U.S. Tax Basics for Non-Resident Investors
The United States is one of the most attractive places for foreign capital — deep markets, relative stability, and strong investor protections. But the U.S. also has a uniquely complex tax environment.
For inbound investors (non-U.S. individuals or entities investing in the U.S.), understanding the basic tax framework at the start is essential. This first post in our Inbound Investor U.S. Tax Playbook series outlines how the U.S. taxes inbound investors, some of the key filings required, and how federal and state systems interact in sometimes unexpected ways.
1. Who’s a “Non-Resident” for U.S. Tax Purposes?
The U.S. distinguishes between resident and non-resident taxpayers using two tests for individuals and one for entities.
A. Individuals
- Green Card Test: If you hold a green card, you are a U.S. tax resident regardless of where you live or how long you spend in the U.S.
- Substantial Presence Test (SPT): You’re a resident if you are physically present in the U.S. for at least 31 days in the current year and 183 days over a three-year period, counting:
- All days in the current year,
- ⅓ of days in the prior year,
- ⅙ of days in the year before that.
The SPT often surprises executives or investors with recurring business trips. Certain exceptions (teachers or students on certain visa programs, diplomats on certain visa programs, professional athletes participating in charitable sporting events) may apply.
Those who fail both tests are non-resident aliens (NRAs) — taxed only on U.S.-source income.
B. Entities
- Formed under U.S. law → U.S. tax resident.
- Formed under foreign law → non-resident entity, unless it has a U.S. trade or business.
- Note: Check-the-box regulations under Treas. Reg. §301.7701 allow certain foreign entities to elect U.S. classification (corporation, partnership, or disregarded entity)
2. Three Buckets of Income: ECI, FDAP, and DEA
The U.S. system divides taxable income for non-residents into three broad categories:
A. Effectively Connected Income (ECI)
Income that is effectively connected with the conduct of a U.S. trade or business (USTB).
Typical examples:
- Operating income from a U.S. business.
- Rents or gains from real estate when the investor has elected to treat them as ECI under IRC §871(d) or §882(d).
- Income from partnerships or other flow-through entities engaged in a USTB.
Tax treatment:
- Taxed on a net basis at applicable rates (graduated rate scale for individuals (top rate 37%), flat 21% for corporations; subject to potential treaty reduction).
- Foreign companies report this income on Form 1120-F (U.S. Income Tax Return of a Foreign Corporation).
- Non-resident individuals report on Form 1040-NR.
- Deductions are allowed for related expenses (assuming a return, or protective return, is filed; failure to file a return can result in denial of deductions).
A key concept is the “force of attraction” rule — once a non-resident is engaged in a U.S. trade or business, all U.S.-source income connected to that business can be treated as ECI.
B. Fixed, Determinable, Annual, or Periodical (FDAP) Income
Passive U.S.-source income — dividends, interest, royalties, and certain rents.
- Taxed on a gross basis at 30% withholding, unless reduced by a tax treaty.
- No deductions permitted (gross basis tax).
- Reporting generally handled by the U.S. payor via Form 1042 (annual withholding return) and Form 1042-S (statement to the foreign payee).
C. DEA / The Branch Profits Tax
When a foreign corporation operates a U.S. business directly (without a U.S. subsidiary corporation or LLC taxed as a corporation “blocker”), it may face an additional Branch Profits Tax (BPT) under IRC §884.
- This tax approximates the dividend withholding that would apply if the U.S. operation were conducted through a domestic corporation.
- The BPT is imposed at a 30% rate (often reduced by treaty) on the corporation’s “dividend equivalent amount” (DEA) — essentially, the after-tax earnings deemed repatriated out of the U.S. branch during the year.
- The calculation starts with the U.S. branch’s effectively connected earnings and profits (ECE&P), adjusted for increases or decreases in U.S. net equity.
Many investors assume that forming a “U.S. branch” is simpler than establishing a domestic corporation, but the BPT can make it significantly more expensive from an after-tax standpoint. This is because the BPT applies in addition to the 21% tax on ECI.
Treaty Note: Most modern U.S. tax treaties reduce or eliminate the Branch Profits Tax (e.g., 5% under the U.S.–U.K. treaty), but only if the foreign corporation qualifies under the treaty’s limitation on benefits (LOB) provisions.
3. Tax Treaties: Analyze & Document Relief
The U.S. has income tax treaties with about 60 countries. Key potential benefits common in treaties are:
- Reduced withholding rates (e.g., sometimes 0% but commonly between 5%–15% on dividends, interest or royalties, instead of 30%).
- Exemption for business profits if the foreign investor has no permanent establishment (PE) in the U.S.
- Relief from double taxation through foreign tax credits or exemptions.
