Abstract
The purpose of the research paper will be to look at taxation issues that affect non-US citizens in the country. The first aspect will be to look at which residents in the United States are subject to paying taxes and which of their incomes earnings will be taxed under the US tax law system. The tax exemptions for these groups of people will also be analyzed by looking at which part of the resident’s income is exempted from taxation.
The various taxation issues that affect non-US residents or aliens will also be assessed and analyzed with regards to how the issues affect the alien who earns their income within the borders of the US. The appropriate technique to deal with these issues will also be looked at which has been identified to be taxation treaties between the US and the country the non-US resident resides in.
Introduction
As globalization increases around the world, the need for understanding taxation based on jurisdiction and residency continues to gain more prominence. Taxing people who are not citizens has created taxation problems as well as jurisdictional issues. These issues have arisen at both the state and international level within the United States for citizens who are either residents or non-residents. The two principles which are applied when dealing with taxation within the U.S. include the residency and source principle. The residency principle determines the residency of the party be taxed while the place that the income has been earned is known as the source principle.
The residency principle states that individuals or companies who meet the jurisdiction’s rules of residency are subject to pay taxes according to that jurisdiction’s guidelines on taxation. The source principle entails the jurisdiction where the income-producing taxable event is carried out (Escoffier & Fortin, 2008).
Many countries around the world use the source principle when it comes to determining which foreign individuals and companies will pay taxes according to the income they have earned within the country’s borders. Some countries however use the residency principle to tax the income of resident citizens and companies that operate within the country’s borders. This creates a taxation issue where individuals who work in one country and earn an income in another country are taxed twice a concept referred to as double taxation.
Countries such as the U.S. are grappling with the multi-jurisdictional taxation issue of whether to tax non-U.S. citizens who work in the country but earn their income in their home countries. They also face the issue of which country should tax the international worker’s income, should it be the home country or the international country where the employee is earning an income.
Taxpayers Subject to US Taxation
The people who are subject to taxation in the United States include U.S. citizens, resident aliens or foreigners who have permanent residency, and U.S. companies. A resident alien is referred to as an individual who is not a U.S. citizen but has established residency in the country by obtaining a green card or resident visa after meeting the criteria for residency set out by the United States immigration department. Individuals who do not meet the criteria for permanent residency in the U.S. are referred to as non-U.S. citizens or non-resident aliens (IRS.gov, 2010).
In certain cases, non-resident aliens are required to file their tax returns with the U.S. tax department while at other times they have the option of choosing whether they want to file their tax returns or not (Lymer & Hasseldine, 2002). The income that is earned by non-U.S. citizens can be categorized into three groups which are effectively connected income or U.S. business income, non-US business income and the United States investment income which includes taxation on items such as interest, royalties and dividends at a rate of 30 percent. The taxation rules that apply to U.S. citizens also apply to non-U.S. citizens and foreign corporations that are based in the country.
Foreign. companies are taxed on their business income or effectively connected income that results from the sale of goods or services that have been produced in the United States. The business income that is exempt from taxation is the income that is generated from activities that are not related to the US (Escoffier & Fortin, 2008).
The tax returns of a non-resident alien who is married to a U.S. citizen or a resident are filed separately regardless of their marital status. The non-resident however has the option of deciding whether their worldwide income will be taxed as a U.S. resident or a non-U.S. alien because of their marriage to the U.S resident or citizen. Such an option will provide the non-resident and their spouse the alternative of filing joint tax returns at a lower rate than the stipulated 30%. Foreign corporations can establish their presence in the U.S. by opening office branches or establishing foreign subsidiaries in the country. The profits or losses that are earned by these branches or foreign subsidiaries combined with the income and loss of the companies other operations are subject to U.S. taxation (Escoffier & Fortin, 2008).
