Subject: Tax Code - Non-Resident Aliens and US Holdings
Last-Revised: 8 October 2010
Contributed-By: Vladimir Menkov (vmenkov at cs.indiana.edu), Chris Lott (contact me), Enzo Michelangeli (enzomich at gmail.com)
Non-resident aliens can hold investments in the United States quite easily, and most aliens are exempt from many taxes on income from those investments. For example, if a non-U.S. national works in the U.S. for some period of time and amasses a nice portfolio of stocks while here, that person can hang on to the portfolio forever, no matter whether they continue to live in the U.S. or not.
A "non-resident alien" (NRA) is the U.S. government's name for a citizen of a country other than the U.S. who also lives outside the U.S. Confusingly, the term is also used for citizens of a non-U.S. country who are temporarily residing in the U.S., like students.
Non-resident aliens with U.S. holdings must comply with U.S. taxation rules, as enforced by the U.S. tax authority, the IRS. Thanks to the U.S. Congress, the tax laws are complicated, and nonresident aliens must look carefully to find a tax advisor who understands all the issues. Here's an overview.
Basically a person is considered non-resident for U.S. tax purposes in the years when that person is in the US fewer than 183 days. The exact rule is complex and takes prior years into account; see IRS
In the years when a non-US citizen is considered a non-resident for tax purposes, that person owes tax on investment income according to the following special rules.
- No tax on bank interest. This exemption covers regular accounts with credit unions, savings and loans, etc.; it specifically excludes interest from mutual funds.
- No tax on portfolio interest. It's not always easy to figure out what bond interest qualifies as "portfolio interest", though. Some readers have reported that brokerage firms are confused on this issue, unfortunately.
No tax on capital gains. This includes short-term or long-term
capital gains from buying low and selling high, for example by trading
stocks. This means that a brokerage should withhold nothing when
selling shares. Note that as of 2010, capital-gains distributions
from mutual funds are taxed.
Caveat on the capital-gains tax exemption: if the alien is a non-resident for tax purposes in a given year, but spends 183 days or more in the U.S., all capital gains are also subject to the 30% flat tax. For example, this applies to foreign students (always non-resident aliens for tax purposes) who have US-source income such as a scholarship and have stayed in the U.S or intended to stay 1 year or more.
- A 30% flat-rate tax on dividends, including interest-related dividends. As of 2010, all mutual-fund distributions are considered dividends. This rate may be reduced by a tax treaty with the NRA's country of residence; for example, Canadians pay 15%. Progressive taxation does not apply to NRAs; i.e., the first and last dollars are taxed at the same rate. This tax may be withheld by a broker and passed along directly to the U.S. government.
- A 30% flat-rate tax on interest that neither is paid by a bank nor qualifies as "portfolio interest." This rate may be reduced by a tax treaty with the person's country of residence. This tax may also be withheld directly by a broker and sent to the U.S. government.
- No personal exemption or deductions can be applied against investment income (which is, technically, "income not effectively connected with your US trade or business"). Further, according to the IRS, "if your sole U.S. business activity is trading securities through a U.S. resident broker or other agent, you are not engaged in a trade or business in the United States" so the income is not effectively connected with a US trade or business.
The issue of an investment paying dividends versus paying interest is simple in case of stocks (dividends) and basic savings accounts (interest), but what about money-market accounts? Well, money-market mutual funds pay dividends, while money-market bank accounts pay interest, for the purposes of 1040 NR. However, if you have a money market fund with a bank, and the bank reports the income as dividends, it is probably simplest to report the income exactly as the institution reported it rather than try to fight it. I don't know why this isn't straightforward, but for some reason it is not. For more information, see IRS Publication 550, "Investment Income and Expenses." In the 2000 edition, the relevant language appears in the first column of page 5, in the section "Interest Income," subsection "Taxable Interest - General."
An issue with short-term capital gains is that mutual-fund companies like to report them as dividends (not as gains). This manner of reporting exists for the benefit of US resident taxpayers. This is why a special provision exists in IRS Pub 519 to allow non-residents to treat those distributions as a capital gain, and thereby avoid paying tax on them. Note that the rules for non-resident aliens and short-term capital gains distributions by mutual-fund companies were only valid through 2009. As of this writing in 2010, the exemption is gone, and NRAs owe tax on all mutual-fund distributions.
Tax treaties are very important. If the individual's country of residence has an agreement (tax treaty) with the US government, those rules pretty much supersede the standard rules set by the Internal Revenue Code. In particular, they often reduce the tax rate on interest and dividend income.
While you are a non-resident alien, you are supposed to file Form W-8BEN (it replaces older Forms W-8 and 1001) with each of your mutual funds or brokers every 3 or 4 years, so that they will automatically withhold tax from your investment income. Since you have to indicate your country of residence for tax purposes on this form, the investment income payor will know what tax treaty, if any, applies. In the spring, the payor will send you a form 1042-S reporting your income, its type, and the tax withheld.
If a NRA is required to file a tax return, the person files form 1040 NR instead of a typical 1040 form. However, if Form(s) W-8BEN have been filed and the appropriate tax has been withheld, you won't need to send any money to the IRS with your 1040 NR in April; in fact, you won't even need to file 1040 NR at all if you don't have other US-source income. Note also that as a non-resident you will not be eligible to claim standard deduction, or to claim married status, or file form 1116 (foreign tax credit).
The IRS enacted some rules in late 2000 to establish "Qualified Intermediary" status for foreign financial institutions. The rules did not change tax liabilities, just made it more difficult for a person to escape paying tax. To summarize, a financial institution must withhold money from payments of US-source income to individuals outside the US unless the institution qualifies for the newly introduced status of "qualified intermediary", or unless the institution agrees to disclose the list of all beneficiaries to the IRS. A financial institution is eligible to apply for qualified intermediary status if it is in a country that has been approved by the IRS as having acceptable 'know-your-customer' rules.
None of this discussion applies to resident aliens, or for that matter or to US citizens living abroad. Once you are considered a bona fide resident of the U.S., all the tax rules that apply to U.S. citizens also apply to you.
Here are some IRS resources that offer all the details:
- IRS Publication 515, "Withholding of Tax on Non-Resident Aliens"
- IRS Publication 519, "U.S. Tax Guide for Aliens"
- IRS Publication 901, "Tax Treaties"
- IRS Tax Topic 851, "Resident and Nonresident Aliens"
- The IRS web site "Digital Daily" has a collection of information
for the International Taxpayer.
- The IRS Digital Daily's area includes this article which focuses
on the taxation of capital gains Of nonresident aliens (the link is
unfortunately buried in another article).
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