TAXATION OF NON-U.S. PERSONS

TAXATION OF NON-U.S. PERSONS

Persons who are neither U.S. citizens nor U.S. residents (nonresident aliens, or NRAs) are subject to U.S. taxes as follows:

A. Income Tax: NRAs are subject to U.S. income tax only on (1) U.S. source “fixed, determinable, annual, or periodical income,” which generally is subject to withholding at a 30 percent rate on a gross basis (with no offsetting deductions), and (2) income that is effectively connected with a U.S. trade or business (“effectively connected income”), which is taxed on a net basis at graduated rates.

U.S. Source Income for Income Tax Purposes (IRC § 871(a))

• Dividends from U.S. corporations, including U.S. mutual funds, but not the proceeds of the sale of most U.S. securities.
• Passive rent from U.S. real property.
  
• Interest on debts of U.S. obligors. However, interest on most publicly traded bonds issued after July 18, 1984 (and private debts in registered form), constitutes “portfolio interest” and therefore qualifies for the portfolio exemption and is not taxed as U.S. source income. (IRC § 871(h)) A similar exception applies to interest on U.S. bank accounts, including time deposits and certificates of deposit, which is not U.S. source income. (IRC § 871(i))
• U.S. royalties.
• Certain limited service payments.

Income Effectively Connected With a U.S. Trade or Business (IRC § 871(b))

NRAs are subject to income tax at the same graduated rates as U.S. persons on their income earned in connection with the conduct of a trade or business in the United States. (IRC § 871(b)) In most cases, this will include wages and other compensation paid for services performed in the United States. This also includes rental income from actively managed properties and passive rental income if the taxpayer makes an election to treat the passive rent as effectively connected income. (IRC § 871(d))

Gains from the sale of interests in U.S. real property, including stock of U.S. real property holding corporations and certain partnerships that hold U.S. real property, are taxed as effectively connected income under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). (IRC § 897) Subject to certain exceptions, buyers of U.S. real property interests are required to withhold 15 percent of the consideration paid to a non-U.S. seller. (IRC § 1445)

A foreign partner of a U.S. or foreign partnership that itself is engaged in a U.S. trade or business will be deemed so engaged through the partnership and will be subject to federal and possibly state return filing obligations. The partnership may be subject to withholding obligations with respect to U.S. source earnings allocated to its foreign partners. (IRC § 1446) Further, the disposition of an interest in a partnership by a non-U.S. person may be taxable under IRC § 864(c)(8) and subject to withholding under IRC § 1446(f) if the partnership is engaged in a U.S. trade or business.

Treaties

Income tax treaties between the United States and other countries can alter these rules, including by reducing withholding rates and making outright exemptions on certain types of income.

B. Estate Tax: Estates of NRAs are subject to U.S. estate tax only on U.S. situs assets. The tax is assessed at the same rates as for U.S. citizens, up to 40 percent, but with only a

$60,000 exemption (as opposed to the 2024 exemption of $13.61 million for a U.S. person). (IRC § 2106 (b))

Worldwide debts and administration expenses may only be deducted if the worldwide estate is disclosed and only in the proportion that the U.S. assets bear to the decedent’s worldwide assets. (Nonrecourse debts are allocated to the properties they secure, but

most commercial lenders prefer a choice of remedies in the event of default, including imposition of personal liability against the borrower, so most third-party loans will be considered recourse debts for this purpose.)

The unlimited marital deduction is only available if the surviving spouse is a U.S. citizen; otherwise, the assets must be left to a qualified domestic trust in order to obtain the deduction (see Section VIII (B) below). The charitable deduction is available only for bequests to U.S. charities, with the exception of trusts that are required to use the funds within the United States.

