Two Different Tax Regimes: US persons and Non-US persons
U.S. persons are taxed on their Worldwide Income (Income from US and Foreign sources). They are entitled to a Foreign Tax Credit to the extent of their Foreign Source Income.
Foreign person are mostly taxed only on their U.S. source income.
Because of this distinction, we need to ask two questions whenever dealing with any International Tax issue:
1 – What is the residence of the taxpayer?
2 – What is the source of the income?
In week 1 we will focus on answering Question 1
In week 2 we will focus on answering Question 2
The most useful approach is to determine if a person or entity is a U.S. person, if not, you can assume they are a non-US person.
An individual can obtain US person status if ANY of the following 4 methods applies:
Citizenship – Person is a US citizen
Legal Residency – Person holds a Green Card
Permanent Resident under Substantial Presence Test 1 (SPT 1)
Permanent Resident under Substantial Presence Test 2 (SPT 2)
Substantial Presence Tests
SPT1: If a person is present in the US for 183 days or more in a given year, they are a US person. This is an objective test because you are jus counting the days.
SPT 2: This test is met if the following elements are met:
1 – a person is present in the US for 31 days or more in a current year AND
2 – they are present in the US for 183 days or more over the last 3 years using a weighed systems AND
3- they do not have a Closer Connection to a Foreign Tax Home in the current year, then they are a U.S. person.
Note that SPT2 contains objective elements (1 & 2) and a subjective element (3). All of them must be met for SPT2 to apply. Let’s look at them in more detail.
Element 1 is straight forward: count the days they are in the US in the current year, if it’s less than 31 days then SPT2 will not apply.
Element 2 is tricky. You need to count all the days the person was in the US over the last three years. Let’s say they are contemplating their tax position for 2004. You must look at the days they were in the US for 2004, 2003 and 2002. The days in 2004 will count as one full day. The days in 2003 will count as 1/3 of a day and the days in 2002 will count as 1/6 of a day. Add them up using this weighted measure, if it is 183 or more you can go to Element 3.
Element 3 is a subjective element. You first have to determine if they have a Foreign Tax Home. To determine if they have a Foreign Tax Home you must ask the question “what is their home for purposes of taking travel expense deductions?” Then you have to determine if they have a Closer Connection to that Foreign Tax Home. This is a subjective test where you look at a number of variables: where they are employed, where their family lives, where they belong to clubs, etc… There is no right or wrong answer, it is an issue of fact.
Days that don’t count in the calculation: For purposes of SPT1 and SPT2 you do not include certain days in your calculation, these exempted days apply for days for commuting, medical emergencies, charitable sports events, teachers, and students.
Corporations: The residence of a corporation is based on where it is incorporated.
Some countries define residence based on central place of management. So It is possible to have a dual-resident corporation.
For further clarification I will elaborate on the following two areas:
The difference between the tax regime for U.S. persons and non-U.S. persons, and
The exceptions to the Substantial Presence Test.
The difference between the tax regime for U.S. persons and non-U.S. persons
Let’s assume that a Taxpayer, T, earned $500 in 2004 with $100 of expenses. His tax calculation would be as follows:
Gross Income: $500
Taxable Income: $400
Tax Rate 35%
Tax Liability $140
Now let’s assume that of the $500 of income, $200 was from services performed in the U.S. (US source income) and $300 was from services performed in France (foreign source income). Also assume that a French tax of 30% was imposed on the $300.
If T is a non-U.S. person (i.e. not a US citizen, green card holder and fails both Substantial Presence Tests), then his tax calculation would be as follows:
Gross Income: $200 (foreign source income is not taxable)
Taxable Income: $100
Tax Rate: 35%
Tax Liability: $35
If T is a U.S. person, then his tax calculation would be as follows:
Gross Income: $500 (Worldwide income is subject to US tax)
Taxable Income: $400
Tax Rate: 35%
Tax Liability: $140
Foreign Tax Credit: ($90) 30% French tax on the $300 French income
Tax Due: $50
As you can see, for a Non-US person foreign source income is not even included in the tax calculation. For a US person, the foreign source income is included in Gross Income. However, the US person may get a Foreign Tax Credit for taxes paid on foreign source income.
There are exceptions, but this is the general framework of the two different tax regimes. We will be exploring both of these in greater detail as the course develops. Starting next week, we will only be looking at Non-US persons and how they are taxed on their US activities (referred to as Inbound Transactions). After the midterm we will focus on US person and how they are taxed in the US on their foreign activities (referred to as Outbound Transactions).
The exceptions to the Substantial Presence Test
Generally, when performing the Substantial Presence Test calculation you count every day that the Taxpayer was present in the US. However, the following days are not included in the SPT calculation even though the Taxpayer was physically present in the US:
Commuters from Canada & Mexico: If a person returns home at least once during each 24 hour period they are not considered to have spent a day in the US for SPT purposes.
