Overview of Foreign Investment in The US
Christopher Klug – International Tax Attorney, Washington DC
Nonresident aliens (“NRA”) or foreign companies can invest in the US on a very favorable tax basis as compared to US taxpayers. There are many factors to consider for NRAs investing in the US. The US provides a NRA investor with a strong economy and financial market for investment. For professional advisors working with international investors, it is important to have a basic understanding of the opportunities for foreign investment in the US and other tax considerations.
In general, a NRA is taxed on US source dividends and income effectively connected to a US trade or business, but is not taxed on US source capital gains (other than on the sale of US situs real estate) and interest income that qualifies as portfolio interest. These rules allow the NRA to invest in the US on a tax favored basis and for opportunities to repatriate funds tax free.
This will be the first newsletter in a series on foreign investment in the US. This newsletter will provide an overview of tax considerations for foreign investment in the US.
US Taxation of NRAs
Below are the general rules for US taxation of NRAs:
- The NRA does not pay any US income tax on their foreign source income except under very limited circumstances;
- The NRA pays US income tax at regular income tax rates on any income that is effectively connected with the conduct of a US trade or business;
- The NRA pays a maximum 30 percent US withholding tax on dividends, some interest, and other investment income the NRA derives from US sources. The 30 percent US tax rate may be reduced by favorable income tax treaty provisions. However, anti-treaty shopping rules may restrict their ability to use third-country treaties;
- Interest income derived by the NRA from US banks and savings institutions or from Eurodollar bonds is tax free;
- The NRA pays US income tax on capital gains from the sale of US real property interests. The NRA does not pay any US tax on most other capital gains from US or foreign sources; and
- The NRA is probably not a domiciled alien and can therefore avoid US estate and gift taxes by holding their US property in a foreign corporation. It is important to note that the foreign corporation’s US business income and gains are subject to the regular corporate income tax rates and a branch profits tax of up to 30 percent of the after-tax profits.
Income Effectively Connected with a US Trade or Business
All US source or effectively connected income is taxed at ordinary income tax rates unless (1) the NRA is a resident of a treaty country and the NRA does not operate through a permanent establishment or (2) the income is passive or capital gains income. In other words, unless the item of income is both independent of the NRA’s business and within the passive or capital gains classification, it is taxable at ordinary income tax rates. If the item of income is independent of the NRA’s business and can be classified as passive income or capital gain, it is either not taxed at all (as to most capital gains) or it is taxed exactly as if the NRA were not engaged in business in the US during that year, that is, at the flat 30 percent rate. If the item of income cannot be classified as either passive income or unrelated capital gain, the income is taxed at the normal tax rates whether or not the item of income is in fact related to the NRA’s business.
Applicable Tax Rates on Income Effectively Connected with A US Trade or Business
The NRA is subject to the same tax rates on income effectively connected with a US trade or business that applies to the income of US citizens and resident aliens. Income that is taxed at personal income tax rates will be taxed at marginal tax rates with all taxable income over $418,400 being taxed at 39.6%. Income that is taxed at corporate tax rates will be taxed at marginal tax rates ranging from 15% to 39%, but once the income reaches certain levels the overall tax rate is 35%.
For an NRA investing in a business in the US, it is important to do an analysis of the corporate tax rates as compared to the individual tax rates that would apply to a partnership or disregarded entity structure. For a foreign corporation investing in the US, the corporate tax rates will apply whether the foreign corporation invests through a US corporation or through a US partnership or disregarded entity. As part of this analysis, it should be kept in mind that a NRA or foreign corporation can repatriate profits from a US corporation tax free through liquidating distributions, thus avoiding the second level of tax which is the typical reason US based investors would avoid forming a corporation.
For a NRA it is also important to determine the character of income that the investment is expected to generate. For example, the sale of real estate in the US would generate capital gains, which would be taxable in the US. If the US real estate is owned by the NRA directly or through a partnership or disregarded entity structure, the sale would generate a capital gain taxed at a maximum rate of 20% (long-term capital gains rate). Instead, if the land were held through a corporation, there is no preferred corporate tax rate for capital gains and the sale would be taxed at rates up to 39%. In this situation, preserving capital gain tax treatment through a partnership or disregarded can save the NRA a significant amount in US taxation.
