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Tax Consequences of U.S. Investments for Non-U.S. Citizens

Ten questions and answers to help non-U.S. investors understand the U.S. tax system.

summary

  • If you are a non-U.S. citizen considering an investment in the United States, a better understanding of the U.S. tax system may help you avoid the unintended application of U.S. taxes.
  • The U.S. federal government imposes not only income tax, but also transfer tax, including estate, gift, and generation-skipping taxes.
  • Cross-border planning increasingly requires an awareness of the implications of international family relationships, investments, trusts, and entities.

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WHAT A GLOBAL FAMILY NEEDS TO KNOW

If you are not a United States ("U.S.") citizen (or a U.S. resident/domiciliary) and are considering an investment in the United States, you may have questions about the U.S. tax rules. The U.S. federal government imposes not only income tax, but also transfer tax, which includes estate, gift, and generation-skipping transfer ("GST") taxes.

There is also the question of double taxation. Will your home country impose tax over and above the taxes that you pay in the United States? Or, is there a tax treaty or foreign tax credit that can provide tax relief? Finally, privacy also is a key concern for many, so it is important to understand tax filing and reporting obligations.

This paper answers 10 questions that can help the non-U.S. individual investor better understand the U.S. tax system, and provides takeaways that may help mitigate the unintended application of U.S. tax.

Please note that you should always discuss any desired U.S. activity with a professional tax advisor and / or international legal counsel before making any decisions to properly understand the U.S. tax implications of your particular situation.

tax consequences chart

1. DO THE FEDERAL INCOME TAX CONSEQUENCES OF MY INVESTMENT DEPEND ON HOW MANY DAYS I SPEND IN THE UNITED STATES?

Yes. For income tax purposes, U.S. residents are taxed as U.S. citizens, which means the U.S. resident is taxed on his or her worldwide income, even if the income is earned outside the United States. Thus, a non-U.S. citizen who avoids U.S. residency status may achieve certain tax benefits.

A U.S. resident is a Green Card holder or someone who meets the "substantial presence test."

The substantial presence test looks at whether the non-U.S. citizen is physically present in the United States for at least 31 days during the current year, and then takes the sum of (a) the days physically present in the United States during the current year, plus (b) one-third of the number of days physically present in the United States during the first preceding calendar year, plus (c) one-sixth of the number of days physically present in the United States during the second preceding year. If this formula equals or exceeds 183 days, then the non-U.S. individual is a U.S. resident.

tax consequences chart

Note that the substantial presence test can be overcome if the individual can prove that, based on all facts and circumstances, he or she has a closer connection to a foreign country than to the United States.

TAKEAWAY: If you are not a U.S. citizen or green card holder, then spend 121 days or less in the United States each year in order to prevent U.S. income tax on your worldwide income.

2. DO THE FEDERAL TRANSFER TAX CONSEQUENCES OF MY INVESTMENT DEPEND ON HOW MANY DAYS I SPEND IN THE UNITED STATES?

No. Transfer tax (gift, estate, and GST) consequences for a non-U.S. citizen depend on whether the individual is domiciled in the United States or not domiciled in the United States. A U.S. domiciled individual is an individual who has relocated to the United States indefinitely with no current intentions of leaving. In contrast, a non-U.S. domiciled individual is an individual who does not intend to remain in the United States permanently. The individual may be in the United States temporarily, may have children living in the United States, or may own real estate in the United States, but, as long as he or she intends to return home, he or she will escape the full burden of the U.S. transfer tax system.

Notably, an individual who spends an average of 183 days in the United States may face all of the income taxes that a U.S. citizen faces because he is a U.S. resident, for income tax purposes. But, as long as the individual intends to return home, he will not face all of the transfer taxes that a U.S. citizen faces because he is not a U.S. domiciliary.

TAKEAWAY: To prevent having to pay the U.S. transfer tax, be prepared to show that you intend to return to your home country. Owning real estate in your home country and maintaining business and social relationships there help prove intent.

