Nonresident alien taxation

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Ambox globe content.svg This article contains details specific to non-US investors. It does not apply to United States (US) investors, or to US citizens and US permanent residents (green card holders) living outside the US.

Nonresident alien taxation summarizes how the US applies its taxes to a non-US investor (specifically, a US nonresident alien) holding assets such as US stocks, US bonds, US cash deposits, and US domiciled ETFs and mutual funds.

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. There can also be a risk of US gift taxes.

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).[1]

In short, if you are not a US citizen or green card holder and have not been in the US for 183 days (calculated over a 3 year period), you are a nonresident alien for US tax purposes.

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:[2]

A nonresident alien usually is subject to U.S. income tax only on U.S. source income. If you were in the United States for less than 183 days during the tax year, capital gains are tax exempt unless they are effectively connected with a trade or business in the United States during your tax year.

— IRS Publication 519

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

Investing in ETFs will not count as effectively connected income and therefore any capital gains from the sale of these will be tax free as a nonresident.

— 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.[3] 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.[4][5]

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.[3] 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.[4][5][note 1]

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.[6] 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.

Investors in countries with poor or no US tax treaty coverage should strongly consider using non-US domiciled ETFs instead of US domiciled ones, as a way to reduce or even eliminate the US tax they pay on dividends from funds holding stocks.[note 2]

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'[7] and can be exempted from nonresident withholding.[8] 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.[6] 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.[note 3][note 4][note 5] MUB holds US municipal bonds, which are tax-exempt from US federal taxes. VXUS holds stocks of non-US companies.[9]

Date Holding activity Amount
03/06/2015 01:07:48 NON-TAXABLE DIVIDENDS (MUB) 1.20
03/06/2015 01:10:05 ORDINARY DIVIDEND (BIV) 1.05
03/06/2015 01:10:05 W-8 WITHHOLDING (BIV) -0.32
03/06/2015 01:10:09 ORDINARY DIVIDEND (LQD) 1.31
03/06/2015 01:10:09 W-8 WITHHOLDING (LQD) -0.39
03/06/2015 01:12:00 ORDINARY DIVIDEND (BNDX) 0.62
03/06/2015 01:12:00 W-8 WITHHOLDING (BNDX) -0.19
03/27/2015 09:38:40 ORDINARY DIVIDEND (VIG) 2.75
03/27/2015 09:38:40 W-8 WITHHOLDING (VIG) -0.83
03/31/2015 02:17:29 ORDINARY DIVIDEND (VTI) 2.54
03/31/2015 02:17:29 W-8 WITHHOLDING (VTI) -0.76
03/31/2015 02:21:56 ORDINARY DIVIDEND (VXUS) 1.58

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.[10]

If you supply your broker with a form W-8BEN, this should ensure the correct US tax withholding on dividends.[11] 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"[note 6] 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.[note 7]

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.[12]

Warning: Where an account holder who is a US nonresident alien dies, and there is no US estate tax treaty coverage, the US will levy up to 40% estate tax[13] on US assets over the value of $60,000 USD.[14][note 8] This includes US domiciled holdings such as funds and ETFs, as well as cash sums in a US-based brokerage account,[15] stocks of US corporations, and US IRAs, 401ks, and similar retirement saving accounts,[16][note 9] but excludes cash deposits at a US bank and most directly-held US treasury bonds.

Investors in this situation should strongly consider using non-US domiciled ETFs instead of US domiciled ones, and if using a US-based broker, ensure that the cash balance does not exceed $60,000. This eliminates the threat of estate taxes for most nonresident aliens, the main exception being nonresident aliens who hold US situated retirement accounts such as IRAs and 401ks.[note 10][note 9]

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

Upon the death of the beneficial owner, the U.S. brokerage firm is forbidden under U.S. tax law from transferring the assets from the decedent’s account until the IRS has concluded its estate tax audit.

— Charles Schwab, U.S. Tax and Estate Disclosure to Non-U.S. Persons[17]

A US estate tax treaty may provide protection from US estate taxes up to or even beyond 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.[18] 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.[19]

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?