Branch Profits Tax
The branch profits tax is a tax on the after-tax earnings of the US branch of a foreign corporation doing business in the US. The concept of the tax is that it substitutes for the withholding tax on dividends that would be paid if the branch were a domestic subsidiary corporation and the earnings were distributed to the foreign parent.
The purpose of the branch profits tax is not to allow foreign corporations to invest in the US on a more favorable basis than a US corporation that would incur a second tax on dividend distributions. The branch profits tax regime is generally less favorable than the second level of tax on dividend distributions.
Foreign Investment in Real Property Tax Act
A NRA who disposes of a United States real property interest (“USRPI”) shall be treated as if such gain or loss were effectively connected with a US trade or business. USRPI means an interest in real property located in the US or any interest (other than an interest as a creditor) in any United States real property holding corporation (“USRPHC”). A USRPHC means any corporation if the fair market value of the USRPI interests equals or exceeds 50 percent of the fair market value of the corporation’s total assets.
The Foreign Investment in Real Property Tax Act (“FIRPTA”) provides that on the disposition of a USRPI by a foreign person, the transferee (purchaser) shall be required to deduct and withhold a tax equal to 15 percent of the amount realized on the disposition.
The gain or loss resulting from a nonresident alien’s sale of USRPI shall be treated as effectively connected with a US trade or business. This rules requires the NRA to pay capital gains tax on the sale of US real estate.
US Federal Estate and Gift Tax Planning
To develop a comprehensive plan for an NRA investing in the US, planning needs to be completed for the US estate tax. An NRA is subject to US (federal) estate tax on US situs assets and only has a $60,000 estate tax exemption. A non-resident of the US is subject to US gift taxation on lifetime transfers of real and tangible personal property located in the US and they do not have a gift tax exemption.
An important planning opportunity is that an NRA can gift US stock tax free, but if the same US stock is held until death, the US base stock will be subject to US estate tax. The NRA will have an estate tax exemption of $60,000 with the balance being taxed at 40 percent, which is typically a significant tax burden.
For example, since the estate tax is a tax on the fair market value of the assets and not on income, an NRA who purchases US based real estate for $3,000,000 and dies 1 year later when the US real estate is valued at $3,200,000, would owe US federal estate tax of $1,256,000. In my view, by not structuring the investment correctly the significant estate tax results in the investment being a huge loss.
Through proper planning, a structure can be created to hold the US based investment assets and avoid the US estate tax. This planning is a tremendous benefit for the NRA. The structure will involve the use of a foreign corporation to invest in the US so what the NRA holds at death is stock in a foreign corporation and not US situs assets, which avoids the US federal estate tax.
Also of significant importance to a lot of NRAs is the ability to keep their matters private. Even though the US forced financial institutions located in other countries to report their US account holders through the Foreign Account Compliance Act (“FATCA”), the US has not joined the Common Reporting Standards (“CRS”), an agreement of about 90 nations to exchange financial account information, so the US is seen and is a location where an NRA can have financial accounts and maintain privacy. Even where the US has a reciprocal FATCA exchange of information agreement, the exchange of information is typically not as robust as it is for the reporting of US account holders to the US. If the NRA’s assets are from verified and legitimate sources, then the NRA can certainly arrange their affairs to avoid an automatic exchange of information. If a structure with a foreign corporation is utilized, there are certain jurisdictions where the foreign corporation can be formed that do not report under the CRS.
The NRA or foreign company can invest in the US on a tax favored basis. For investments in brokerage accounts, the NRA or foreign company can avoid US taxation on interest income and capital gain income. For investments in business ventures through a US corporation, the NRA or foreign company can repatriate profits through liquidation distributions and avoid the second level of tax on dividend distributions. For NRAs, the US estate tax can be a significant amount, however, there are structures that can be created to avoid the US estate tax on any investment in the US.
While there are many planning opportunities for NRAs and foreign companies investing in the US, it is important the investment is structured properly as there are many traps that can result in significant taxation.« 4 Times You Should Call an Estate Planning Attorney Right Away Free Your Clients From Old, Obsolete Trusts »