Subject: Tax Code - Non-Resident Aliens and US Holdings

Last-Revised: 26 Jan 2003
Contributed-By: Vladimir Menkov (vmenkov at cs.indiana.edu), Chris Lott (contact me), Enzo Michelangeli (em at who.net)

Non-resident aliens can hold investments in the United States quite easily. 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. The only thing non-resident aliens have to be concerned about if they have U.S. investments is taxation.

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. But they will have to continue to deal with the U.S. tax authority, the IRS.

Thanks to the U.S. Congress, the tax laws are complicated, and a resident or nonresident alien must look carefully to find a tax advisor who understands all the issues. Here's an overview.

A person is considered non-resident in the years when that person is in the US fewer than 183 days; the actual rule is a little more complex, and takes prior years into account; see IRS publication 519 for details. Anyhow, in the years when a non-US citizen is considered a non-resident for tax purposes, that person files the US tax return on form 1040 NR, instead of regular 1040 (EZ, A), and pays tax on investment income according to the following special rules.

• No tax on capital gains. This means that a brokerage or a mutual fund should withhold nothing when selling shares. With respect to mutual funds, long-term capital gain distributions are exempt as well.
• No tax on bank interest. This means regular accounts with credit unions, savings and loans, etc.
• No tax on portfolio interest. (It's not always easy to figure out interest on what bonds qualifies as "portfolio interest", though. Some readers have reported that brokerage firms are confused on this issue, unfortunately.)
• 30% flat-rate tax on dividends. Generally this includes dividend and short-term cap gain distributions by mutual funds. This rate may be reduced by a tax treaty with your country of residence. (Progressive taxation does not apply to NRAs; i.e., the first and last dollars are taxed at the same rate.)
• 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.
• 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.
• If the alien is a non-resident for the tax purposes in a given year, but spends 183 days or more in the country, any capital gains are also subject to the 30% flat tax. This is a fairly rare but possible situation.

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."

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 Forms 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 to US citizens living abroad. Once you are considered a bona fide resident of the U.S., 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"
  http://www.irs.gov/pub/irs-pdf/p515.pdf
• IRS Publication 519, "U.S. Tax Guide for Aliens"
  http://www.irs.gov/pub/irs-pdf/p519.pdf
• IRS Publication 901, "Tax Treaties"
  http://www.irs.gov/pub/irs-pdf/p901.pdf
• IRS Tax Topic 851, "Resident and Nonresident Aliens"
  http://www.irs.gov/taxtopics/tc851.html
• The IRS web site "Digital Daily" has a collection of information for the International Taxpayer.
  http://www.irs.gov/businesses/small/international/
• The 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).
  http://www.irs.gov/businesses/small/international/article/0,,id=96400,00.html

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