TAXATION OF NON-BUSINESS INCOME FROM U.S. SOURCES
(FDAP INCOME), or, Fixed or Determinable Annual or Periodical income refers to income from items like interest, dividends, rents, and royalties for example. For nonresidents, FDAP income is subject to a flat 30 percent (or lower treaty rate) and is typically collected through withholding.
FLAT RATE TAXATION UNDER SECTIONS 871(a) AND 881
The U.S. taxation regime on essentially passive investment income earned by foreign persons is contained in sections 871(a) and 881. These sections impose a flat 30% rate tax and lay out the income streams to which it applies. The 30% flat tax applies to US-source FDAP income and similar income items of foreign taxpayers, along to the extent they are not effectively connected with a U.S. trade or business.
NO DEDUCTIONS
The flat tax found under sections 871(a) and 881 is determined on gross income and no deductions are permitted. Expenses incurred in earning passive FDAP income therefore do no produce any tax benefit to the foreign investor. For example, investment interest is nondeductible by a foreign investor. Similarly, many of the costs surrounding passive investments in real estate and in generating passive royalties are non-deductible including amortization, depletion, depreciation, and other common cost recoveries available to U.S taxpayers.
Gross income subject to the 30% flat tax may include amounts that were never actually received by the taxpayer. Take a net lease for example, where a tenant pays the owners property taxes and interest under a net lease, those items are still included in gross rents and subjected to the 30% flat tax. Furthermore, expenses unequivocally associated with FDAP income do not offset the gross taxable amount.
Additionally many of the credits allowed to U.S. taxpayers that reduce income tax are not available to nonresident aliens and foreign entities against the flat tax. The credits so disallowed include the credit for the elderly, childcare credit, and the general business credit.
THE BREADTH OF CLASSIFICATION OF FDAP INCOME
Over time, a seemingly infinite variety of economic gains, regardless of being paid in a lump sum or periodic cash flows, whether a one off or from reoccurring transactions, and indeterminate of generating a steady, intermittent, or erratic stream of cash flow has been deemed by the IRS as FDAP income.
The breath of the classification is evident in the following regulation:
The term fixed or determinable annual or periodical is merely descriptive of the character of a class of income. If an item of income falls within the class of income contemplated in the statute and described in paragraph (a) of this section, it is immaterial whether payment of that item is made in a series of payments or in a single lump sum. Further, the income need not be paid annually if it is paid periodically; that is to say, from time to time, whether or not at regular intervals. The fact that a payment is not made annually or periodically does not, however, prevent it from being fixed or determinable annual or periodical income (e.g., a lump sum payment). In addition, the fact that the length of time during which the payments are to be made may be increased or diminished in accordance with someone’s will or with the happening of an event does not disqualify the payment as determinable or periodical.
INTEREST
Notwithstanding the above, interest received by nonresident investors from unrelated borrowers often is not subject to withholding tax if the interest is “portfolio interest.” The purpose of this exemption is to allow U.S. borrowers to compete for loans with borrowers from other countries that often do not tax interest payments made to foreign lenders. Likewise, interest earned by a nonresident investor on U.S. bank deposits is not subject to the 30 percent tax on FDAP income even though the income is U.S. source income.
DIVIDENDS
Dividends from U.S. sources are generally subject to withholding tax with two major exceptions. First, where at least 80 percent of the dividend paying domestic corporation’s gross income is derived from foreign source business income for the preceding three years, the dividend paid is not subject to withholding tax to the extent the dividend is attributable to the foreign income. Second, under I.R.C. §871 Congress has now clarified that FDAP taxation does not apply to dividends paid by a foreign corporation.
RENTS
If the activities of the nonresident (or agent) managing the property do not rise to the conduct of a U.S. trade or business, (passive) the income is subject to withholding tax (gross – no deductions). However, if the activities do amount to a U.S. trade or business (active – akin to real estate professional) the income is taxable as business income (net of expenses).
INCOME FROM SERVICES
Salaries and wages are generally considered to be in a trade or business so that services are taxable as effectively connected income. However, pensions and other distributions from retirement plans are potentially subject to the 30 percent withholding tax. A nonresident can potentially not have gross income for annuity payments received under a qualified retirement plan. This applies if all the personal services giving rise to the annuity were either:
• Performed outside the United States while the taxpayer was a nonresident, or
• Within the United States while the taxpayer was temporarily present earning $3,000 or less.
Furthermore, if fewer than 90 percent of the participants in the retirement plan are citizens or residents when the nonresident’s annuity begins, there is no exclusion unless the nonresident’s country of residence either grants a substantially equivalent exclusion to U.S. residents and citizens or is a beneficiary developing country under the Trade Act of 1974.
