Nonresident alien taxation

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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)?

Main article: Domicile

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]

Are capital gains taxable for a nonresident alien?

No. Capital gains from US domiciled ETFs 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 can mean that holding US treasuries directly, rather than through an ETF, 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 stocks and by US domiciled ETFs.

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]

Apart from an exemption for some US source 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.

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 an 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 can be exempted from nonresident withholding.[7] 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 1][note 2][note 3] MUB holds US municipal bonds, which are tax-exempt from US federal taxes. VXUS holds stocks of non-US companies.[8]

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

US estate taxes

If your home country does not have an 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.

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.[12]

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

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.

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.

Foreign Account Tax Compliance Act (FATCA) and NRAs

See also: FATCA

The Foreign Account Tax Compliance Act (FATCA) 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." [13] [14]

— Wikipedia

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". [15]

— Deloitte FATCA FAQs

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)". [16]

— Northern Trust, FAQ for Fund Managers

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.[17] 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. The 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.
  2. 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.
  3. BNDX holds non-US bonds, and so may not benefit from the QII exemption.
  4. 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.

References

External links