The United States generally taxes nonresident aliens and foreign corporations on their U.S.-source income. A foreign taxpayer’s U.S.-source income falls into one of two general categories: (i) “fixed or determinable annual or periodical gains, profits, and income” (“FDAP income”) or (ii) income that is “effectively connected” with the conduct of a U.S. trade or business (“ECI”). In this post, we focus on the taxation of FDAP income.
A non-U.S. person is generally taxed on a gross basis and at a 30-percent rate on U.S.-source FDAP income, which is subject to withholding. In many cases, however, FDAP income is subject to a reduced rate of tax, or entirely exempt from tax, under the Code or a bilateral income tax treaty.
What is FDAP Income?
Under Treasury regulations, FDAP income includes all gross income under section 61 except for specifically excepted items of income. FDAP income includes, for example, interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, and emoluments.
FDAP income is indeed broad and includes the following items, which are merely examples:
- Compensation for personal services
- Original issue discount
- Pensions and annuities
- The distributable net income of an estate or trust that is FDAP income, and that must be distributed currently, or has been paid or credited during the tax year, to a nonresident alien beneficiary
- A distribution from a partnership that is FDAP income, or such an amount that, although not actually distributed, is includible in the gross income of a foreign partner
- Taxes, mortgage interest, or insurance premiums paid to, or for the account of, a nonresident alien landlord by a tenant under the terms of a lease
- U.S. source FDAP income includes 85% of any U.S. Social Security benefit (and the Social Security equivalent part of a Tier 1 railroad retirement benefit). This income is exempt under some tax treaties.
- Gains realized on the disposition of timber, coal or domestic iron ore, with a retained interest covered by IRC § 871(a)(1)(B) and IRC § 631(b)
- U.S-source gains from the sale or exchange of intangibles if they are contingent on the productivity, use, or disposition of the property sold.
Exclusions From FDAP Income
Although FDAP income captures a broad range of gross income, it is subject to a number of important exceptions. Capital gains of nonresident aliens generally are foreign source; however, capital gains of nonresident aliens present in the United States for 183 days or more during the year are income from U.S. sources.
In addition, gains from the sale of U.S. real property interests are treated as effectively connected income under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”).
Interest on bank deposits may be exempt from FDAP income treatment. For example, interest on deposits with domestic banks, and certain amounts held by insurance companies, are U.S.-source income, although they are exempt from the 30-percent tax when paid to a foreign person. Such portfolio interest does not, however, include interest received by a 10-percent shareholder, certain contingent interest, interest received by a CFC from a related person, or interest received by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business.
Interest on deposits with foreign branches of domestic banks is not U.S.-source income and, thus, is not subject to U.S. tax. Interest and original issue discount on certain short-term obligations are also exempt from U.S. tax when paid to a foreign person.
And as with any good fine print, other exclusions may apply.
Withholding on FDAP Income
Unlike effectively connected income, which is generally subject to the same U.S. tax rules and rates that apply to business income earned by U.S. persons, FDAP income is generally subject to a 30-percent tax and is collected by withholding. In many cases, however, FDAP income is subject to a reduced rate of tax, or entirely exempt from tax, under the Code or a bilateral income tax treaty. Withholding on FDAP payments to foreign payees is required unless the withholding agent, i.e., the person making the payment to the foreign person, can establish that the beneficial owner of the amount is eligible for an exemption from withholding or a reduced rate of withholding under an income tax treaty.
The United States is a signatory to more than 60 income tax treaties. While a non-U.S. person is generally subject to withholding on U.S.-source FDAP income, such income may be subject to a reduced rate of tax, or entirely exempt from tax, under the Code or a bilateral income tax treaty.
Our Freeman Law interactive tax treaty map provides a link to tax treaty materials for each U.S. treaty partner: