Don’t Let Your Foreign Non-Compliance Turn Criminal (Examples)

Don’t Let Your Foreign Tax Non-Compliance Become Criminal

When a Taxpayer is considered a U.S. person for tax purposes, they are required to report their worldwide income on their U.S. tax return. In general, a U.S. person for tax purposes includes U.S. Citizens, Lawful Permanent Residents, and foreign nationals who meet the Substantial Presence Test — while Taxpayers who are not considered U.S. persons for tax purposes are generally only taxed by the United States on their U.S.-sourced income. That is because the United States cannot tax a foreign person on foreign income. After all, it has no relation to the United States. When a foreign person invests in the United States, one of the key issues to determine is whether the income is considered ECI or FDAP — and whether the income is U.S.-sourced or foreign-sourced. Let’s work through some basics involving the taxation of foreign persons with U.S. investment activities. Noting there are several exceptions, exclusions, and limitations based on the category of income whether there is a treaty, election, etc. *For all examples, please note that the Taxpayers are Non-Resident Aliens (NRA). Also, these examples are for illustrative purposes only and Taxpayers should consult with a Board-Certified Specialist if they have specific questions about their reporting requirements and not rely on this article for legal advice.

FDAP vs ECI

There are two main categories of income when it involves the taxation of foreign persons. The first category of income is FDAP, which refers to Fixed, Determinable, Annual, and Periodical. Generally, this is referred to as passive income and it is taxed in the U.S. at a flat rate of 30% (the 30% may be impacted by whether any treaty rules apply). The other category of income is ECI, which is referred to as Effectively Connected Income and is typically going to be taxed at graduated rates similar to the income tax rates for U.S. person individuals. 

Treaty or Non-Treaty Country

A key issue involves whether a foreign person will be taxed on their U.S. investment activities or if there is a treaty between the United States and the foreign country of residence or not. When there is a treaty, sometimes the tax withholding will be reduced or eliminated. In addition, some types of income that may ordinarily be taxed may not be taxed as a result of the treaty.

W-8 BEN to Reduce or Eliminate Withholding

Taxpayers who are NRAs (especially those in treaty countries) will want to submit a W-8BEN to the withholding agent because it may reduce or eliminate the withholding based on the treaty.

Interest Income

In general, interest income is taxable by the resident country of the recipient of the interest income. Therefore, an NRA would not generally be taxed on U.S. interest income from typical sources such as bank interest. When it comes to bond and treasury bills it can get more complicated as well as the overall concept of portfolio income.

• • • Example 1: David decides he wants to invest in U.S. bank interest because the CD rates were high. David earned $45,000 in the year from interest income generated from U.S. deposits — the interest income would generally not be taxable.

    • Example 2: Scott purchased a bond fund in which several bonds are pooled together and Scott receives dividend income. Since the actual income that Scott is receiving is dividend income, it may be taxable — noting there are some exceptions for mutual fund interest income (see below).

Dividend Income

Dividend is sourced from whether the payor company is a U.S. or foreign corporation. In most circumstances, dividend income will be sourced in the country where the corporation issues the dividend. Therefore, if the company issuing the dividends is U.S.-based, then the dividend will be U.S.-sourced income.

• • • Example 1: Jennifer wants to expand her portfolio and decides to invest in a few companies located in the United States that issues dividends. The dividends are taxable even though she lives outside of the United States and is not considered a U.S. person for tax purposes.

    • Example 2: Michelle invests in various mutual funds located in the United States. As part of the annual distributions, Michelle received certain interest related dividends. Interest related dividends from mutual funds are typically an exception to the withholding so that Michelle may not have to pay any tax on these dividends. (See section 26 USC § 871(k)(1) and 852(a)).

    • Example 3: Danielle also invests in U.S. mutual funds and as part of the investment the fund distributes certain short term capital gain dividends. Sometimes short-term capital gain dividends will not be taxable, but it is based on various facts and circumstances including whether the taxpayer is in the United States for 183 days or more.

Capital Gain Income

In general, capital gain income is going to be sourced at the location where the taxpayer lives and therefore capital gain income is generally not taxable to an NRA as U.S.-sourced income. Certain items are excludable from this list, including real property in accordance with FIRPTA.

• • • Example 1: Scott buys and sells U.S. stock but does not live in the United States for at least 183 days in the current year. This income will (generally) not be subject to U.S. tax.

    • Example 2: Peter buys and sells U.S. stock is a Non-Resident Alien but he resided in the United States for 190 days in the tax year. As a result, Peter’s income from the buying and selling of stock may become taxable in accordance with the 183-day Caital Gains rule. But since Peter lives in a treaty country, he may be able to reduce the overall tax liability on the income.

    • Example 3: Brian lives and works outside of the United States and had not traveled to the United States in several years but he still owned a rental property in California. In the current year, Brian sold the property and therefore Brian is required to report this sale on a U.S. tax return and he will be taxed on the gain. He may be able to reduce the withholding by making an 8288-B election

The Tip of the Iceberg

The goal of this article is to help clarify some of the basics of international information reporting for NRAs. Reporting foreign assets to the U.S. tax authorities can be very complicated, especially when it involves additional items such as foreign life insurance policies, foreign corporations, foreign partnerships, and transactions between U.S. persons and foreign companies. Taxpayers should try to stay in compliance if they are already in compliance or should consider getting into compliance if they have not properly filed the necessary reporting forms if for no other reason than the fact that the IRS has made offshore compliance a key enforcement priority and has been issuing fines and penalties for non-compliance. 

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and/or other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist Taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs. Prior Year Non-Compliance

Once a Taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, Taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for Taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting.  *This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure.  Contact our firm today for assistance.