U.S. Situs Assets (and Exceptions) for Estate Tax Purposes (a Partial List)

• Real property situated in the United States, including houses and condominiums. (Treas. Reg. §§ 20.2104-1(a)(2); 20.2105-1(a)(2))
• Tangible personal property, such as jewelry, antiques, artworks and cars, situated in the United States, unless the items are in transit or on loan for an exhibition at a museum. (Treas. Reg. §§ 20.2104-1(a)(2); 20.2105-1(a)(2))
• Shares of stock of U.S. corporations, including shares of a U.S. cooperative corporation representing a co-op apartment. (IRC § 2104(a)) The location of the certificate and the custody account and the situs of the underlying assets are immaterial. Conversely, shares of non-U.S. corporations are not U.S. situs property even if such corporations hold U.S. situs assets.
• Mutual funds, including money market funds, organized in corporate form are

U.S. situs property if incorporated in the United States, regardless of the situs of the underlying assets. (IRC § 2104(a)) If the fund is structured as a grantor trust, the situs of the fund depends on the situs of the underlying assets of the fund.

• The situs rules are less clear for partnerships, which are not addressed in the Internal Revenue Code or the Treasury regulations. Some older authorities suggest one would look to the underlying assets or where the partnership conducts its business, if any, while other authorities suggest one might look to where the partnership is organized. One may generally assume that interests in limited or general partnerships organized in the United States are likely U.S. situs assets, but the law is not settled regarding the situs of interests in foreign partnerships that either do business in the United States or own assets in the United States.
• Cash deposits with U.S. brokers, money market accounts with U.S. mutual funds and cash in U.S. safe deposit boxes are U.S. situs property. (IRC § 2104(c))
• Debts of U.S. obligors. Once again, however, publicly traded bonds and registered private debt issued after July 18, 1984, qualify as “portfolio debt” and therefore are not subject to U.S. estate taxation if owned by an NRA
  

decedent, provided the decedent was also an NRA for income tax purposes. (IRC § 2105(b)(3))

Life insurance proceeds paid by a U.S. insurer on the life of a non-U.S. person are not U.S. situs property. However, the cash surrender value of life insurance owned by a non-U.S. person on the life of another person is U.S. situs property if issued by a U.S. insurer. (Treas. Reg. § 20.2105-1(g))

• Bank accounts maintained with U.S. banks are not U.S. situs property; this includes checking and savings accounts, time deposits, and certificates of deposit. (IRC § 2104(c))

Again, treaties with various countries can alter these rules, particularly as to whether U.S. stocks owned by a citizen and resident of another country will be taxed by the United States.

Basis Step-Up at Death (IRC § 1014)

Under IRC § 1014(a), the basis of property acquired by bequest, devise, or inheritance or by the decedent’s estate from the decedent is stepped up or down to fair market value at the time of death.

• Non-U.S. situs property held by an NRA at death is eligible for a basis step-up (or step-down) under this provision even though it is not subject to estate tax. (Rev. Rul. 84-139)
• Property that is otherwise includable in the decedent’s taxable estate (for example, U.S. situs assets held in a trust settled by an NRA with certain “retained strings”) is eligible for a basis adjustment at death even if such property does not pass by bequest, devise or inheritance. (IRC § 1014(b)(9))
• Property transferred in trust that is not otherwise includable in the decedent’s taxable estate (for example, non-U.S. situs assets held in a trust settled by an NRA) is eligible for a basis adjustment at death only if certain delineated powers are retained by the decedent during his or her lifetime. (IRC § 1014(b)(2)-(3))

Gift Tax: NRAs are subject to gift tax only on gifts of U.S. situs real property and tangible personal property. The annual exclusion of $18,000 for gifts of a present interest may apply; however, the $60,000 credit afforded to NRAs for estate tax purposes may not be applied to gifts. Gifts of shares of stock of U.S. corporations are not subject to U.S. gift tax even though they have a U.S. situs for estate tax purposes, because the gift tax does not reach gifts of intangible property by NRAs. However, gifts of cash that take place within the United States, possibly including checks drawn from a U.S. account, may be subject to gift tax; therefore, any gifts of cash by a non-U.S. person to a U.S. person should be made outside the United States. (IRC §§ 2501(a)(3); 2511(b))