Innocents Abroad

In a previous column (March 2002, “The Globalization of U.S. Taxation”) we discussed the tax issues confronting the international investor who is a non-U.S. citizen or resident. In this article, we’ll address what happens when a U.S. citizen or resident makes investments or holds assets outside the United States.

Many U.S. citizens or residents have investments and transactions around the globe. Some have moved overseas and intend to live there for an extended period. An understanding of how the U.S. tax system applies to them, and how it interacts with foreign tax systems, will help them to make informed investment, business, and legal decisions. The U.S. has income tax and estate tax treaties with many countries, and these treaties have a significant impact on how the U.S. investor gets taxed.

The United States probably has the most far-reaching tax jurisdiction base over its citizens and residents in the world. For income tax purposes, if you are a U.S. citizen or resident, then you are subject to U.S. taxes on your worldwide income from all sources. This rule applies not just to those who are legal immigrants (a person who is a permanent resident, i.e., with a “green card”), but may apply to non-permanent visitors to the U.S. (such as those with a B, E, H, or L visa), and who meet what is known as the “substantial presence” test.

For U.S. estate and gift tax purposes, if you are a U.S. citizen or resident (for estate tax purposes), then you are subject to U.S. estate and gift tax on your worldwide assets. Determination of “residence” for “estate and gift tax purposes” operates under a different set of rules than those for “income tax purposes.” While for income tax purposes the standards are very precise and codified in U.S. tax law, residency for U.S. gift and estate taxes are based on a “facts and circumstances” test. Therefore, it happens quite frequently that a person can be classified as a U.S. resident for income tax purpose while not being considered a U.S. resident for estate and gift tax purposes. The reverse situation is also possible, although it happens less frequently. One example is the United Nations employee who has been working in the U.S. on a G-4 visa for an extended period. Such an individual is exempt from the “substantial presence” test and is clearly a “non-resident” for income tax purposes. However, for U.S. estate tax purposes, this person can be classified as a U.S. resident and be subject to the U.S. estate tax on worldwide assets.

In this article, the term “U.S. person” shall include both a U.S. citizen and any person who is considered as a “resident for tax purposes” (for the type of tax we are discussing then: income tax or estate tax).

Income Taxes Overseas

How a U.S. person gets taxed on income from investments abroad depends on two initial questions: What is the U.S. person’s residency status in the country where the investment is located? Does the U.S. have an income tax treaty with that country?

If the U.S. person is not a resident in the country where the investment is located, then investment-type income (such as interest, dividends, or royalties) from abroad are typically subject to local withholding taxes.

If an income tax treaty exists between the U.S. and the particular country, then probably the withholding tax rate will get reduced. Possibly, for treaties with certain countries, some categories of income are exempt from tax altogether.

An example is the U.S. person who has a bank deposit at a bank in Canada. Under the Canada-U.S. Tax Treaty, a 15% Canadian withholding tax on the gross interest income is imposed (rather than a higher 25% tax rate against someone from a country that has no tax treaty with Canada). The U.S. person will then report the interest income on her or his U.S. tax return, and claim a “foreign tax credit” for the Canadian tax paid. Therefore, it is possible that the U.S. person will have no additional tax cost due to the overseas investment, since the foreign tax paid is in fact “cancelled” out by the credit claimed on her or his U.S. tax return.

It’s important to note that other countries can have different concepts of what income should be taxed, and how they should be taxed, as compared to the U.S. tax system.