property interests –§865(a)(2) gain from sale of personal property sourced on tax home

7 Nonresident Alien - Deductions Itemized deductions allowed only for expenses connected to ECI (e.g., state income tax) –Casualty losses to property located in the US –Contributions to US charities –Allowed only against effectively connected income No standard deduction Only one personal exemption No deduction/credit for foreign taxes MFS rates, no head of household or MFJ rates

8 Nonresident Alien – Filing Requirements §864(b)(1) – No US tax if the alien earns less than $3000 and is in the US for less than 90 days § (b)(2)(i) – NRA not engaged in trade or business in the US at any time during the taxable year are not required to file US return if the tax liabilities are fully satisfied by withholding at source § (b)(1)(i) – NRA engaged in US trade or business must file returns even if –No effectively connected income or domestic source income is recognized or –Income is exempt by statute or treaty

9 Nonresident Alien - Taxability Taxed when received, not when earned or accrued Potential treaty benefits for dependent personal services –Typical requirements Must be tax resident in home country Cost must be borne outside of the US Must not be present in US for more than 183 days –Economic employer rules – primarily in Europe

10 F, J, and Q Visa Granted to alien students, scholars, trainees, teachers, professors, etc. and their spouses and children for the purpose of teaching, instructing, lecturing, studying, observing, etc. Section 872(b)(3) –No federal tax is imposed –Taxpayer must be paid by foreign employer J visa holders days exempt 7701(b)(5)(A) –Not counted in substantial presence test –7701(b)(5)(E) – not treated as exempt if for any 2 calendar years during the preceding 6 calendar years the person was exempt –Compensation qualified under 872(b)(3) not treated as exempt if for any 4 calendar years during the preceding 6 calendar years the person was exempt No FICA taxes

11 F, J, and Q Visa - states California, PA do not follow these rules PA has domicile requirement plus permanent abode/183 day rule NYS follows Federal

12 Dual Status Arrival – US resident for part of year that begins with residency start date; nonresident before that date Departure – US resident for part of year the ends with residency end date; nonresident after that date Doesn’t apply if you make election to be treated as a full year resident

13 Dual Status During residency period taxed on worldwide income received –Follows residency rules –Includes amounts earned while nonresident, but received while resident During non-residency period taxed as nonresident Tax treaty provisions usually limited to nonresident period

14 Dual Status Itemized deductions –Allowed for period of residence –Deductions against non-ECI income limited Standard deduction – considered NRA; not available Combine ECI and all income while a resident to determine tax under graduated rates Foreign tax credits claimed for residency period

15 Dual Status Exemptions –Taxable income for period of residency: 1 exemption –Spouse: 1 exemption if has no gross income and isn't the dependent of another taxpayer –Dependent: exemptions allowed –Exemptions for spouse and dependents can’t exceed taxable income for the period of residency –Special rules of Canada, Mexico, or Korea apply Can’t use Head of Household Can’t file joint return –Married residents of Canada, Mexico, or Korea may file single if live apart from spouse during last 6 months of the year

16 Full Year Resident vs. Dual Status Before Assignmt During Assignmt Total Salary Deductions Exemptions $50,000 -1,000 -6,800 $100, ,700 -6,800 Taxable Inc$42,200$82,500 Tax FTC $6, $13,479 -6,740 Tax after FTC$6,968$6,739

17 Community Property Rules General definition Disregarded if – –both H & W are NRA –H or W is NRA and other is US citizen or RA –Separate property income Earned income Trade or business Partnership income

18 Filing Status Resident alien – file 1040 Nonresident alien – file 1040 NR Dual status –Both a resident alien and a non resident alien in the same year –Usually applies in arrival and departure year –Income/deductions is separated into RA and NRA –Taxed when received, not when earned –Claim itemized deductions during RA period –Can’t claim standard deduction –Personal exemptions for self, spouse, and dependents –Single – single, no head of household –Married – MFS, unless elects to be taxed as full-year residents

19 Practical Issues Year of arrival –Resident at year end, 1040NR under 1040 –Full year resident only 1040 Year of departure –NRA at year end, 1040 under 1040NR –Tax on 1040 carries to 1040NR 1040NR filed with IRS in Austin, TX Social security numbers –If alien has a valid visa, they must get a social security number Must go to social security office while in the US and file Form SS-5 If they don’t get SSN while in US, then they need to go to the embassy to obtain a SSN Can’t qualify for an ITIN –If not eligible for SSN, apply for ITIN Form W-7 For tax processing only Doesn’t entitle recipient to social security benefits

20 Sailing Permits Foreign citizens must obtain a certificate of compliance before permanently departing from the US –Departure permit or sailing permit –Part of Form 1040C or Form 2063 –Must be filed before leaving –Exemption for diplomats, alien students, industrial trainees, exchange visitors, and others who have no income subject to tax –All US tax due up to date of departure must be paid Form 2063 – short information form § (b) –No taxable income for year of departure and for preceding year –RA who continue resident status in the US –RA who received taxable income in current year or preceding year and whose departure will not hinder the collection of tax. Regular income tax return still required for year of departure Practical answer – no one files

