Can Foreign Investors Be In The U.S. Without Being Here For Income Tax Purposes? by Joseph L. Saka, CPA/PFS
Posted on September 13, 2016
A fragile global economy and political uncertainty continue to fuel the United States’ status as the world’s most attractive location for foreign investment. However, investors chasing positive returns, high yields and portfolio diversification face a tricky U.S. tax system that may provide tax-savings opportunities in some instances and significant income-tax traps in others.
Contrary to popular belief, the U.S. system of taxation is not based on an individual’s immigration status nor does it imply that a resident for tax purposes is a permanent resident of the United States. For example, while it is true that non-U.S. persons will generally pay U.S. income tax only on U.S.-source income or income effectively connected with a U.S. trade or business, foreign individuals may inadvertently become subject to U.S. taxes on their worldwide income when they meet certain tax residency tests. Similarly, a foreign investor may escape U.S. taxation on their worldwide income when they plan appropriately in advance of stepping on U.S. soil.
For income tax purposes, foreign individuals are categorized as resident aliens or non-resident aliens based on whether or not they meet certain tax residency thresholds, including the primary Substantial Presence Test.
Substantial Presence Test
A foreign person will be considered a U.S. tax resident subject to the same income tax laws as U.S. citizens when they have a “substantial presence” in the U.S. More specifically, the U.S. will impose taxes on a foreign individual’s worldwide income when he or she is physically present in the states for 183 days or more during a tax year, or a minimum of 31 days during a calendar year and 183 days or more over the past three years. According to the Tax Code, an individual need not spend the requisite 183 days consecutively; rather the Internal Revenue Service (IRS) relies on a three-year weighted formula to determine one’s substantial presence in the country. Moreover, the U.S. often counts an individual’s travel days coming into or leaving the country towards his or her physical presence, unless the individual is commuting for work to the U.S. from a residence in Canada or Mexico.
While foreign individuals may be diligent in counting and limiting the number of days they spend in the U.S. to avoid meeting the substantial presence threshold, there are a number of other ways that they may qualify as exempt from this rule.
Exceptions to the Substantial Presence Test
Closer Connection/Tax Home. Foreign persons who meet the Substantial Presence Test may be treated as non-resident aliens for U.S. income tax purposes when they maintain a tax home in a foreign country during the year and can demonstrate that they had a closer connection to that country than they had to the U.S.
A tax home may be a house where one permanently resides or it may apply to the location of one’s business or employment. The IRS’s definition of a closer connection is more ambiguous, but it does consider a number of facts and circumstances to determine if such a link exists. They include the types of forms filed by the individual, the country of residence designated on those forms and the following:
- The location of an individual’s permanent home, which must be available to the individual at all times during the calendar year
- The location of the individual’s family members
- The location of the individual’s personal belongings, such as clothing, jewelry and automobiles
- The location of the social, political and religious organizations with which the individual associates
- The location where the individual conducts business activities, other than his or her tax home
- The location of the jurisdiction where the individual holds a driver’s license
- The location of the jurisdiction where the individual votes
Meeting these qualifications should prove simple for many foreign investors seeking to maintain their status as non-resident aliens for U.S. tax purposes. However, it is prudent for investors to seek the advice of a U.S.-based tax accountant before taking any action that could lead to significantly different tax liabilities than they had planned.
Regardless of whether the facts substantiate the utilization of the closer-connection exception, if a taxpayer surpasses 182 days in the year that he or she desires the exception to apply, the non-resident will not be able to utilize the exception and would be taxed on worldwide income.
Tax Treaties. If the closer-connection exception is not an option because of the number of days an individual spent in the U.S., he or she may have another chance to qualify as a non-resident for U.S. income tax and avoid having to file and pay taxes on worldwide income. For example, an individual who qualifies as a resident of the U.S. and of another country may be subject to the tax laws of both jurisdictions. When a tax treaty exists between the two countries, investors should identify if there is a tie-breaker provision that resolves the conflict and allows them to benefit from potentially more advantageous tax treatment in the foreign country. When this is the case, the investor will need to file a U.S. tax return to make the election. However, it is important to remember that while the taxpayer will not be considered an income-tax resident for paying tax on worldwide income, the taxpayer may instead be considered an income tax resident for other provisions of the Tax Code. As a result, he or she may need to file information reporting forms in addition to a U.S. tax return.