Sometimes. Nonresident aliens are not subject to US gift tax on gifts of 'intangible property', such as US domiciled ETFs and US stocks,[20][21] even though these assets might be taxable under the US estate tax.

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.

Warning: Even though a cash deposit in a US bank is excluded under the US estate tax, the IRS views cash deposits as 'tangible property' and so subject to US gift tax.[22][23] Note that there is no unlimited marital gift tax exemption for US nonresident aliens.

Non-US investors holding any US cash accounts should avoid directly making any gifts of US cash above the minimal US gift tax exemption.

Foreign Account Tax Compliance Act (FATCA) and NRAs

See also: FATCA

The Foreign Account Tax Compliance Act (FATCA)[24] is a United States federal law that requires United States persons, including individuals who live outside the United States, to report their financial accounts held outside of the United States, and requires foreign financial institutions to report to the Internal Revenue Service (IRS) about their U.S. clients. Congress enacted FATCA to make it more difficult for U.S. taxpayers to conceal assets held in offshore accounts and shell corporations, and thus to recoup federal tax revenues.

— Wikipedia[25]

Regarding non-US clients of a foreign financial institution (FFI) who will not provide the documentation needed for FATCA:

Generally, any account holder whose account is at least $50,000 that does not comply with reasonable requests for information necessary to determine whether its account is a United States account will be a "recalcitrant account holder" and will be subject to 30% withholding on withholdable payments and gross proceeds from the sale or disposition of U.S. assets which can produce interest or dividends.

— Deloitte FATCA FAQs[26]

FATCA withholding also applies to gross proceeds from the sale of U.S. securities, which are excluded from NRA withholding. In addition, FATCA withholding may not be reduced or eliminated by making a treaty claim on a Form W-8. Where an FFI is not FATCA-compliant, full 30% FATCA withholding will apply. When FATCA withholding is required, the withholding agent does not impose withholding under the existing NRA rules. Conversely, where an FFI is FATCA-compliant, FATCA withholding will not apply, and withholding under the existing NRA withholding rules will apply (subject to treaty rates).

— Northern Trust, FAQ for Fund Managers[27]

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.[28] 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.

See also

Notes

  1. At the time of writing, the US maintains income tax treaties with Australia, Austria, Bangladesh, Barbados, Belgium, Bulgaria, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, Latvia, Lithuania, Luxembourg, Malta, Mexico, Morocco, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, Romania, Russia, Slovak Republic, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Thailand, Trinidad & Tobago, Tunisia, Turkey, Ukraine, United Kingdom, and Venezuela.
  2. The countries with poor US income tax treaties, ones that provide a US dividend tax rate that is above the 15% US/Ireland tax treaty rate, are Greece, Pakistan, Trinidad and Tobago, India, Israel, Philippines, Tunisia, and Turkey.
  3. The lack of VXUS dividend withholding by the US seems to contradict the predictions. It was expected that the US would withhold dividend taxes on this US-domiciled fund. One possible explanation is that the dividend in question was actually payment of short-term capital gains. This type of dividend is exempt from US withholding when paid to a nonresident alien. Forum member "furion" confirms that at least one brokerage considers VXUS subject to US tax withholding, in Bogleheads® forum post: Re: Question about a Bogle wiki article. 2 Jul 2016, viewed 12 Apr 2020.
  4. Also unexpected is that the LQD and BIV dividends were all withheld at 30%. These ETFs hold only bonds, and so their dividends should be all QII, making them exempt from nonresident withholding.
  5. BNDX holds only non-US bonds, and so will not benefit from the QII exemption.
  6. The use of "simplified" here is a relative term.
  7. At the time of writing, the US maintains estate tax treaties with Australia, Austria, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, South Africa, Switzerland, and the United Kingdom. The estate tax treaties with Ireland and South Africa may be deficient in important areas.
  8. For example, a deceased nonresident alien in a country without a US estate tax treaty and who held US domiciled ETFs valued at $500,000 on death would face a US estate tax liability of $142,800, and so lose 28.56% of their assets. In comparison, a US citizen with the same holdings at the same level would pay no US estate tax at all.
  9. 9.0 9.1 Nonresident aliens cannot directly open US IRAs, 401ks, and similar accounts. They may however retain these types of accounts when opened during a past period of US residency or citizenship, and they can also inherit them.
  10. For US IRAs, 401ks, and similar accounts, nonresident alien investors without estate tax treaty coverage who hold them might consider taking early withdrawals to further reduce US estate tax exposure.

