Inbound Transactions Tax Framework | US International Tax Lawyer & Attorney
Inbound transactions deal with Non-US persons who operate in and/or derive income from the United States. This introductory essay opens a series of articles concerning US taxation of inbound transactions. Today, I will set forth the general inbound transactions tax framework; in future articles, I will explore in more detail each element of this framework.
Inbound Transactions Tax Framework: General Guiding Principals
US taxation of inbound transactions is mainly based on the following guiding principle – nexus to the United States. In other words, the US government taxes Non-US persons in a different manner depending on the level and extent of a Non-US person’s activities in the United States.
The more extensive and regular these activities are, the more likely the income derived from these activities to be taxed by the IRS on a net-income basis (as opposed to gross income) at graduated tax rates. On the other hand, if a Non-US person’s activities are limited, less frequent and more passive, then they are likely to be subject to a completely different type of taxation – the one based on gross income at a set rate.
This “US nexus” principal is subject to numerous exceptions due to the fact that the inbound transactions tax framework incorporates two additional goals. The first goal is the US government’s attempt to design the framework in a manner which would attract foreign investments into the United States. For this reason, the Internal Revenue Code (“IRC”) may exclude entire categories of income from US taxation either directly or by altering the source-of-income rules (i.e. excluding certain income from the definition of “US-source income”).
Second, as a counter to the “attraction of foreign investments” principal, the US government wishes to make sure that all income of Non-US persons that needs to be taxed is actually taxed and there is no inappropriate non-taxation of US-source income. As a result of the IRS efforts to ensure the effectiveness of this principal, certain types of income are subject to special regimes of taxation. The most prominent example is the taxation of foreign investments in US real property.
Finally, one should remember to consult US income tax treaties for country-specific exceptions. In particular, treaties often modify tax-withholding provisions with respect to various categories of US-source income.
Inbound Transactions Tax Framework: Main Test
The analytical framework for the taxation of inbound transactions is comprised of a test with seven critical questions. The answers to each question will point us to the right sections of the Internal Revenue Code and establish the correct tax treatment for specific types of income.
- Is the person who derives the income is a US person or a Non-US person?
Obviously, if the answer to the question is “US person”, then we are not dealing with an inbound transaction, but a domestic investment. Hence, the taxation of a transaction or investment should be examined under a different tax framework (the one that applies to US persons) than the inbound transactions tax framework.
The difference between these tax frameworks is huge. A US person is subject to worldwide income taxation, whereas a Non-US person is generally taxed only on the income derived from US business activities and US investments.
2. Is it a US-source income?
The question whether a Non-US person derives US-source income or foreign-source income is of huge importance and complexity. The answer to this question involves the analysis of relevant source-of-income rules as modified by a relevant tax treaty.
Generally, Non-US persons are taxed only on their US-source income. This means that if it is determined that the income is derived from a foreign-source, none of it is likely to be subject to US taxation. However, certain types of foreign-source income deemed “effectively connected” with US business activities may still be taxed in the United States. Hence, even if the answer to this question #2 is “no”, you must still continue your analysis by answering question #4 below.
3. Does the Non-US person engage in US trade or business activities?
The determination of whether a Non-US person engages in “trade or business within the United States” depends highly on the facts of a case. In a future article, I will discuss in more detail what the IRS and the courts have determined this term of art to mean.
4. Is the income effectively connected to these US trade or business activities?
The term “effectively connected income” or ECI is one of the most important concepts in US international tax law. It may include not only US-source income generated by a US trade or business, but also certain foreign-source income closely related to a US trade or business. In a future article, I will explore ECI in more detail.
5. Is the ECI subject to a special tax regime such as BEAT or Branch Tax?
The ECI of a foreign person may be subject to a special tax regime related to US companies owned by a foreign person or US branches of a foreign corporation. I will discuss each of these regimes in more detail in the future.
6. If the Non-US person is not engaged in US trade or business activities, is his US-source income classified as FDAP (Fixed, Determinable, Annual or Periodic) income?
FDAP income typically includes passive investment income, such as interest, dividends, rents and royalties. Unless modified by a treaty, FDAP income is subject to a 30% tax withholding on gross income. I will cover FDAP income in more detail in the future.
7. Is this FDAP income subject to an IRC or Treaty Exemption?
In order to promote foreign investment into the United States, certain types of FDAP income are entirely exempted rom US taxation. These exemptions can be found in the IRC or a relevant tax treaty. Again, I will discuss FDAP exemptions in more details in a future article.
Inbound Transactions Tax Framework: Information Returns
In addition to income tax considerations, it is important to remember that the answers to the questions above may lead to the determination of additional compliance requirements in the form of information returns. For example, if a Non-US person engages in a US trade or business through a foreign-owned US corporation, then this corporation may likely have to file Form 5472. A failure to file relevant information returns may lead to an imposition of significant IRS penalties.
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