Inbound International Taxation System
The United States taxes citizens and resident aliens (foreign citizens who are residents of the United States under either the “green card” or “substantial presence” test) on their worldwide incomes. However, nonresident aliens (individuals who are neither citizens nor residents of the United States) are subject to different U.S. tax rules.
A nonresident alien is taxed only on the income earned or derived within the United States. In general, a nonresident alien’s income is categorized into two separate categories:
- Effectively connected income (ECI), and
- Fixed, determinable, annual or periodical (FDAP) income that is not effectively connected with the conduct of a trade or business, including, but not limited to: interest, dividends, services, rents, royalties, wages, etc.
The main difference in taxation between these two categories of income is the rate at which the income is taxed. Generally, if the income is treated as ECI, the tax rate on the net income will be graduated and will range from 10% to 35%, depending on the amount of taxable income and the entity that generated the taxable income. If the income is treated as FDAP, the tax and withholding rate will generally be a flat 30%, which is on a “gross” basis and does not allow for any deductions or modifications to reduce the income. Foreign persons may be subjected to graduated tax rates on the disposition of certain real property located in the United States.
Since foreign persons are only subject to U.S. tax on their income that is connected to the United States, it is critical to properly determine the source and underlying character of the income in question. Because these situations are highly-specific and unique to each circumstance, tax advisors should be enlisted to assist with the determination process.