3. IF I AM NOT A U.S. RESIDENT, DO I STILL OWE U.S. INCOME TAX ON U.S. INVESTMENTS?

Yes, but only on U.S. source income, not on all worldwide income. U.S. source income falls into two categories: "ECI" or "effectively connected income" and "FDAP" or "fixed or determinable annual or periodical gains, profits, and income."

ECI arises when a non-U.S. resident conducts a trade or business in the United States. All U.S. source income that is "connected" with that U.S. trade or business is ECI. There is no bright line test for when commercial activity rises to the level of a U.S. trade or business. But, the U.S. taxing authorities (the "Internal Revenue Service or "IRS") generally will find a U.S. trade or business when commercial activity is considerable, continuous, regular, and substantial.

FDAP generally includes interest, dividends, rents, and royalties. Capital gains are not FDAP income. However, the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA") imposes U.S. income tax when a non-U.S. resident sells (a) U.S. real estate, or (b) shares in corporations that own significant real estate. Additionally, a non-U.S. resident who sells an interest in a partnership (including an LLC taxed as a partnership) will be taxed on whatever amount of capital gain, if any, that is attributable to assets used in a U.S. trade or business.

ECI: EXAMPLE

A non-U.S. resident invests in a private equity fund, and the private equity fund invests directly in U.S. businesses. The fund and the businesses are U.S. limited liability companies ("LLCs") that are treated as partnerships for U.S. federal income tax purposes. Absent further measures to "block" or prevent U.S. tax, the non-U.S. investor could receive a percentage of the net profits from the underlying U.S. businesses via the private equity fund. These profits would be ECI because they come from a U.S. business. Thus, the non-U.S. investor could owe U.S. income tax on the profits, which are ECI.

tax consequences chart

TAKEAWAY: Portfolio composition matters. If you want to minimize U.S. income tax, consider investments in U.S. corporate debt, U.S. government debt, U.S. corporate stock, and U.S. bank deposits.

4. IF I HAVE U.S. SOURCE TAXABLE INCOME, WHAT IS THE TAX RATE?

ECI is taxed at ordinary U.S. individual income tax rates, which can be as high as 37%.

FDAP is taxed at a flat rate of 30%. And, unlike ECI, FDAP is a tax on the gross amount of income. This is in contrast to ECI, which is a tax on net income.

FIRPTA gain is taxed like ECI, meaning that ordinary individual income tax rates apply to net gain.

tax consequences chart

In addition to these federal income tax rates, individual U.S. states may also impose income taxes. A full discussion of state income taxes is beyond the scope of this piece.

5. IF I AM NOT DOMICILED IN THE UNITED STATES, AM I SUBJECT TO U.S. FEDERAL ESTATE TAX?

Yes, but only on assets located in the United States. The gross estate of a U.S. citizen or U.S. domiciliary includes the value of all of the individual's property, real or personal, tangible or intangible, and wherever in the world it may be situated. In contrast, a non-citizen, non-domicilary's gross estate only includes property that is situated in the United States.

Often, it can be difficult to tell when assets, particularly intangibles, are located in the United States. This chart provides some examples of U.S. and non-U.S. property:

tax consequences chart

TAKEAWAY: Keep personal valuables like jewelry and artwork in your home country in order to avoid U.S. estate tax.

6. IF I AM NOT DOMICILED IN THE UNITED STATES, AM I SUBJECT TO U.S. FEDERAL GIFT TAX?

Yes, but only on tangible assets that are located in the United States. Whereas the U.S. estate tax applies to all U.S. assets, the U.S. gift tax only applies to U.S. assets that are tangible. Examples include real estate and tangible personal property such as jewelry.

TAKEAWAY: The discrepancy between the U.S. estate tax rules and the U.S. gift tax rules means it could make sense to give away U.S. situs intangible assets before death so that they are not included in the U.S. estate and subject to U.S. estate tax at death.

