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1. Overview
The United States imposes tax on nonresident alien individuals and foreign corporations (collectively, foreign persons) only on income that has a sufficient nexus to the United States. In contrast, the United States imposes tax on U.S. persons on all income, whether derived in the United States or in a foreign country.
Foreign persons are subject to U.S. tax on income that is "effectively connected" with the conduct of a trade or business in the United States, without regard to whether such income is derived from U.S. sources or foreign sources. Such income generally is taxed in the same manner and at the same rates as income of a U.S. person. An applicable tax treaty may limit the imposition of U.S. tax on business operations of a foreign person to cases where the business is conducted through a permanent establishment in the United States.
In addition, foreign persons generally are subject to U.S. tax at a 30-percent rate on certain gross income derived from U.S. sources. Pursuant to an applicable tax treaty, the 30-percent gross-basis tax imposed on foreign persons may be reduced or eliminated. The source of income for U.S. tax purposes is determined based on various factors, including the location or nationality of the payor, the location or nationality of the recipient, the location of the activities that generate the income, and the location of the assets that generate the income. For example, income from the sale or exchange of inventory property that is produced (in whole or in part) within the United States and sold or exchanged outside the United States, or produced (in whole or in part) outside the United States and sold or exchanged within the United States, is treated as partly from U.S. sources and partly from foreign sources. In general, 50 percent of such income is treated as attributable to production activities and is sourced based on the location of the production assets; the other 50 percent of such income is treated as attributable to sales activities and generally is sourced where the sale occurs.
2. Net-basis taxation
The United States taxes on a net basis and at the generally applicable U.S. tax rates the income of foreign persons that is "effectively connected" with the conduct of a trade or business in the United States. Any gross income earned by the foreign person that is not effectively connected with the person's U.S. business is not taken into account in determining the rates of U.S. tax applicable to the person's income from such business. The determination of whether a foreign person is engaged in a U.S. trade or business is based on the facts and circumstances. Basic issues involved in the determination include whether the activity constitutes business rather than investing, whether sufficient activities in connection with the business are conducted in the United States, and whether the relationship between the foreign person and persons performing functions in the United States with respect to the business is sufficient to attribute those functions to the foreign person.
The factors taken into account in determining whether income, gain or loss is effectively connected with a U.S. trade or business include, for example, in the case of U.S.-source capital gains and certain U.S.-source passive income, whether the amount is derived from assets used or held for use in the conduct of the U.S. trade or business and whether the activities of the trade or business were a material factor in the realization of such amount. In the case of any other U.S.-source income, gain, or loss, such amounts are all treated as effectively connected with the conduct of the trade or business in the United States. Only specific types of foreign-source income are considered to be effectively connected with a U.S. trade or business (sec. 864(c)(4)). Foreign-source income of a type not specified generally is exempt from U.S. tax.
3. Gross-basis taxation
In the case of U.S.-source interest, dividends, rents, royalties, or other similar types of income (known as fixed or determinable, annual or periodical gains, profits and income), the United States generally imposes a flat 30-percent tax on the gross amount paid to a foreign person if such income or gain is not effectively connected with the conduct of a U.S. trade or business. This tax generally is collected by means of withholding by the person making the payment to the foreign person receiving the income. Accordingly, the 30-percent gross-basis tax is generally referred to as a withholding tax. In most instances, the amount withheld by the U.S. payor is the final tax liability of the foreign recipient and, thus, the foreign recipient files no U.S. tax return with respect to this income. Certain exclusions or exceptions from the withholding tax apply. For example, the United States generally does not tax capital gains of a foreign corporation that are not connected with a U.S. trade or business. Capital gains of a nonresident alien individual that are not connected with a U.S. business generally are subject to the 30-percent gross-basis tax only if the individual was present in the United States for 183 days or more during the year (sec. 871(a)(2)). In addition, certain types of interest (for example, interest from certain bank deposits and from certain portfolio obligations) are not subject to the withholding tax.
For a discussion of the taxation of nonresident aliens click Taxation of Nonresident Aliens.
For a discussion of the taxation of U.S. persons living abroad click Tax Treatment of U.S. Persons Living Abroad
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