Short stopovers: Presence in the US while in transit between two points outside the US does not count as a day spent a day in the US for SPT purposes. This is relevant if an Irish person, for instance, was in the US 182 days in a given a year and she also spent 1 day at Miami International Airport on a layover to Brazil. That extra day won’t put her over the 183 day threshold. However, if she conducts a business meeting at the Miami airport, then that day would count.
Medical emergencies: If a person is unable to leave the US because of a medical emergency, those days are not counted for SPT purposes. However, if the taxpayer came to the US with the intent of pursuing a medical treatment, those days would count for SPT purposes.
Teachers, trainees and students: Teachers and trainees who are in the U.S. for the purpose of teaching with a J visa are not required to count their days in the US for SPT purposes. Students are also exempt if they are in the US with a F, J or M visa.
Diplomats, employees of international organizations and their families.
Participants in charitable sports events.
Crew members of foreign vessels.
With all areas we will be discussing, it is most important to remember the general rule. Exceptions rarely apply, however it is important to know they exist and run a check just in case.
Question No. 1
W and H, wife and husband, are citizens of Canada. They do not have U.S. citizenship nor do they hold a U.S. green card. They maintain homes in both Quebec and Florida. W and the couple’s minor children spend about nine months each year at the Florida home, and the children attend school in Florida public schools. W and the children spend the summer months (80 days) in Quebec. H, who owns a construction company in Quebec, spends most of the year in Quebec, but makes several trips to Florida each year, aggregating 70 days annually. H’s income comes from the construction business. W owns several farms in Quebec which are rented to tenants and produce a significant amount of rental income. H & W do not file a joint return in the U.S.
How are H and W taxed by the U.S.?
W is present in the U.S. for about 285 days (in Canada for 80 days). This is sufficient for W to be a resident under SPT1 since she is present in the US for more than 183 days.
H’s presence in the U.S. does not meet the thresholds of SPT1 or SPT2:
Current year: 70 X 1 = 70 days
Prior year: 70 X 1/3 = 23.3
Two years prior: 70 X 1/6 = 11.6
Total days in the US using the weighted method: 105 days which is less than the 183 day threshold.
How does the analysis of H’s situation change if he stays in the U.S. a total of 125 days annually.
Now H would be the threshold of SPT2:
Current year: 125 X 1 = 125 days
Prior year: 125 X 1/3 = 41.6
Two years prior: 125 X 1/6 = 20.8
Total days in the US using the weighted method: 187.5 days which is more than the 183 day threshold.
In order for H to be a US person under SPT 2, he must also satisfy the subjective element of the test (i.e. closer connection to a foreign tax home). Since this is a subjective test and you only have limited facts to work with your answer could go either way.
Question No. 2
Nelson is a citizen of Brazil. He has a full-time job in that country and generally lives there with his family in a home he has owned for over 20 years. In 2015, Nelson comes to the United States for the first time. The sole purpose of the trip is business. Nelson intends to stay in the U.S. for only 180 days, but he runs into problems with his business and is required to stay 300 days.
In 2016, Nelson comes to the U.S. again on business and stays for 90 days. He returns to Brazil as planned.
Early in 2017, Nelson comes to the United States on business and stays for 170 days. Later in 2017, he returns to the U.S. to take his 6 year old son to Disney World for 10 days and then return to Brazil. On the last day of the planned visit, Nelson breaks his leg in an automobile accident. He is checked into the hospital for treatment, where he remains for five days. Nelson and his son leave the U.S. as soon as possible after he is released from the hospital.
Under these facts, discuss Nelson’s residence status in the U.S. in 2015, 2016 and 2017.
Nelson is a US person for 2015:
He is present in the US for 300 which meets SPT1 (note that his intention to stay less is irrelevant)
Nelson is probably not a US person for 2016 despite the fact that he satisfies the first two elements of SPT2.
2016: 90 X 1 = 90 days in the US
2015: 300 X 1/3 = 100 days in the US
Total days in the US: 190 days, which is greater than the 183 day threshold. However, Nelson can make a reasonable argument that he has a closer connection to a foreign tax home since he has many associations with Brazil. Since he does not meet the subjective element of SPT2, he would not be a US person for 2016.
Nelson is probably not a US person for 2017
2017: 180 days (don’t count the 5 days he is in the US for the medical emergency).
2016: 90 X 1/3 = 30 days
2015: 300 X 1/6 = 50 days
Total days in the US: 260 days. However, since he probably has a closer connection to a foreign tax home, he does not meet the subjective element of SPT2 and he would not be a US person for 2017.