The foreign subsidiary office allows the corporation to conduct its business operations in the foreign country. These foreign subsidiaries are also referred to as controlled foreign corporations (CFC). CFCs are usually owned by 50 percent of the company’s shareholders. The parent company of the CFC is not usually taxed on the earnings that are generated by the foreign subsidiary office unless these earnings are brought back to the parent company’s country of operation. These earnings can only be repatriated to the company in the form of dividends which are then added to the corporation’s income (Escoffier & Fortin, 2008).
The parent company is entitled to a foreign tax credit that will be based on the income tax that has been paid by the subsidiary company. The parent company has tax exemption on its income earnings as long as it does not receive any repatriated earnings from the foreign subsidiary office in the form of dividends. There are certain forms of foreign income earned by the CFC that do not have to be repatriated to the parent company for taxation purposes.
An example is the subpart F income which is treated as a constructive dividend that is taxed even though it is not repatriated to the parent company. The subclass F income consists of dividends, royalties, interest, and foreign-based income. This class of income is taxed in a similar way to that of income earnings that are generated by a flow-through entity. Since the parent company is taxed on the Subpart F income in the country where the earnings have been made, it does not face taxation again if the foreign subsidiary office pays its dividends (Escoffier & Fortin, 2008).
Jurisdictional issues when it comes to taxing non-resident aliens do not only occur on an international level but also on a state level. Most states in the U.S. impose a personal income tax and corporate taxes on citizens who are both resident and non-residents. People are taxed according to the income they have earned within the state of residency or the property that they own within the state. If a resident who resides in one state generates their income in another state within the U.S., the individual will be subject to double taxation on their income from both states. Systems have however been developed to reduce the cases of double taxation where states that tax their residents who work in other states allow them to claim tax credit from the state where they earn their income (Escoffier & Fortin, 2008).
For foreign corporations based in certain states within the U.S., the state has the right to impose income tax on that corporation based on the residency principle. If the foreign business has an economic connection that enables it to derive its income from resources or assets that are located within the state, the state has the right to tax the corporation based on the source principle of taxation in the U.S. The type of relationship that the foreign corporation and the state has with regards to the state’s right to tax is referred to as nexus (Escoffier & Fortin, 2008).
Non U.S. Resident’s Tax Exemptions or Exclusions
Given the increasing mobile population that is composed of people seeking residency in other countries and international travelers who want to work and reside in other countries, the issue of whether to tax them in the country of intended residency or the home country has always arisen. Visitors to the United States may be subject to taxation on their incomes as long as they fall into the category of resident or non resident aliens (Lymer & Hasseldine, 2002). A non- U.S. citizen is termed as a resident once they gain a permanent residency card also referred to as a green card. This card is can only be gained once the non U.S. citizen completes a substantial presence test (IRS.gov, 2009).
Once they become a resident, their world wide incomes are subject to taxation. They are also entitled to receive deductions and tax credits that are similar to those received by U.S. citizens. Non resident aliens who do not have a green card are subject to have their income taxed based on U.S. sources and the deductions or tax credits they are entitled to are always limited (IRS.gov, 2009). If the non alien’s country has a taxation treaty with the U.S., then their income will be taxed at a lower rate than 30 percent (Isla Associates, 2009).
Resident and non resident citizens are exempt from being taxed on certain aspects of their income. Resident aliens in the U.S. are exempt from paying foreign earned income and housing allowances that are paid by U.S. citizens. These tax exemptions apply to those residents who have been in the country for 330 full days. Non resident aliens are exempt from having some forms of their income from being taxed. These exemptions cover items such as scholarships, grants, personal services offered to foreign employers such as babysitting, housecleaning or catering services. The amount of money that can be taxed from the scholarships or grants is the amount that exceeds the total cost of tuition and the expenses that come with course (IRS.gov, 2010).
The non resident alien is exempt from paying taxes on their income if they have worked for the foreign employer for less than 90 days and have earned an income of $3,000 and less. Foreign students and exchange visitors who have worked for a foreign employer that is based in the U.S. are exempt from having their incomes taxed. Non resident aliens also get tax exemption on their incomes if a foreign government has a tax treaty with the U.S. government that has a provision that allows for tax exemptions (Lymer & Hasseldine, 2002).
