Business expansion to the United States will inevitably create tax consequences for foreign investors and enterprises. This post will discuss the basic concepts of U.S. Taxation that foreigners doing business in the U.S. need to be familiar with.
In general, foreigners engaged in a trade or business will be taxed on two categories of income:
1. Income that is effectively connected with the conduct of a trade or business in the U.S., and
2. Certain fixed and determinable annual or periodic income that is not connected to a trade or business in the U.S, such as interest, dividends, services, rents, royalties, etc.
The primary difference in taxation between the two categories is that effectively connected income is taxed at graduated rate on a net basis, and the fixed and determinable income is taxed at a fixed rate on a gross basis. The graduated rate ranges from 10% to 35% depending on the amount of taxable income and the entity that generated the taxable income. The fixed and determinable income is tax at a flat rate of 30%. Treaty provisions could apply to both tax regimes, which would reduce the rate of tax.
What does it mean to be engaged in a trade or business?
Whether a foreigners are engaged in a trade or business is a question of fact. The determination rests upon the person’s economic activities conducted within the U.S. As a general rule, to be engaged in a trade or business, foreigners’ activities must be regular, continuous and substantial.
Special Provisions for Selling U.S. Real Estate
Foreigners that sell or otherwise dispose of certain interests in real property located in the United States are taxed on a net basis at graduated rates on the gain form the sale or disposition, as though it were effectively connected income.
Rental of Real Property
Foreigners who own real property in the United States and rent it out may be considered to be engaged in a trade or business if the activities related to their investment are regular, continuous, and substantial. If, on the other hand, the activity is limited to receipt of rent and payment of related expenses, the foreigner will generally not be regarded as engaged in a trade or business.
Taxation of certain entities
U.S. Partnership with Foreign Partners
If a partnership is engaged in a U.S. trade or business, each of the foreign partners will also be deemed so engaged. Effectively connected income will be provided on a separate report, and the partnership will be required to withhold taxes based on the applicable percentage of the effectively connected income associated with each foreign partner. Unless a treaty benefit applies, the withholding rate will be set at 30%.
The effectively connected income will be taxed to the partner at the graduated rates ranging from 10% to 35%. The withholdings from the partnership will be applied towards the tax due.
U.S. Corporation with Foreign Shareholders
A U.S. corporation with foreign shareholders will be taxed at the same rate as any other U.S. corporation. The graduated tax rates between 15% and 35% will apply. However, the distributions from a U.S. corporation to the foreign shareholders will generally require a withholding of 30% unless there is an applicable international tax treaty.
A foreign partnership doing business in the U.S. and generating effectively connected income will have to file the same U.S. income tax return as a U.S. based partnership. In addition, foreign partners with effectively connected income allocations will have to file the individual income tax returns and pay U.S. income tax.
A foreign corporation doing business in the United States will be taxed at graduated tax rates between 15% and 35%. The principles of taxation are similar to those applied to nonresident aliens.
In addition to the graduated income tax, a foreign corporation may be subject to a branch profits tax. The branch profits tax is a flat tax of 30% and is imposed on the dividend equivalent amount of each U.S. branch of a foreign corporation. Essentially, the tax is assessed on the corporate earnings that are deemed repatriated. Subsequently, foreign corporations may bear U.S. tax rate as high as 54.5%.
Foreigners who receive U.S. income are generally subject to withholding. A withholding agent is required to withhold 30% from the gross amount payable to a foreign person unless the payee can establish that they either are a U.S. person or are entitled to a reduced rate of withholding.
A withholding agent is a U.S. or foreign person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding. A withholding agent may be an individual, corporation, partnership, trust, association, nominee, or any other entity. Withholding agents are required to withhold on Form 1042-S Foreign Person’s U.S. Source Income Subject to Withholding and file an annual Form 1042 Annual Withholding Tax Return for U.S. Source Income of Foreign Persons.
A Form W-9 Request for Taxpayer Identification Number is used to certify a payee is a U.S. person. A foreign person certifying that they are the beneficial owner of the U.S. payment will use the Form W-8 series (W-8BEN, W-8IMY, W-8ECI, and W-8EXP).
International Tax Treaties
The objective of the international tax treaties is to avoid double taxation on the international level. The parties of the treaty achieve this goal by limiting their right to tax income earned from its territory by residents of the other country and by the requirement that the country of residence allow a credit for taxes that are paid to the source country under the provisions of the treaty.
The international tax treaties will define the term resident so that an individual or a corporation would not be subject to tax as a resident in both countries. Further, the treaties will determine the taxation source rules for dividends, interest, royalties, and real property income, as well as business profits and personal service income.
The taxation of international transactions is extremely complex, and there is a variety of requirements applicable to each situation. The variations of U.S. tax laws relevant to foreigners doing business in the United States are too numerous to detail here.
If you are doing business internationally, it is imperative to engage a knowledgeable tax advisor. San Diego Tax Law Group can help you with your international tax planning and compliance needs.