References

  1. "Determining Alien Tax Status". IRS. Retrieved July 25, 2020.
  2. "Publication 519, U.S. Tax Guide for Aliens" (PDF). IRS. Retrieved July 25, 2020.
  3. 3.0 3.1 "Publication 515 - Withholding of Tax on Nonresident Aliens and Foreign Entities" (PDF). IRS. Retrieved July 25, 2020.
  4. 4.0 4.1 "NRA Withholding". IRS. Retrieved July 25, 2020.
  5. 5.0 5.1 "Tax Treaty Tables". IRS. Retrieved May 27, 2019.
  6. 6.0 6.1 Jeffrey M. Colon. "Foreign Investors in U.S. Mutual Funds: The Trouble with Treaties, p. 487". Fordham. Retrieved May 26, 2019.
  7. "Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities". IRS. Retrieved August 6, 2020.
  8. "Permanent U.S. Withholding Tax Relief for Non-U.S. Investors in U.S. Mutual Funds". K&L Gates. Retrieved May 23, 2019.
  9. "Publication 515, Income subject to withholding, Withholding of Tax on Nonresident Aliens". IRS. Retrieved April 3, 2015.
  10. "About Form 1040-NR, U.S. Nonresident Alien Income Tax Return". IRS. Retrieved February 13, 2020.
  11. "About Form W-8 BEN, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities)". IRS. Retrieved February 13, 2020.
  12. "Canada - Tax Treaty Documents". IRS. Retrieved August 9, 2020.
  13. "Estate and Gift Taxes for Nonresident Aliens". Congressional Research Service. June 2, 2014. Retrieved August 7, 2020.
  14. "Estate tax in the United States". Wikipedia. Retrieved July 25, 2020.
  15. "Estate taxation of a nonresident alien" (PDF). JPM Financial Services. Retrieved July 25, 2020.
  16. "Investing and Financial Planning for Foreign Nationals in US". Thun Financial. Retrieved December 14, 2019.
  17. "U.S. Tax and Estate Disclosure to Non-U.S. Persons" (PDF). Charles Schwab. Retrieved July 25, 2020.
  18. "United States Estate and Gift Tax - An Overview for Foreigners Investing in the United States" (PDF). Kohnen & Patton LLP. Retrieved February 13, 2020.
  19. "Estate, Gift, and Generation-Skipping Transfer Tax Treaties" (PDF). SMU Law Review. 1983. Retrieved August 1, 2020.
  20. "U.S. Gift Taxation of Nonresident Aliens". Kerkering, Barberio & Co. Retrieved August 8, 2020.
  21. "Gift Tax for Nonresidents not Citizens of the United States". IRS. Retrieved August 8, 2020.
  22. "U.S. Estate and Gift Planning for Non-Citizens". SGR Law. Retrieved May 9, 2021.
  23. "Gifts of cash by nonresidents are surprisingly taxable". HodgenLaw PC. Retrieved May 9, 2021.
  24. "Foreign Account Tax Compliance Act". IRS. Retrieved July 25, 2020.
  25. "Foreign Account Tax Compliance Act". Wikipedia. Retrieved July 25, 2020.
  26. "FATCA Frequently Asked Questions (FAQs) - Bullet 39" (PDF). Deloitte. Retrieved July 25, 2020.
  27. "FAQ for Fund Managers - Bullet 9, page 6" (PDF). Northern Trust. Retrieved July 25, 2020.
  28. "About Form W-8 BEN, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities)". IRS. Retrieved November 18, 2019.

External links