Other than personal tax exemptions, non U.S. citizens can be able to claim exemption for their spouses or dependents if they are either a Mexican, Japanese, South Korean or Canadian citizen. They can also claim tax exemption if they are in the U.S. for study or business purposes. For the resident to claim tax exemption, their spouse should not be working or earning any form of income. They should also state in the tax exemption form that they are dependent on the working resident’s income.
Dependents have the same qualification criteria for exemptions similar to those of U.S. citizen dependents. Residents who are not citizens in the United States are entitled to itemized tax deductions on items such as injury, theft losses, income and state taxes as well as contributions to charitable organizations. These deductions are effected on the basis that their income earnings are connected to the type of work or business they are performing within the U.S. borders (Lymer & Hasseldine).
The non resident citizens can also claim tax credits on items such as child care, foreign tax and earned income credit. If any or all of these tax credits are claimed then the non resident’ tax liability is considerably reduced. Taxes that have not been prepaid or have been withheld from the income source can be categorized as tax credits in the tax returns form. If the tax has been paid in excess or it has been withheld by the income source, the non resident is entitled to receiving a refund of the balance after the tax has been deducted from their income (Lymer & Hasseldine, 2002).
Non resident aliens who have property or holdings in the U.S. are expected to comply with the taxation rules in the country which are enforced by the U.S. tax authority, the IRS and the U.S. Congress. These rules apply to non U.S. resident’s who have been in the country for less than 183 days. During the 183 day period, the non resident owes tax on their investment income earnings according to the U.S. tax rules which are no taxes on bank interest; an exemption which covers regular accounts with credit unions, savings and loans, no taxes on the non resident’s portfolio interest, and no tax on capital gains which include both short term and long term gains (Menkov et al, 2010).
The exemption from tax in regards to capital gains is applied if the non resident has resided in the United States for less than 183 days. The capital gains will therefore be subject to a taxation of 30 percent. Such a provision applies to foreign students who have a source of income in the U.S. such as a scholarship or grant that is meant to last for one year and more. Any dividends that the non resident alien holds as well as portfolio interests are subject to 30 percent taxation or a lower rate than 30% if the foreigner’s country holds a taxation treaty with the U.S. (Isla Associates, 2009). The tax can also be withheld by a tax broker who later sends it to the U.S. government. No personal deductions can be applied against the investment income of the foreigner (Menkov et al, 2010).
Taxation Issues that affect Non U.S. Citizens
A new international tax bill that was formulated in Washington has created taxation issues because of the new provisions that have been included in the bill. These new provisions have changed the international tax provisions that were in use by the U.S. tax department by eliminating the Extraterritorial Income Act that provides tax relief to non U.S. citizens. Since the worldwide income of foreigners is subject to taxation within the U.S., tax systems have been designed to provide tax relief to the residents and non residents income earnings. Tax relief comes in two forms which are the limited deferral of U.S. taxation on income that has been earned outside of the U.S. and taxation on the foreign income (Prysock, 2002).
Another taxation issue that affects non U.S. citizens is the issue of residency and worldwide taxation of income earnings. As stated earlier, the U.S. taxes the worldwide income of its citizens, residents and non-residents. The issue arises in determining the residency status for income and transfer purposes from the income tax rules which outline the standards that will be used to assess the resident’s status. A resident of a foreign country qualifies for taxation in the U.S. once they obtain a green card. Determining the residency status of residents and non residents in the U.S. becomes complicated when income and tax transfers are affected by the regulations of tax treaties (Everest Group, 2008).
A taxation challenge that will affect non U.S. citizens will be the recently enacted exit tax law which applies to citizens who have been residents of the U.S. for an extended period of time otherwise referred to as long term residents (LTR). For a non resident to qualify as a LTR, they have to have earned an average worldwide income of $2,000,000 for the duration of their stay, their net income for 5 years preceding expatriation exceeded $139,000 and they should have failed to file Form 8854 that is meant to certify their tax compliance with the U.S. federal tax laws for the last five years.
