For U.S. income tax purposes, persons who are not U.S. citizens are considered to be either residents or nonresidents of the U.S. The importance of this distinction is that persons considered to be residents are subject to U.S. income tax on their worldwide income, while nonresidents are taxed only on their U.S. source income.
The rules for determining whether a person is a resident for tax purposes are not necessarily the same as the rules for immigration purposes. The U.S. Internal Revenue Service (IRS) has two basic tests for determining residency. One of these is the green card test, which is in line with immigration laws, in that it states that a resident is a person who has been admitted as a lawful permanent resident of the United States. The other test is the substantial presence test, which determines resident status based on the number of days of actual physical presence in the U.S. These rules are explained in IRS Publication 519 – U.S. Tax Guide for Aliens, which can be found on the IRS website at www.irs.gov.
Source Rules and Determining Factors
If you do not meet either the green card test or substantial presence test and are therefore considered a nonresident for U.S. income tax purposes, you are subject to U.S. income tax only on your U.S. source income. This is true whether you are actually residing in the United States or outside the country. Depending on the type of income, there are different factors that determine whether the income is U.S. source, and therefore taxable. These are referred to as the source rules.
Salaries, wages, and other compensation you receive for work performed in the United States are considered U.S. source income. If you work both inside and outside the U.S., you will need to prorate your compensation to determine how much is U.S. source. Normally you can do this based on the proportion of days you worked in the U.S. You would take the number of days you worked in the U.S. divided by the total number of days you worked, times the total compensation you received for the period.
If you are a nonresident and work as a regular crew member of a foreign vessel that makes stops in the United States, your compensation for the days you are temporarily in the U.S. is not U.S. source, and is therefore exempt from U.S. income tax. There are special sourcing rules that apply to transportation income, but the income earned by crewmembers is not considered transportation income for these purposes.
If you were paid by a foreign employer, your income for personal services may be exempt from U.S. income tax, even if the services were performed in the U.S. Your income would not be considered U.S. source, and would be tax exempt, if you performed the services for a foreign employer, you perform the services while you are a nonresident temporarily in the U.S. for a period, or for different periods, totaling not more than 90 days during the year, and your compensation for those services is not more than $3,000.
A foreign employer includes nonresident alien individuals, and foreign partnerships and corporations. A foreign employer can also be a trade or business maintained in a foreign country or in a U.S. possession by a U.S. citizen or resident, a U.S. partnership, or a U.S. corporation. For example, if you are employed by a U.S. company based overseas, and you work temporarily for a branch office of that company in the U.S., your income will be exempt from U.S. income tax provided you worked in the U.S. not more than 90 days during the year, and did not earn more than $3,000 for the services you performed in the U.S.
Employees of Foreign Governments and International Organizations
Nonresidents who work in the U.S. for foreign governments and international organizations may also be exempt from U.S. income tax on their income. Employees of foreign governments can be exempt based on the provisions of a tax treaty or consular agreement between the U.S. and the foreign country, or by meeting the requirements of U.S. tax law. Employees of an international organization can only be exempt by meeting the requirements of U.S. tax law.
Normally, U.S. citizens and residents working for a foreign government do not qualify for exemption, but there may be certain cases in which a dual citizen could qualify. You should check the provisions of the applicable tax treaty. But nonresidents would normally be able to qualify for this exemption.
If you work for a foreign government and do not qualify for exemption based on a tax treaty, the foreign government must certify that you are their employee and that the services you perform are similar to services performed by U.S. government employees in that foreign country. This certification must be presented to the Department of State. If you work for an international organization and are not a U.S. citizen, your income for personal services is exempt from U.S. income tax. The organization must be designated in an Executive Order issued by the President of the United States. You should know the number of that order, and should have some written evidence from the Department of State, of your acceptance or designation.
