The general rule is that only U.S. Persons are subject to tax on their worldwide income on their respective Form 1040. Non-U.S. Persons, in contrast, are only subject to tax on their U.S. source income, and file Form 1040NR. Let us review the distinction and thresholds that determine whether someone is considered a U.S. Person, and by doing so, we should also discover when and how an individual may fall outside this classification.
U.S. Citizens are, by default, U.S. Persons under the Internal Revenue Code (“IRC”) Section 7701(a)(30)(A). Non-U.S. Citizens are only U.S. Persons if they are U.S. Residents (i.e., a resident alien or green-card holder).
Physical presence is a main test for determining U.S. residency. A resident alien falls into one or two of the following categories:
The substantial presence test is based on days present in the U.S. It is formula based and is satisfied when someone is physically present in the United States (U.S.) on at least:
The days counted for these elements of the substantial presence test include all of the days you were present in the current year, plus:
While this analysis is fairly straight forward so far, some complicating elements exist with respect to capital gains. Generally, a non-resident alien is not subject to tax on any capital gains other than gains related to U.S. property or otherwise where gains are effectively connected to a U.S. trade or business. However, if a non-resident alien is present in the U.S. for at least 183 days, this person becomes subject to taxation on their gains on the sale of capital assets located in the U.S. There also exists a number of rules to navigate that stipulate what constitutes actual presence, when residency ends, and several exceptions. Thus, due care should be exercised when relying on the substantial presence test.
Lastly, if someone does not have a green card and does not satisfy the substantial presence test, but still wants to be a U.S. resident for income tax purposes, there is an election to facilitate this under IRC Section 7701(b)(4). However, taxpayers should proceed with caution when making this election as it is predicated on current and future residency with resulting tax implications.
Income Tax Residency and Treaties
Tax residency follows in step with a taxpayer’s tax home. A tax home is where an individual maintains his or her regular or principal place of business. If there is no place of business, a tax home is generally the individual’s regular place of abode.
Even where an individual satisfies the physical presence test, the individual may still avoid classification as a U.S. resident if he or she:
There are a multitude of criteria to consider when evaluating location of closer connection. In general, it is the place where the individual more closely associates and is consistent with where the individual claims his or her tax home is located. High-level criteria used in the determination can include:
If an individual is considered a U.S. resident due to meeting the physical presence test or otherwise being a lawful permanent resident, he or she may still be able to avoid being taxed as a U.S. resident if the individual is also treated as a resident of a foreign country under the statutory laws of the foreign country and can satisfy the residency rules of the income tax treaty between the U.S. and the foreign country.
These rules vary from treaty to treaty, but summarized below are typical determining factors that are commonly found in the residency ‘tie-breaker’ rules of U.S. treaties:
To avoid double taxation, an individual would likely make an election under an income tax treaty if he or she would be treated as a resident of the U.S. and a resident of another country for income tax purposes. This election is made on Form 8833. Due to the limitation of benefits clauses that exist in most treaties, only true residents of a country can use the income treaty between that country and the U.S. to determine one’s tax residency.
This election should be made only with careful consideration, especially in the context of green-card holders. Making this treaty residency election means that one would calculate his or her income tax liability to the U.S. as if a nonresident. However, for all other purposes besides tax liability, the individual is considered a U.S. resident. Thus, foreign bank account disclosure and Form 8938 filing requirements still apply in addition to other important U.S. foreign reporting obligations which the IRS takes extremely seriously!
Procedures – Acquiring a U.S. Tax Residency Certificate
Income arising from sources in one country paid to residents of a different country will often be subject to withholding tax from the first (or source) country at a statutory rate set by the tax authorities in the source country. The withholding tax rate can be reduced or eliminated in some countries if an income tax treaty between the two countries is in force or in cases of the recipient also being resident of the source country.
Where a U.S. resident receives non-U.S. source income, the U.S. resident must prove its residency to benefit from these lower withholding tax rates if an applicable tax treaty can be availed. This is accomplished by applying for a U.S. residency certificate from the Internal Revenue Service. The U.S. residency certificate (Form 6166) is applied for annually on Form 8802. The Form 6166 certifies to the withholding agent that the U.S. taxpayer was a resident in the United States for U.S. tax purposes during the year being certified. In general, any individual or entity that is a resident in the United States is eligible for tax residency certification. The IRS will only issue a Form 6166 if it can verify that that applicant filed its proper income tax return for the year of certification or prior year when said return is not yet due. Form 8802 requires a processing fee of $85 per form that can cover multiple countries but generally, just one tax year. The fee increases to $185 for entities other than individuals.
Whereas the application is straightforward for a corporation or a U.S. individual, fiscally transparent entities have additional steps to complete to obtain certification. Entities operating as partnerships, S-corporations, or as disregarded entities are not treated as U.S. residents for most U.S. income tax treaties. Therefore, the Form 8802 application requires a list of all U.S. partners, members, or owners that are requesting the reduced withholding tax rate. In addition, each of these individuals is required to sign an authorization (including all partners in a tiered partnership) that allows the third-party requester to receive the partner’s tax information but cannot include matters other than federal tax.
Certain countries require the authentication of the residency certification prior to acceptance via the Apostille process. This means that once Form 6166 is received, the U.S. taxpayer must then deliver the document to an Apostille/Certification of Authentication center, often a state-run government office.
Some countries offer a mechanism to bypass the foreign country tax residency certificate by having the entity receiving money from the local country register as a non-resident entity in the other local country and file a non-resident income tax return in its country. See the India permanent account number (PAN) process as an example.
In cases where the U.S. individual or entity is the payor/withholding agent of allocable funds to non-U.S. individuals or entities, withholding is required under IRC Sections 1441-1446. The withholding rates can again be reduced or eliminated by the applicable income tax treaty if the U.S. withholding agent receives a local country residency certificate from the recipient and the taxpayer otherwise satisfies treaty eligibility.
If you have inquiries about this article, or would like assistance obtaining a tax residency certificate, please contact any member of the international team at FGMK:
Michael R. Pearson
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.