The exit tax law is meant to provide an immediate mark to market taxation on deferred compensation items, property owned in the U.S., and tax interests on foreign trusts. The mark to market taxation provision has a $600,000 dollar exclusion that is available for built in gains. There is however no tax exclusion available for items that are under the special income tax provisions. The new exit tax laws take effect on the last day of the resident’s green card expiration date. Because of this it limits the any tax relief’s that the LTR qualifies for under the income tax treaty between the resident’s home country and the U.S. The items that were subject to taxation in the exit law might be subjected to taxation years after the LTR has left the U.S. This might create a situation where the LTR faces double taxation when they leave the U.S. (Everest Group, 2008).
When people decide to work in other countries, they have to consider how they are going to handle their financial investments and dispose of their personal wealth. If the investment interests of the individual go beyond their home country, then problems will arise as to how these investments will be managed in the new country. Problems arise for residents who want to migrate to the U.S. because the financial planning system for investments in their home country cannot be translated to the U.S. tax and financial system without any errors or issues arising.
The financial system of the home country will handle investments in a different way when compared to the financial system in the United States. The home country’s tax system has strategies that are best suited to meet the individual’s income tax and investment needs. The tax system in the U.S. might therefore seem to not meet the resident’s needs as it is designed for U.S. citizens only. The system does not put into consideration the international client who might want to invest and pay taxes in the U.S. (Everest Group, 2008).
In the U.S., it is a general rule for foreign citizens to pay estate tax as long as they have assets in the U.S. that exceed $60,000. The assets that U.S. residents and non residents can hold in the country include U.S. pension funds, real estate property, personal property, 401(k) plans, company stocks, investments in U.S. securities and deferred compensation plans. Having these assets does not however qualify one for tax relief under the tax treaty.
The residents or non residents also face higher estate tax rates which are currently 45 percent. U.S. citizens who are married will get all of the assets of the first spouse once they die tax free while those who are non U.S. citizens will have an unlimited deduction on the estate tax. This might create a liquidity crisis for the non U.S. alien where the surviving spouse is forced to liquidate all the family’s assets at the death of the first spouse so that they can be able to pay the estate tax. This might leave the surviving spouse and family with little to live on (Everest Group, 2008).
There is a system that has been set up to deal with deferred payments on the estate tax where the assets or property are put in a qualified domestic trust. These trusts are however expensive to maintain, manage and they also limit the surviving spouse’s expenditure as the income tax can only be used by the surviving spouse without having to pay any estate tax. If the surviving spouse is a non U.S. citizen who does not have any form of employment, he or she is likely to return to their home country leaving their assets or property in the hands of a U.S. trust. This becomes a burden as they have to make payments to ensure that their assets are being maintained by these trusts (Everest Group, 2008).
The U.S. tax and financial system has a set of reporting rules for income tax that are very complex when applied to the foreign and international trusts. If the non U.S. resident does not understand how these reporting rules work, they might face penalties when paying their income tax.
Some potential tax implications that a foreigner should understand to avoid being penalized include taxation of built in gains for property held in the U.S. that has been donated to a foreign trust, taxation of trust property to the grantor of the trust once the U.S. residency of the grantor or the U.S. beneficiary has been terminated, taxation of the grantor of the trust on their income even though they have no interests in the trust property, taxation of beneficiaries who are U.S. residents on their accumulated income in the trust property by adding charges such as compound interest on tax deferrals and taxation on the ordinary income of the accumulated capital gains of the trust property. Taxing the U.S. grantor’s accumulated income once the beneficiary becomes a U.S. resident is also a potential tax implication.
Foreign grantors, foreign trusts and beneficiaries are subjected to multiple tax and filing requirements that mandate them to comply with the U.S. tax system to avoid severe penalties. These penalties are in the form of 5 percent of the trust assets that are held by the foreign trust, grantor or beneficiary and 35 percent of the value of their contributions to the trust property (Everest Group, 2008).