Scholarships, Fellowships, and Grants
The source of scholarships, fellowships, grants, and similar types of awards is generally the residence of the payer. So, if you receive one of these types of awards from a payer located in the United States, it will generally be U.S. source income to you. But if the award is given for services performed, or to be performed outside the United States, the income would normally be foreign source. Payments from a foreign government, a foreign company, or an international organization are generally considered foreign source income.
The source of interest income is generally the residence of the payer, regardless of where or how the interest is paid. U.S. source interest income includes interest on bonds, notes, or other obligations of U.S. residents or domestic corporations. Interest income paid by a domestic or foreign partnership, or a foreign corporation, is also U.S. source interest income if the partnership or corporation was engaged in a U.S. trade or business at any time during the year. Interest income in the form of original issue discount, and interest on U.S. government obligations, or on the obligations of states or the District of Columbia, is also considered U.S. source interest income.
Interest is not considered U.S. source if the payer is a resident alien or domestic corporation, and during the prior 3 years, at least 80% of the payer’s income is from sources outside the United States, and is attributable to the active conduct of a trade or business in a foreign country or a U.S. possession.
Interest paid by a foreign branch of a domestic corporation or partnership on deposits or accounts in savings and loan institutions is not considered U.S. source income. And, interest on deposits with a foreign branch of a domestic partnership or corporation in the commercial banking business are not U.S. source income.
The source of dividend income generally depends on whether the paying corporation is a U.S. or foreign corporation. Dividends from a U.S. corporation are considered U.S. source income. Dividends from a foreign corporation are foreign source income.
But part of the dividends received from a foreign corporation could be considered U.S. source income if during the 3-year period prior to the dividend declaration date, at least 25% of the foreign corporation’s gross income was effectively connected with a trade or business in the United States. In this case, you would need to prorate the dividends to determine the amount that is U.S. source. You would take the foreign corporation’s gross income connected with a U.S. trade or business for that 3-year period, divided by its total gross income for the period, times the dividend payment. The result would be U.S. source dividend income.
Pensions and Annuities
The source of pensions and annuities depends on where the services that earned the pension or annuity were performed. If you receive a pension for services you performed both inside and outside the United States, part of the pension income will be U.S. source. This will be the part that represents employer contributions to the pension or annuity plan, and earnings on the account, that correspond to the services performed in the U.S. This applies to distributions from qualified or nonqualified stock bonus, pension, profit-sharing, and annuity plans.
Rents and Royalties
The source of rent income depends on the location of the property that generates the income. If the property is located in the United States, the rental income is U.S. source income. Royalties on natural resources, such as oil or mineral properties, are U.S. source income if the natural resources are located in the United States. Royalties for the use of intangible assets, such as patents, copyrights, formulas, trademarks and franchises, are U.S. source income if the intangible assets are used in the United States.
Gains and Losses on the Sale of Property
The source of gains and losses on the sale of property depends on whether the property is real property, personal property, or natural resources. Personal property includes inventory, depreciable property, and intangible property.
Real property includes land and buildings, and generally anything attached to them, or growing on the land. The source of gains and loss on the sale of real property depends on where the property is located. If it is located inside the United States, any gain or loss on the sale or disposition of the property would be U.S. source income.
For personal property, such as machinery, equipment, or furniture, the source of a gain or loss on a sale is the tax home of the seller. Your tax home is the general area of your main place of business or employment, or post of duty. It is where you permanently or indefinitely work, as an employee or self-employed, and may not be the same as your family home. The general rule is that if your tax home is in the U.S. and you sell personal property, the source of the income is in the U.S.
The source of income from the sale of inventory property, that is, property held as stock in trade or held for sale to customers in the ordinary course of your trade or business, depends on whether you purchased the merchandise for sale, or produced it. If you purchased the inventory, the income is sourced where it is sold. So if you sell inventory in the U.S., the income is U.S. source income, regardless of where you purchased the merchandise. If you produce the inventory in the U.S. and sell it outside the country, or vice versa, part of your income will be U.S. source, and part foreign source. This determination is made according to the rules defined in section 1.863-3 of the tax regulations. These rules are the same that apply for “Natural Resources” and are briefly described below. These rules will apply even if your tax home is not in the United States.