7. ASSUMING I OWE U.S. FEDERAL TRANSFER TAX, WHAT IS THE RATE?

The top estate, gift, and GST tax rate is 40%.

EXAMPLE

Although a U.S. citizen does not pay estate tax until his or her assets exceed $10 million, adjusted for inflation ($11.18 million in 2018), a non-domiciliary only can exclude the first $60,000 of assets from the estate tax.'

tax consequences chart

Additionally, a non-domiciliary can deduct funeral expenses, administration expenses, losses, and debts from his or her U.S. gross estate, just like a U.S. citizen or U.S. domiciliary. However, only expenses that are attributable to the U.S. assets are deductible. This means that, in order to calculate and claim the deduction, the non-U.S. citizen subject to U.S. estate tax must tell the IRS on a U.S. estate tax return the total value of the decedent's worldwide assets. In many instances, executors for non-domiciliaries choose to forgo the estate tax deduction because they do not want the IRS to know the decedent's full financial picture. The fear is that once this information is disclosed to the IRS, the United States will turn the data over to the decedent's home country under one of its mutual exchange of information agreements.

For U.S. federal gift tax purposes, a non-domiciliary can give $10,000, adjusted for inflation ($15,000 in 2018) to an unlimited number of people each year free of gift tax. This number is $100,000, adjusted for inflation ($152,000 in 2018) for gifts to a non-U.S. citizen spouse.

For U.S. GST tax purposes, a non-domiciliary has the same lifetime exemption amount as a U.S. citizen ($11.18 million in 2018, adjusted for inflation). This means he or she can transfer $11.18 million during life or at death without owing GST tax.

TAKEAWAY: Calculate whether the value of the U.S. estate tax deduction is worth having to disclose all of your worldwide assets to the IRS.


Non-Domiciliary Gift Tax Limits

$15,000 annually to unlimited recipients

$152,000 annually to a non-U.S. citizen spouse

Non-Domiciliary GST Tax Limits

$11.18 million transferred during life or at death


8. IF I AM NOT DOMICILED IN THE UNITED STATES, AM I SUBJECT TO U.S. FEDERAL GST TAX?

Yes, but only on assets located in the United States. The GST tax applies a tax on transfers to beneficiaries that are more than one generation removed ("skip persons"). Grandchildren are the classic example. These multi-generational transfers are taxed on the theory that, if the assets had passed from parent to child at the parent's death, and then again from child to grandchild at the child's death, the government could collect estate tax not only when the parent dies, but also when the child dies. The GST ensures that the child cannot avoid estate tax by asking the parent to transfer the asset directly to the grandchild.

The general rule is that if a non-US domiciliary would have been subject to U.S. estate tax or gift tax on a transfer, then the transfer may also be subject to GST tax as well, but the GST tax cannot be imposed on transfers that were not first subject to U.S. estate or gift tax.

9. IF I INVEST IN THE UNITED STATES, WILL I HAVE TO FILE A U.S. FEDERAL TAX RETURN?

It depends. Filing obligations are as follows:

tax consequences chart

10. IF I PAY TAXES IN THE UNITED STATES, WILL I ALSO PAY TAXES IN MY HOME COUNTRY?

It depends. If the home country has any income, social security or transfer tax treaties with the United States, the treaty rules can mitigate double taxation. The home country laws also may grant tax credits for U.S. taxes paid. A tax advisor in your home jurisdiction can provide additional information.

CONCLUSION

The confluence of the global economy, international investment, and personal mobility in the modern day has resulted in a wealth and tax planning landscape that is dynamic, to say the least. Cross-border planning increasingly requires an awareness of the implications of international family relationships, investments, trusts, and entities.

Suzanne L. Shier

Wealth Planning Practice Executive & Chief Tax Strategist/ Tax Counsel
Suzanne L. Shier is the Wealth Planning Practice Executive and Chief Tax Strategist/Tax Counsel for Wealth Management at Northern Trust and serves on the Wealth Management Operating Group.