Non U.S. citizens face taxation issues in the form of their foreign investment portfolios. Certain investments that they might hold in the U.S. are subject to being taxed. These investments are subject to taxation at the ordinary taxation rates that are charged for income earnings. To reduce the high taxation on these investments, non residents who decide to expose their portfolio investments to taxation can restructure their investments to fit into asset classes that are subject to lower taxation rates in the U.S. Advance planning to restructure these portfolio investments is necessary to reduce any taxation issues that might arise if the U.S. tax system was to be applied (Everest Group, 2008).
Life insurance presents another challenge for non U.S. citizens as it offers coverage from loss of income as well as the financial burden that might arise due to estate taxation. The benefits of a life insurance to the beneficiary are usually free of any income tax deductions and the growth in cash surrender value has provisions that allow for tax deferral payments. The beneficiary of the life insurance policy can borrow money for the cash surrender value without having to incur any taxation on their income earnings.
However, these benefits are only available if the life insurance policy meets the conditions and requirements of life insurance under the U.S. tax system. Foreign nationals who migrate to the U.S. often hold life insurance policies with their home country. These policies are not usually compliant with the U.S. tax rules and if the foreign resident was to continue using these policies, they would be exposing themselves to U.S. tax exposures and penalties (Everest Group, 2008).
Any investments in U.S. real estate present income and tax transfer issues to the foreign citizen who is exposed to income taxation. Transferring interests in U.S. real estate property is deemed to be a taxable gift and the foreign resident is required to properly plan for any transfers of real estate property from the home country to the U.S. to avoid U.S. transfer taxation. Many non U.S. citizens usually hold their U.S. real estate investments with foreign corporations or subsidiaries. If this system is properly structured and maintained, it can reduce the exposure of the property to transfer taxes. However if the non resident were to move to the U.S. and become a permanent resident, then they would have to face multiple tax issues and tax penalties for failing to comply with the U.S. taxation federal law (Everest Group, 2008).
Another taxation issue arises if the estate property of the foreign resident is not able to offset the amount associated to U.S. real estate mortgage debt when the tax deductions are being made. This situation might occur on the death of the foreigner who was not domiciled in the U.S. despite paying income tax. Even though a tax deduction will be available, taxation will still be conducted on the estate because the foreign resident owned leveraged real estate property in the U.S. (Everest Group, 2008). The most effective tool that can be used to deal with the taxation issues that affect non U.S. citizens is the taxation treaties.
Taxation Treaties
Taxation treaties have been developed to deal with the issue of double taxation. A tax treaty is defined as an agreement that is forged between two countries that offers guidelines on how a non resident taxpayer will be taxed in one country while they conduct their work or business transactions in the second country. The underlying goal of the taxation treaty is to reduce an incident of double taxation from taking place. The treaty ensures that the individual or foreign corporation is taxed only by the country of residency unless the individual or corporation has established permanent residency in the second country of operation. If a permanent residency visa exists, the taxation treaty will allow the second country to tax the income of the person or company that has been earned within its borders (Escoffier & Fortin, 2008).
The U.S. has income tax treaties with a total of forty eight international countries such as Australia, Canada, Mexico, Brazil, the UK, Morocco, Japan, and South Korea. Residents of these countries are either taxed at a reduced rate or are exempted from paying U.S. income taxes on certain aspects of their income. The resident country that is under the tax treaty is supposed to allow its residents to offset their domestic tax on foreign income by providing foreign tax credit in the amount that coincides with the tax paid in the source country. The net tax that the individual or company pays will be greater than the tax imposed by the source and home country that claim a jurisdiction on the income earned. Through this system the taxpayer is able to pay only one level of tax (Frew, 2000).
The reduced taxation rates for resident and non U.S. residents will vary with the type of taxation treaty their country has with the U.S. The taxation treaty is meant to reduce the amount of taxation these citizens will be subjected to on certain aspects of their income as long as it has been earned within the U.S. If there is no treaty that exists between the U.S. and the foreigner’s country, then they are required to pay tax on their income at a flat rate of 30 percent (IRS, 2010).