In order to determine the source of income from the sale or disposition of depreciable property, you must first determine the total depreciation adjustments that have been allowed on the property. This portion of the gain is then allocated between U.S. source income and foreign source income based on the ratio of depreciation adjustments for U.S. income tax purposes to total depreciation adjustments allowed for all sources. If all the depreciation adjustments were in the U.S., the gain up to this amount would be U.S. source. But if depreciation adjustments were also taken in a foreign country, the part of the gain up to the total depreciation adjustments would be allocated between U.S. and foreign source income. Any gain on the sale that is more than the total depreciation adjustments allowed on the property is sourced in the same way as income from the sale of inventory property, as described above.
Gain from the sale of intangible property, such as patents, copyrights, formulas, trademarks, or similar property is sourced in a manner similar to depreciable property. If the intangible property is depreciable or amortizable, the part of the gain up to the total depreciation or amortization allowed is prorated between U.S. and foreign source income, based on the ratio of adjustments inside the U.S. to the total adjustments.
If the income from the sale is contingent on the productivity, use or disposition of the intangible property, the excess of the gain over the depreciable or amortizable amount is sourced in the country where the property is used. If the sale is not contingent on productivity, use or disposition of the property, the source of the income is the seller’s tax home.
Office or Fixed Place of Business in the U.S.
Despite the above rules on the source of income from the sale of personal property, even though your tax home is not in the U.S., your income may be U.S. source if you have an office or other fixed place of business in the United States. Income from the sale of any personal property attributable to that office or place of business would be considered U.S. source income.
According to section 1-863-1(b) of the income tax regulations, if products derived from the ownership or operation of a farm, mine, oil or gas well, other natural deposit, or timber located in the United States are sold outside the U.S., the gross receipts must be allocated between U.S. source and non-U.S. source income based on the fair market value of the product at the export terminal. This also applies to the allocation of gross receipts derived from sources outside the United States that are sold inside the U.S.
Gross receipts up to the fair market value at the export terminal will be considered to have their source where the farm, mine, well, deposit, timber, or other natural resource is located. Gross receipts in excess of the fair market value at the export terminal would be considered to have their source in the country of sale.
But if there is additional production activity, subsequent to shipment from the export terminal and outside the country of sale, the rules of section 1-863-3 apply. These rules specify three different methods for determining the source of the gross receipts. One of these is the 50/50 method, which states that 50% of the gross receipts would be attributable to production activity and the other 50% to sales activity, and the income would be sourced according to separate rules for determining the source of the production and sales activities. The other two methods are the independent factory price method, and the books and records method. The rules for determining the source of income based on these methods are discussed in section 1-863-3 of the U.S. income tax regulations.
If there is additional production activity prior to shipment from the export terminal, gross receipts up to the fair market value immediately prior to the additional production activities are considered to have their source where the natural resource came from. The source of the gross receipts in excess of this fair market value would be determined according to the same rules as described above.
The source rules for business income depend on whether the business income is from personal services, sales of inventory, or gains and losses on the sale of other property. These sourcing rules are described above, under the appropriate category. In summary, the source of business income from personal services is determined by where the services were performed. For business income from the sale of inventory that was purchased, the source is determined by where the merchandise is sold. And, for income from the sale of inventory that was produced, the allocation rules from section 1-863-3 apply.
Withholding Tax on U.S. Source Income
If, as a nonresident or foreign person, you receive interest, dividends, compensation for personal services, or some other type of income that may be considered U.S. source, and subject to U.S. income tax withholding, the payer should provide you with IRS Form 1042-S, Foreign Person’s U.S. Income Subject to Withholding. You may need to file IRS Form 1040NR, U.S. Nonresident Alien Income Tax Return. You can refer to IRS Publication 519, U.S. Tax Guide for Aliens, for information on filing requirements for nonresidents.