US Tax Consequences to Foreign Investors

During the past few decades the United States has received a massive influx of foreign investment from abroad. Much of these international investors are unaware of the domestic tax consequences of investing in the United States. Foreign investors may be subject to US domestic taxation simply by investing or traveling to the US. Whether an individual will be subject to US taxation is dependent on numerous factors. However, whether or not an individual will be subject to US taxation depends on two critical factors. The first factor to consider is whether the individual is considered a US resident. The second factor concerns the source of the income received.

The United States taxes its citizens on their worldwide income. The United States Federal Tax Code provides two basic tests for determining whether or not an alien is a resident of the United States during a particular year. If the conditions of either test are met, then the taxpayer is a US resident for all or some part of that year. These two tests are generally known as the “green card test” and the “substantial presence test.”

Under the “Green Card Test,” an alien will generally be taxed as a resident of the United States during any year in which he or she is considered a lawful permanent resident of the US by the US immigration authorities, i.e., during any year in which he or she holds a valid “green card” or visa stating residency status. See Section 7701(d)(1)(A)(i). If an individual is classified by the US immigration authorities as a resident, unless an applicable tax treaty provides an exclusion, he or she will be taxed as a U.S. resident on all worldwide income.

Under the “Substantial Presence Test,” an alien will generally be considered a resident during any calendar year in which he or she is present in the United States for 31 days during the current year, and 183 days during the 3 year period that includes the current year and the 2 years immediately before that, counting 1) all days the individual was present in the current year; 2) 1/3 of the days the individual was present in the first year before the current year, and; 3) 1/6 of the days the individual was present in the second year before the current year. See Section 7701(b)(3)(A); Treas. Reg. Section 301.7701(b)(1) and (2).

Below, see Illustration 1and Illustration 2 which demonstrates how the substantial presence test is applied.

Illustration 1.

An individual was physically present in the United States for 120 days in each of the tax years for 2002 through 2005. To determine if the individual meets the substantial presence test for tax year 2005, count the full 120 days of presence in 2002, count 40 days presence in 2004 (1/3 of 120), and 20 days in 2002 (1/6 of 120). In this case, the total for the 3 year period is 180 days. Thus, this individual is not considered a resident under the Substantial Presence Test for 2005.

Illustration 2.

An alien was present in the United States from August 27 through December 31 of the current year for a total of 158 days. This individual was also present for 50 days in each of the two prior years. The substantial presence test would be applied to this individual as follows:

All days present during the current year 158
1/3 of the days during the first preceding year 162/3
1/6 of days present during the second preceding year 81/3
Total days counted 183

According to the Substantial Presence Test, this individual became a resident for taxation purposes on August 27th.

Certain individuals are exempt from the substantial presence test. These individuals include diplomats and their families; teachers and trainees; students under an “F,” “J” or “M” visa; commuters from Mexico and Canada; persons who are in the US less than 24 hours who are in transit between foreign destinations out the US; persons who suffered a medical condition that incapacitated them while they were present in the US, and; some professional athletes competing in charitable sporting events. See Treas. Reg. 7701(b)(3). Even though the Treasury Regulations provide an exception to the counting of days toward the 183-day rule, the Regulations do not provide an exemption from the tax on income earned in the United States on those days.

Even if the alien satisfies the substantial presence test, he or she could still qualify for non-resident tax treatment under the so-called “Closer Connection Test.” Under this exception, a foreign resident can avoid the consequences of the substantial presence 2-year look back rule if he or she can show the following: 1) the individual has a tax home in a foreign country; 2) the individual has a closer connection to a country other than the United States; 3) presence in the United States for fewer than 183 days during the taxable year. Unfortunately, the closer connection test is not available to aliens who have applied for a “green card.” See IRC Section 7701(b)(3)(C).

Whenever an alien was not a resident at any time during the prior tax year becomes a resident in the current year, under either test, a residence start date must be determined. In instances where an alien becomes a resident under the green card holder not meeting the substantial presence test, the alien becomes a resident for taxation purposes in the year which he or she is present in the United States as a lawful permanent resident. See IRC Section 7701(b)(2)(A)(ii). In the case of a green card holder not being physically present in the United States at any time during the year in question, the residency starting date is the first day of the following year. In the case of an individual meeting the substantial presence test, the first day of the presence in the United States during that year, he or she becomes a resident for taxation purposes. See IRC Section 7701(b)(2)(A)(iii). If both the substantial presence test and the green card test are met, the residency for taxation purposes is the earlier of the first day present as a green card holder or the first day physically present under the substantial presence test.

In determining the first day of presence under the substantial presence test, the Tax Code provides that an individual may be physically present in the United States for up to 10 days during the year without starting residency for US taxation purposes. In order to exclude these days for the purpose of determining residency starting date, an individual must be able to establish that during this time he or she had a tax home in a foreign country and a closer connection to that country on the days in question. See IRC Section 7701(b)(2)(C); Treas. Reg. Section 301.7701(b)-4(c)(1).

Many Green Card holders residing outside the United States could potentially benefit from tax treaties. However, they must refrain from taking advantage of a tax treaty due to risks associated with keeping their Green Card. Therefore, a full evaluation of U.S. immigration laws should be carefully evaluated in these situations.

The term United States includes the Following: 1) All 50 states and the District of Columbia; 2) The territorial waters of the United States, and; 3) The seabed and subsoil of those submarine areas that are adjacent the US territorial waters and over which the United States has exclusive rights under international law to explore and exploit natural resources. This term does not include U.S. possessions and territories or US airspace. See Publication 519.

A closer connection to a foreign country involves weighing factors such as the taxpayer’s permanent place of residence, employment or business, voting record, the filing of tax returns, registration of vehicles, location of personal possessions, and location of religious and social activities. See IRC Section 7701(b)(3)(A)(i).

In order for an alien to take advantage of the closer connection exception, a special statement must be attached to his or her tax return. See Treas. Reg. Section 301.7701(b)-8.