Fixed, Determinable, Annual, Periodical Income
How FDAP Impacts Foreign Investors
Foreign persons investing in the United States are only subject to limited U.S. taxation. Unlike, U.S. citizens or residents, foreign persons are subject to U.S. taxation on two categories of income. One of these categories is certain sources of income such as U.S. source interest, dividends, annuities, and other types of fixed income or periodical income. This income is known as “Fixed, Determinable, Annual, Periodical” [FDAP] income. FDAP income is subject to a thirty percent withholding tax on the gross basis of the income. Foreign investors are also subject to taxation on income that is effectively connected with a U.S. trade or business [ECI]. Income that is effectively connected with U.S. trade or business is taxed on a net basis at the graduated tax rates applicable to U.S. citizens or residents.
Impact of Tax Treaties
As discussed above, FDAP income obtained by a foreign person is subject to 30 percent tax. However, an international tax treaty and thoughtful tax planning may be utilized to mitigate or eliminate the U.S. withholding on FDAP income. It should be noted that as a general rule, in order to favorably utilize a particular tax treaty to mitigate the U.S. taxation of FDAP income, a foreign person must be a “resident” of the particular tax treaty being utilized and must satisfy the Limitation of Benefits Provision (“LOB”) provision of that treaty. The LOB provision of most tax treaties is satisfied if such person is liable for tax in the treaty’s particular jurisdiction by domicile, residence, citizenship, or incorporation. It should be noted that in most, but not all recently negotiated tax treaties, LOB provisions will only be satisfied if an individual or a corporation is at least 50 percent owned by citizens or residents of the jurisdiction where the corporation is formed.
Planning Opportunities with Tax Treaties
Many tax treaty LOB provisions significantly limit the ability to utilize a tax treaty for planning purposes. The more restrictive clauses of these provisions can be avoided in most tax treaties. However, there are a number of older tax treaties that do not contain such strictly constructed LOB provisions. These treaties include: 1) Hungary, 2) Poland; 3) Korea; 4) Greece; 5) Egypt; 6) Pakistan; 7) the Philippines; and 8) Romania. Not only do these treaties have significantly curtailed LOB provisions, but many of these treaties significantly reduce the requirements on the withholding of U.S. tax for FDAP payments. The combination of favorable LOB provisions and favorable FDAP withholding could result in significant inbound planning opportunities for foreign investors.
Planning to Utilize Beneficial LOB Provisions
Many foreign investors are citizens of countries that have a favorable treaty with the United States that reduces U.S. tax on FDAP income. However, this is not always the case. Not all foreign investors are residents of a jurisdiction that have a favorable tax treaty with the United States. In these situations, tax planning may be taken into consideration to utilize tax treaties without LOB restrictions and reduce the withholding of U.S. FDAP income.
For example, a Hong Kong resident can invest in the United States through a capitalized corporation established in Hungary or Poland. The Hungarian or Polish corporation in turn lends money to a Special Purpose LLC which can invest in real property or other investments in the United States. By establishing a corporation in Hungary or Poland, the Hong Kong investor can take advantage of favorable LOB provisions available in the Hungarian or Polish tax treaties with the United States. This allows the investor to significantly reduce or even eliminate U.S. taxation of FDAP income.
Naturally, whenever an investment vehicle is established in a non-U.S. jurisdiction, the tax law of that jurisdiction must be considered during any tax planning. Hungary currently has a 16 percent corporate income tax rate and Poland currently has a 19 percent corporate income tax rate. In order to reduce the local taxes in these jurisdictions, a financial branch should be created in a third law-tax jurisdiction. Hungary and Poland have tax treaties with Switzerland and Luxembourg. Both these countries have very favorable finance branch tax rates. A finance branch registered in Switzerland or Luxembourg has an effective tax rate ranging from 2 to 4 percent. As such, by owning a Hungarian or Polish corporation that wholly owns a finance branch in either Switzerland or Luxembourg, a foreign investor in the United States could significantly reduce his or her exposure to both U.S and foreign taxes on FDAP income.
As international tax attorneys, we can assist you in your international tax planning needs. One of our areas of expertise is to do for individuals and small businesses, what the Fortune 500 do to make billions in profits and legally eliminate taxes. If you are a foreign investor considering investing in U.S. real estate, U.S. business, or the U.S. capital markets; contact Moskowitz LLP and enjoy the experience our international tax attorneys have in arranging U.S. investments in order to minimize your exposure to U.S. taxes.