Nonresident alien taxation

This page summarizes how a non-US investor (that is, a US nonresident alien) is taxed when investing in US domiciled investment assets such as bonds, mutual funds, and ETFs.

Non-US investors may be subject to both US dividend withholding taxes and US estate taxes, on top of any taxation by their country of residence.

Who is a nonresident alien (NRA)?
If you are an alien (that is, you are not a US citizen), you are considered by the US to be a nonresident alien unless you meet one of two tests. You are a resident alien of the United States for tax purposes if you meet either the green card test or the substantial presence test for the calendar year (January 1-December 31).

Are capital gains taxable for a nonresident alien?
No. Capital gains from US domiciled ETFs and US stocks are not taxable by the IRS. According to IRS Publication 519:

Also, according to a reply received for a paid consultation with Greenback Expat Tax Services Limited:

Is interest taxable for a nonresident alien?
Generally, no. Most US source interest, such as that paid by banks, savings and loan institutions, credit unions, and insurance companies, is not taxable by the IRS. This means that holding US treasuries can be a tax-efficient way for nonresident aliens to hold some US assets.

Some US source interest may be taxable for a nonresident alien. Examples include interest effectively connected with operating a US trade or business, and broker interest on cash deposits held at US brokers. The standard rate is 30%. This can be lowered or eliminated if your country of residence has a tax treaty with the US.

Are dividends taxable for a nonresident alien?
Yes. The US will withhold tax on dividends paid to nonresident aliens by US domiciled ETFs and US stocks.

The broker will apply this withholding to dividends paid to you as an investor. Withholding does not apply to capital gains or to interest payments. A portion of the dividend paid by an ETF may be exempt from nonresident withholding; see below for more. The standard rate is 30%. This can be lowered (usually to 15%) if your country of residency has a tax treaty with the US, by submitting a W-8BEN form via your broker.

Apart from an exemption for some US source 'portfolio interest' income, discussed below, US withholding tax applies regardless of the actual assets held by a US domiciled ETF. Even if all of the ETF's assets are non-US stocks, the US will still take 30% or lower treaty rate in dividend tax. Holding the same assets in a non-US domiciled ETF eliminates this US tax overhead.

Estimating tax withholding leakage
Other than the tax withholding that shows on your brokerage account's statement, the fund itself gets taxes withheld on dividends received. This is usually applicable to funds holding international equities. This number affects investors, but is mostly invisible unless you look at the annual reports.

Short-term capital gain distributions paid as dividends
A US domiciled ETF that pays a short-term capital gains distribution will generally include this in its dividend. For US investors this makes no difference to their tax or other positions.

However, capital gains are not US taxable to nonresidents. In this case, an ETF should exempt the portion of a dividend that is due to short-term capital gains from nonresident alien withholding. For this to occur correctly, the broker needs to be aware that the withholding rate on this payment to nonresidents is less than the standard or treaty rate.

Interest distributions paid as dividends
Where a US domiciled ETF receives US source interest on its holdings, and that interest would not have been taxable to a US nonresident if paid directly, the portion of the dividend attributable to this interest is 'portfolio interest' and can be exempted from nonresident withholding. This situation is unlikely in ETFs that hold only stocks, but will be common in bond ETFs, and any mixed-asset ETFs.

Again, for this to occur correctly both the ETF provider and the broker need to be aware of the relevant qualified interest income (QII) regulations.

Also, note that this exemption is particularly narrowly drawn. It does not apply to any non-US source interest or dividends that the ETF receives. This means that a US domiciled ETF containing non-US bonds or non-US stocks suffers the standard 30% or lower treaty rate US tax on dividends. If the investor had instead held the ETF's assets either directly or through a non-US domiciled ETF, they would have paid no US tax.

TD Ameritrade tax withholding experiment
A test in 2015 using a TD Ameritrade account and a selection of US domiciled ETFs: MUB, BIV, LQD, BNDX, VIG, VTI and VXUS, shows that all had tax withheld at 30% from the dividends distributed, with the exception of MUB and VXUS. MUB holds US municipal bonds, which are tax-exempt from US federal taxes. VXUS holds stocks of non-US companies.

Is filing a US 1040-NR tax return necessary?
Generally, no. Provided your broker applies the correct US tax withholding for your home country (so 30% without a tax treaty, or the treaty rate if applicable), your US tax withholding will exactly match your US tax liability. In this case, and provided you have no other taxable US source income, the IRS does not require you to file a form 1040-NR nonresident alien US tax return.

If you supply your broker with a form W-8BEN, this should ensure the correct US tax withholding on dividends. The most common case where US tax withholding is incorrect is where the broker has withheld 30% rather than the lower treaty rate. This can occur if you have not provided a W-8BEN, it has expired, or the broker has ignored it. In this case, you can file a 1040-NR with the IRS to recover the overwithholding. The IRS provides a special "simplified procedure" for this.

Are nonresident aliens at risk from US estate taxes?
Potentially, yes. Except for Canada, if you hold US domiciled ETFs or US stocks and your home country does not have a separate estate tax treaty with the US, you risk becoming liable for US estate taxes. While the US has an extensive network of income tax treaties, only a handful of countries have estate tax treaties with the US.

Canada does not have a separate estate tax treaty with the US. Instead, the US maintains a single treaty with Canada that combines both income taxes and estate taxes. Under this combined treaty, Canadians receive protection up to the level of the US estate tax exemption allowed to US citizens, the same as generally provided by the separate US estate tax treaties for other countries.

Even where a treaty protects nonresident investors from US estate tax, there are still hurdles and delays in accessing US domiciled holdings:

A US estate tax treaty may provide protection from US estate taxes to a level equivalent to that allowed to US citizens, but the presence of a US estate tax treaty does not guarantee that this is the case. In particular, the US estate tax treaties with Ireland and South Africa may not offer worthwhile protection from US estate taxes. US nonresident aliens considering holding US domiciled ETFs and other US situated assets should check any applicable US estate tax treaty details very carefully before proceeding. Note that residency is not normally a sufficient condition for using a US estate tax treaty. This type of treaty is generally controlled by domicile, a legal concept that, although it includes residency as one of its components, is different and distinct from residency; citizenship may also be a factor.

Local estate taxes may apply as well, and in the absence of a US estate tax treaty this can cause double taxation. In addition, some US estate tax treaties do not provide for estate tax credits, and this may also cause double taxation.

Are nonresident aliens at risk from US gift taxes?
Generally, no. Nonresident aliens are not subject to US gift tax on gifts of 'intangible property', such as US domiciled ETFs and US stocks.

In contrast, gifts of 'tangible property', such as US situated real estate, are potentially subject to US gift tax, even when made between two US nonresident aliens with no other connections to the US. A few US estate tax treaties also cover US gift taxes.

Foreign Account Tax Compliance Act (FATCA) and NRAs
Regarding non-US clients of a foreign financial institution (FFI) who will not provide the documentation needed for FATCA:

To avoid running into FATCA withholding issues, use a FATCA-compliant broker where possible, and make sure your W-8BEN form is up-to-date. Most US brokers and larger international ones are FATCA-compliant. You can confirm by checking with your brokerage firm if you are investing in US domiciled securities.