21 Planning a Transfer Timing of transfer Timing receipt of income –Sale of principal residence –Sale of other capital assets –Exercise of stock options Timing the payment of deductible expenses

22 Withholding on US-Source Non-Business Income Persons subject to withholding –Nonresident alien individuals –Foreign corporations –Foreign partnerships –Foreign estates and trusts §1441 income subject to withholding –Fixed or determinable, annual, or periodical –Derived from sources in US 85% of the social security benefits received by NRA are subject to 30% withholding tax §871(a)(3)

23 Withholding on US-Source Non-Business Income Applicable tax rate –30% –Except Portfolio interest Disposition of US real property interest Foreign partner’s distributive share of partnership’s ECI 14% withholding rate for certain scholarships and fellowships received by NRA Treaties, usually 15% Reported on 1042S

24 Withholding on US-Source Non-Business Income Withholding agent –Obligated to withhold –Any person having control, receipt, custody, disposal, or payment of an item of US-source non-business income to a foreign person Corporations distributing dividends Debtors paying interest Tenants paying rent Licensees paying royalties –Agent liable for uncollected tax –Form W-8, W-8BEN or W-9 submitted to withholding agent –Deposits tax and files annual informational return

25 Withholding on US-Source Non-Business Income Administrative matters –Potential for abuses US citizens NRA –Reduced withholding tax rates under US income tax treaties are only available to non-US beneficial owners that reside in a treaty country –Withholding agent (payor) can rely on submitted documentation –If payee fails to provide adequate documentation Presumption that payee is US person 28% backup withholding

26 Withholding on ECI Withholding not required on US-source income effectively connected with US trade or business Personal services: withholding exemption doesn’t apply unless compensation is –Subject to standard wage withholding –Exempt from withholding §3402 –Received by self-employed resident of Canada or Mexico –Exempt from tax by reason of a treaty exemption –Subject to a withholding agreement ECI for foreign partner in partnership –Withhold tax at specified rate for partner –Maximum tax rate for individual or corporation –Partnership remits quarterly tax payment

27 Foreign Corporations Created/organized in another country May be classified as different type of entity How to market products in US How will foreign company be taxed

28 Foreign Corporations Taxed on –Non-effectively connected income –Effectively connected income Similar to NRA rules Tax treaties address PE issues Choice of entity/type of operations –US subsidiary –Branch State tax issues

29 Foreign Corporations Basic planning –Interplay of tax laws in each country –US tax on US sourced income –Foreign tax credits –Repatriating profits Future classes will cover –Controlled foreign corporations (CFC) –Foreign personal holding companies (FPHC) –Passive foreign investment companies (PFIC

30 Foreign Currency Translation US tax liability determined and paid in US $ §985(a) taxpayer generally must make all US tax determinations in functional currency –Usually US $ –Foreign currency is the functional currency if QBU (qualified business unit) Economic environment is in the foreign country Maintains books and record in foreign currency Non QBU –Transactional exchange gains and losses arise when the exchange rate fluctuates between the time a transaction is entered into and when it is closed out –Translate each part of transaction at appropriate exchg rate If QBU functional currency not US$, profit (loss) translated into $ at avg exchange rate

31 Foreign Currency Translation Always a QBU (separate and clearly identified unit of a trade or business) –Corporation –Partnership, trust, and estate Not a QBU –Activities of an employee –But activities of an individual conducted as a sole proprietor if foreign currency is used and books and records maintained in foreign currency can constitute QBU

32 Qualified Business Unit Example: foreign rental property If QBU –All income and expense of property –Converted at weighted average exchange rate for the year Who can elect: taxpayer who has not had foreign rental income or loss in prior year Who can’t elect –Reported prior foreign rentals –Doesn’t meet requirements, i.e., separate books and records

33 Foreign Currency Translation Adoption of functional currency is method of accounting –Once adopted must be used for all subsequent taxable years –Can apply for permission to change – usually granted only if currency changes for US financial reporting §988 entire gain or loss arising from disposition of a nonfunctional currency is treated as an exchange gain or loss –For US tax purposes, only US $ is money –Other currency treated as property with a tax basis –Transactions with debt instruments, receivables, or payables accounted for separately from gain or loss on underlying transaction –Character: ordinary income or loss –Source: Tax home of taxpayer or QBU –§988(e) personal transaction: no exchange gain unless gain exceeds $200 per transaction

34 Foreign Income Tax §986(a) Accrual basis – translate into US dollars at the average exchange rate for the tax year EXCEPT –Foreign tax paid more than 2 years from the close of the tax year –Foreign tax paid in a tax year prior to the year to which they relate –Foreign tax paid in inflationary currency Cash – translated using exchange rate on the date of payment –Adjustment to the amount of the taxes is translated using the exchange rate at the time the adjustment is paid –Refund or credit – use exchange rate when the original payment made

35 NRA – Estate Tax $60,000 exemption for estate tax purposes ($13,000 unified credit) On property situated in US –Stock in US corporations –Unexercised options –US property Potential estate treaty benefits

36 Key Points Taxation of nonresident alien –US source –Effectively Connected Income (ECI) –Non ECI Foreign currency translation –Qualified business unit –Foreign income taxes

37 Contact Information Carol Rutlen