If you are a nonresident alien, you are taxed only on your U.S. source income you have earned. This U.S. Source income is further categorized into:
Effectively Connected Income
Generally, when a foreign person engages in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be Effectively Connected Income (ECI). This applies whether or not there is any connection between the income, and the trade or business being carried on in the United States, during the tax year.
Generally, you must be engaged in a trade or business during the tax year to be able to treat income received in that year as ECI. You usually are considered to be engaged in a U.S. trade or business when you perform personal services in the United States. Whether you are engaged in a trade or business in the United States depends on the nature of your activities. Deductions are allowed against ECI, and it is taxed at the graduated rates or lesser rate under a tax treaty.
Fixed, Determinable, Annual, or Periodical (FDAP) Income
Also known as Passive Income, this Income is fixed when it is paid in amounts known ahead of time. Income is determinable whenever there is a basis for figuring the amount to be paid. Income can be periodic if it is paid from time to time. It does not have to be paid annually or at regular intervals. Income can be determinable or periodic, even if the length of time during which the payments are made is increased or decreased.
The following items are examples of FDAP income:
- Original issue discount
- Pensions and annuities
- Real property income, such as rents, other than gains from the sale of real property
- Scholarships and fellowship grants
- Other grants, prizes and awards
- A sales commission paid or credited monthly
- A commission paid for a single transaction
- The distributable net income of an estate or trust that is FDAP income, and that must be distributed currently, or has been paid or credited during the tax year, to a nonresident alien beneficiary
- A distribution from a partnership that is FDAP income, or such an amount that, although not actually distributed, is includible in the gross income of a foreign partner
- Taxes, mortgage interest, or insurance premiums paid to, or for the account of, a nonresident alien landlord by a tenant under the terms of a lease
- Prizes awarded to nonresident alien artists for pictures exhibited in the United States
- Purses paid to nonresident alien boxers for prize fights in the United States
- Prizes awarded to nonresident alien professional golfers in golfing tournaments in the United States
- Payments to U.S. parties when an nonresident alien entertainer has rights to the performance
F.D.A.P. incomes are taxed at 30 percent or lower tax treaty rate as applicable.
Types of Nontaxable Interest Income
As per IRC subsections 871(h) and (i), Nonresident aliens are not taxed on certain kinds of interest income, provided that such interest income arises from one of the following sources:
- A U.S. bank
- A U.S. savings and loan association
- A U.S. credit union
- A U.S. insurance company
- Portfolio Interest
Types of Nontaxable Capital Gains
The United States boasts a developed financial market with a huge amount of investment coming from Nonresident aliens. Also, capital gains form a major part of your investment returns and therefore you would be curious to know what is the capital gains tax on your investments in the United States.
The following discussion assumes that the capital gains in question are not effectively connected with the conduct of a trade or business in the United States. If this is the case, then the capital gains are taxed at the regular resident tax rates.
To understand the capital gains taxation, you first need to understand the sourcing rule for capital gains taxation which states that for resident aliens, capital gains are sourced within the United States only if the individual does not have a “tax home” in a foreign country. For nonresident aliens, capital gains are sourced outside the United States unless the individual has a “tax home” in the United States.
Aforesaid, the sourcing rule does not apply to real estate properties which are automatically sourced in the United States.
For our analysis, we have bifurcated nonresident aliens into following persons:
1. Nonresident aliens who invest in the United States and do not hold any visa or either come to the United States on a visitor visa
If you fall under this category then the IRS welcomes you and your investment wholeheartedly and treats the complete capital gains you make (other than real estate) as a nontaxable income in the United States as you will have a tax home outside the United States.
2. Nonresident aliens who come to the United States either as a student (F1 visa), or as scholars (J1 visa) or are employees of foreign governments (G1 visa)
Most foreign students, foreign scholars, and alien employees of foreign governments and of international organizations in the United States are considered to be “exempt individuals.” That is, they are exempt for extended periods of time from counting days of presence in the United States for the purposes of determining whether they are resident aliens of the United States.
Thus, most foreign students, foreign scholars, and the alien employees of foreign governments and of international organizations in the United States remain nonresident aliens in the United States for extended periods of time.
A flat tax of 30 percent was imposed on U.S. source capital gains in the hands of nonresident alien individuals physically present in the United States for 183 days or more during the taxable year. This 183-day rule bears no relation to the 183-day rule under the substantial presence test of IRC section 7701(b)(3).
For example, a foreign diplomat, consular officer, or other nonresident alien employee of a foreign government, or nonresident alien employee of an international organization, who is visiting the United States in A or G nonimmigrant status for a period longer than 183 days in a calendar year would be subject to the 30 percent tax on his/her U.S. source capital gains – even if he/she continues to be a nonresident alien per the “exempt individual” rules under the substantial presence test. The same rule applies to a foreign student or scholar visiting the United States in F, J, M, or Q nonimmigrant status whose presence in the United States equals or exceeds 183 days in any calendar year.
Thus, under this rule, most foreign students and scholars and most alien employees of foreign governments and of international organizations have shifted tax homes to the United States on the day of their arrival in the United States – unless the particular program or employment which brings them to the United States clearly terminates in less than one year and they have no intention to remain in the United States after the termination of such program or employment.