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An Advisor’s Guide to Cross-Border Taxes

Tax-planning issues to consider when advising immigrant clients.

With travel bans, security concerns and increased scrutiny on some new arrivals to the U.S., immigration is a hot topic.

The consistent inflow of immigrants from all over the globe contributes to the United States' rich culture, success and innovation. They also bring a unique set of tax, legal and financial-planning needs. Cross-border tax planning is one of the biggest.

Depending on the client’s immigration status, there’s a laundry list of tax-planning issues for advisors to consider, including:

Income Taxation

A U.S. citizen is subject to U.S. income taxation on worldwide income regardless of where in the world they live. The United States is the only industrialized country that taxes its citizens using a citizen-based regime.

Resident Aliens. A non-U.S. citizen is treated as a U.S. tax resident alien—and subject to income tax on a worldwide basis—if one of two tests are met: (1) the individual is a U.S. “lawful permanent resident” (holds a green card), or (2) the individual satisfies the “substantial presence test.” If either test is met for any part of the year, the individual is a U.S. tax resident for that part of the year.

The green card test is met if a foreign individual is lawfully a permanent resident of the United States at any time during the calendar year. The individual must actually enter the United States to meet the green card test. This tax resident status continues unless the green card is revoked or administratively or judicially abandoned.

Under the “substantial presence” test, things get a bit more complex. A foreign individual is considered a U.S. tax resident if the individual was physically present in the United States for at least 31 days during the calendar year and, during a two-year look-back period, present for 183 days or more. The test counts the days using a weighted-average calculation over a three-year period. In counting the 183 days, each day present in the current year counts as one day; each day in the preceding year counts as one-third of a day; and each day in the second preceding year counts as one-sixth of a day. Days in U.S. possessions and territories or U.S. airspace don’t count toward the total, but days spent in U.S. territorial waters do.

The United States currently has almost 60 income tax treaties with other countries to determine where and how income should be taxed. To obtain the benefit of a lower treaty rate, the individual must be a resident of the country that has the treaty with the United States. Note, U.S. tax treaties generally don’t cover state income tax issues, so it’s possible to pay no federal income tax to the United States due to a tax treaty, with that same income still being taxed by a specific state or city.

Nonresident Aliens. If a foreign individual doesn’t meet the criteria of the two tests mentioned above, he’s considered a nonresident alien (NRA). An NRA is usually subject to U.S. income tax only on U.S. income—not worldwide income. An NRA’s income that’s subject to U.S. tax can be roughly divided between two categories.

The first category is income that’s “effectively connected with a U.S. trade or business” ("effectively connected income," or ECI). ECI is taxed at graduated rates, rather than at a flat rate. An NRA is engaged in a U.S. trade or business if his or her activities are “considerable … as well as continuous and regular.” Examples are performing personal services, or having a business, in the United States. If your client is engaged in a U.S. trade or business, all business income, gains or losses that are generated from sources within the United States are treated as ECI.

The second category that NRAs are subject to is a flat statutory rate of 30 percent tax on gross income on most items of "fixed, determinable, annual or periodical (FDAP)" income that isn’t effectively connected with the conduct of a trade or business in the United States. That includes certain dividends, interest, rents, compensation, annuities and royalties. To ensure that foreign recipients comply with U.S. tax law, the 30 percent tax is withheld at the source. However, this rate is frequently reduced or eliminated by a litany of tax treaties or exemptions.

Capital Gains

The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) created an exception to the general rule that NRAs aren’t subject to tax on U.S. capital gains. FIRPTA imposes three levels of withholding on sales of U.S. real estate by NRAs, depending on how much gain is realized and the buyers’ intentions. If the amount realized is less than $300,000 and the buyer intends to use the property as a personal residence, no withholding is required. If the amount realized is between $300,000 and $1 million and the buyer intends to use the property as a personal residence, the withholding rate is 10 percent. If the sales amount realized exceeds $1 million, the withholding rate is 15 percent, regardless of whether the buyer intends to use the property as a personal residence.

Similar to the annual filing of the federal individual income tax return Form 1040, NRAs file a Form 1040NR each year. The 1040NR is normally due by June 15, unless the NRA has income that’s subject to reporting on Form W-2 (aka wages), in which case the 1040NR is due by April 15. However, an NRA is subject to major limitations on deductions and credits:

An NRA can only claim deductions on effectively connected income. Also,

  • An NRA can’t claim the standard deduction or itemize deductions (other than ECI deductions) and, generally, must declare the filing status of single or married individual filing separately.
  • An NRA can deduct the personal exemption and charitable contributions to U.S. charities. If the withholding on the various sources of income is greater than the tax, it may be worthwhile to file a U.S. income tax return and obtain a tax refund.

IRS income statistics for 2014 (the latest year currently available) report that almost 90 percent of the income paid to foreign individuals was exempt from withholding tax either due to a tax treaty or because the income was exempt under the IRC.

Renouncing U.S. Citizenship

Although many individuals dream of becoming a U.S. citizen, each year there are U.S. citizens doing the exact opposite by renouncing their citizenship.

Each quarter, the IRS publishes the names of the U.S. citizens who renounced their citizenships. In the quarter ending March 31, 2017, about 1,300 individuals expatriated. Sadly for those who see expatriation as a way to escape the U.S. tax regime, even permanently leaving the United States might result in a tax. There’s an exit tax for individuals expatriating who have a net worth of $2 million or more and/or an average annual net tax liability for the preceding five years of $161,000 or more in 2016. The tax is calculated on any gain by a hypothetical sale of all the individual’s assets. There are, however, some exceptions and exclusions, and for 2016, any hypothetical capital gains can be reduced by an exclusion of $693,000.   

 

This is an adapted version of the authors' original article in the August issue of Trusts & Estates.

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