Students, Teachers and Trainees. Citizens of a foreign country may exclude some of the days and years they are present in the U.S. if they or their immediate family members have visas, including F visas, J visas, M visas or Q visas, to study, teach or train in the United States. Generally, the exemption is available for five years; however, any portion of a calendar year counts as an entire year. For example, if an individual enters the U.S. on a qualifying student visa in August of 2016 and stays until May 2021, he or she would be considered to utilize the exemption for six years, even though the actual time is less than five years.
To qualify for an F-1 visa, individuals must be enrolled as full-time students in a U.S. college or university, high school, elementary school, seminary, conservatory or other academic institution that culminates in a degree, diploma or certificate of completion. In addition, foreign investors may qualify for an F-1 visa and exclude the days they are present in the U.S. when they are enrolled in a language-training program, which applies to any language, be it English, Spanish, Hebrew or Mandarin. However, the student visa exception can get tricky. U.S. tax authorities may review an individual’s compliance with the visa requirement, and they reserve the right to disallow the exemption.
The J-1 visa is applicable for individuals who participate in a U.S. work-study exchange program that is sponsored by a nonprofit or educational entity, including an au pair program, summer camp, graduate medical school or research institutions. In addition, holders of J-1 visas may include foreign students spending time in the U.S. for an internship or foreign professionals in the U.S. for career training.
Medical Condition. While no one wants to become ill or incapacitated while visiting a foreign country, the IRS provides a narrow exception to the Substantial Presence Test for those individuals who require medical care and/or become unable to leave the U.S. due to a medical condition that occurred stateside. A foreign person who meets these rather restrictive regulations may exclude from the Substantial Presence Test those days that the medical condition preventing them from leaving the country.
Professional Athletes and Foreign Diplomats. Professional athletes who travel to the U.S. to participate in charitable sporting events may exclude from the Physical Presence Test those days that they actually compete; training days may not be excluded. Foreign persons considered diplomats or full-time employees of international organizations are excluded completely from the Substantial Present Test when they are in the U.S. on a temporary basis for official diplomatic activities.
Individuals who are not classified as U.S. tax residents are generally considered nonresident aliens subject to U.S. tax only on U.S. source income and income effectively connected with a U.S. trade or business. When capital gains are not effectively connected with a U.S. trade or business, they are typically not taxable to the nonresident alien. However, there is an exception to this rule when the nonresident alien is present in the U.S. for 183 days or more in the current year. In general, if a nonresident alien is present in the U.S. for 183 days or more in the current year, his or her U.S. source capital gains are subject to a 30 percent tax.
Foreign persons must take the time to plan far in advance of their intent to invest, study, work or conduct business in the United States in order to minimize the risks of being classified as U.S. resident aliens for income tax purposes. Should they fail to do so, they may be liable for U.S. taxes on all wages, interest, dividends, rental income and income from all other sources they earn throughout the world, and not just those earned in the U.S. Advance planning is also beneficial for individuals who obtain a favorable visa and who may become subject to taxable capital gains and other potential pitfalls that will generate addition tax in the U.S. A certified public accountant (CPA) with experience in international tax issues for individuals and businesses is the best resource to begin the planning process.
About the author: Joseph L. Saka, CPA/PFS, is co-CEO of Berkowitz Pollack Brant and co-director-in-charge of the firm’s Tax Services practices. He provides a full range of income and estate planning, tax consulting and compliance services, business advice, and financial planning services to entrepreneurs, high-net-worth families and family companies and business executives in the U.S. and abroad. He may be reached in the CPA firm’s Miami office at (305) 379-7000 or via e-mail at firstname.lastname@example.org.