With regards to U.S. citizens, the U.S. taxes their incomes based on their citizenship and not on their residency. Most countries around the world tax their citizens based on whether they have residency in the country or not. The reason behind taxing people on the basis of their citizenship arose because of the risk that would be arise if non U.S. citizens lived in the country without paying any form of taxes in the U.S. as well as to their home country. The U.S. requires all foreigners to pay taxes on their worldwide income which puts in effect the residency principle of taxation (Frew, 2000).
The U.S. taxation treaty applies to certain types of compensation which include income from personal service such as from healthcare providers, teachers or lawyers, maintenance money for foreign students, wages and salaries paid by a foreign government. The tax treaties also apply to certain stages of investment income which include dividends, bonds, royalties or capital gains. The taxation treaties also cover aspects such as social security payments to the U.S. government as well as payments to pension funds. Some treaty countries however tax the U.S. social security benefits that have been paid by U.S. citizens to a foreign country (Frew, 2000). The following are some examples of taxation treaties the U.S. has with Canada and Australia
The taxation treaty between the United States and Canada states that the individual’s who are exempt from being taxed is those who are in the U.S. to conduct business transactions as independent contractors. Any profits that they earn while they are in the country are exempt from any taxation unless their presence in the country is of a permanent nature. If they have established a permanent presence, then they are subject to being taxed on their income at the 30 percent flat rate (IRS, 2010).
Canadian employees who perform personal services are exempt from paying tax on their income if they earn below $10,000 in a year. For those non residents who earn above the $10,000 amount their income can be exempted from tax deductions if they have been within the U.S. borders for a period of not more than 183 days and they have not paid any form of income during their 183 stay. The tax exemptions apply to Canadian athletes who are in the country for scheduled games or team sport activities but they do not apply to non resident entertainers who have derived more than $15,000 from their entertainment activities (IRS, 2010).
The taxation treaty that U.S. has with Australia states that the income of foreigners will be exempt from being taxed if they have been in the United States not longer than 183 days during the taxation year. The foreigners should not have a fixed base of income during their 183 day period in the U.S. In the event they have a fixed income, it is subject to taxation based on the attributable income placed on the fixed income base. Foreigners from Australia who have been in the U.S. for less than 183 days and have offered personal services to U.S. employers have tax exemption on their income that has been earned during that period. They also face tax exemption if the receive their pay from an employer who is not a U.S. resident (IRS, 2010).
As with Canada, the tax exemptions do not apply to entertainers such as musicians, actors and performers who have earned more than $10,000 form their entertainment activities. Australian athletes who are attending scheduled games or tournaments in the U.S. also do not have tax exemption on the income earned within the U.S. (IRS, 2010).
Conclusion
It is important for any foreigner intending to move to the U.S. for a specific duration of time to familiarize themselves with the tax rules and regulations that are in the country. This will prevent them from experiencing the various taxation issues that have been highlighted in this research paper. Having knowledge of the tax rules in the U.S. is important as it will prevent cases of double taxation where the foreigner is taxed both in the U.S. and in their home country as well as enable the individual to benefit from the various tax exemptions that non U.S. citizens are afforded by the U.S. tax system. Also having information on whether the foreigner’s country has a taxation treaty with the U.S. will also be an important step in ensuring that the individual’s income that is earned within the U.S. border is taxed according to the provisions in the taxation treaty.
References
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Everest International Group (2008). Ten US planning issues for foreign citizens.
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IRS.gov (2009). Taxation of non resident aliens. Web.
IRS.gov (2010). Resident and non resident aliens. Web.
Isla Associates (2009). Capital gains tax exemption for non resident traders in the U.S. Web.
Lymer, A., & Hasseldine, J. (Eds.) (2002) The international taxation system. Massachusetts, US: Kluwer Academic Publishers.
Prysock, M. (2002). International taxation issues still problematic (Washington Insights). Web.
Menkov, V., Lott, C., & Michelangeli, E., (2010). Tax code for non resident aliens and US holdings. Web.