- Legal and dispute resolution mechanisms such as the mutual agreement procedure (MAP) to resolve disputes between the U.S. and treaty partners.
Treaty benefits are claimed via applicable reporting which includes, based on the facts and circumstances, one or more of the following: Form W-8BEN (individuals) or W-8BEN-E (entities), Form 1120-F, Form 8833 Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), and Forms 1042 and 1042-S, provided the investor is a resident of a treaty country and satisfies the limitation on benefits (LOB) clause.
Avoid treaty shopping: intermediate holding companies without substantive activity may fail LOB tests, precluding treaty relief. The IRS increasingly reviews substance, management location, and beneficial ownership.
Consider obtaining a tax opinion to document the expected comfort level of treaty applicability and associated U.S. tax impact.
4. Structuring the Investment
Choosing an entry structure has long-term tax and compliance implications. The below chart offers a high-level overview of key considerations in structural options for nonresident investment in the U.S.
| Structure | Pros | Cons |
|---|---|---|
| Direct ownership (individual) | (individual) Simple, transparent | Exposed to ECI, FIRPTA, U.S. estate tax for U.S. stock holdings, and personal filing obligations (Form 1040-NR, others as applicable), no corporate liability limits. |
| U.S. corporation or LLC taxed as corporation (C-corp “blocker”) | Generally shielded from ECI and Branch Profits Tax, potentially limits FIRPTA, simplifies compliance, corporate liability limitations for shareholders / members | Double taxation (21% corporate + dividend withholding) |
| U.S. LLC (treated as partnership or disregarded) | Flow-through taxation, flexibility, corporate liability limitations for members | Foreign owner becomes directly taxable and must file Form 1040-NR/Form 1120-F, exposed to FIRPTA |
| Foreign corporation holding U.S. assets (including LLC treated as disregarded or partnership) | Potential treaty benefits, estate tax protection, corporate liability limitations for shareholders / members | Branch Profits Tax, 30% withholding on certain payments, complex reporting (Forms 1120-F, 5472, 8833) |
5. FIRPTA: The Real Estate Trap
The Foreign Investment in Real Property Tax Act (FIRPTA) taxes foreign persons on gain from the sale of U.S. real property interests (USRPI) (which includes interest in a U.S. real property holding company (USRPHC), very basically, a U.S. real-property rich – at least 50% FMV of its assets – holding company)) as if it were ECI.
- Withholding: Buyers must withhold 15% of the gross sale price, unless the seller obtains a reduced-withholding certificate on Form 8288-B.
- Reporting: Withholding submitted on Form 8288; seller receives Form 8288-A as credit evidence.
- Election: Foreign investors in rental real estate may elect to treat rental income as ECI (thus deductible) under IRC §871(d)/§882(d) — often made by attaching a statement to Form 1040-NR or 1120-F.
6. Key Federal Tax Filings for Inbound Investors
| Form | Description | General Filing Requirements / Purpose |
|---|---|---|
| 1040-NR | Non-resident individual U.S. income tax return | Direct investor or member of U.S. LLC (if disregarded for tax purposes) |
| 1120-F | U.S. income tax return for foreign corporations | Foreign corporation with ECI or U.S. branch |
| 5472 | Information return of a 25% foreign-owned U.S. corporation or a foreign corporation engaged in a U.S. trade or business | Reporting corporation required to disclose reportable transactions with foreign or domestic related parties |
| 8833 | Treaty-based return position disclosure | Claiming treaty benefits to override domestic law |
| 1042 / 1042-S | Annual withholding return / statement for FDAP income | U.S. payor with foreign recipient |
| 8288 / 8288-A / 8288- | FIRPTA withholding forms | Non-U.S. party disposition of real property interest / interest in U.S. real property holding company |
| 8804 / 8805 / 8813 | Partnership withholding on foreign partners | U.S. partnership with foreign investors |
Failure to file can result in steep penalties and the loss of treaty benefits.
7. State Tax Considerations: The Overlooked Layer
Federal planning alone isn’t enough. States operate semi-autonomously, and foreign investors can create state “nexus” — a taxable presence — much more easily than they realize.
A. Key Triggers for State Nexus
- Owning or leasing property in the state.
- Having employees, agents, or contractors there.
- Exceeding sales thresholds under economic nexus standards (post-Wayfair).
- Holding a partnership interest in an entity operating in that state.
B. Filing Implications
- Corporate income/franchise tax: Many states follow federal taxable income but have unique state tax addback or deductions based on whether the state conforms to or decouples from federal tax law. Income is also apportioned with state-specific income apportionment formulas.
- Partnership or pass-through entity tax: Some states impose entity-level taxes or mandatory withholding on non-resident partners.
- Sales/use tax: Separate compliance system — nexus rules differ from income tax nexus.
- Net Worth tax: Some states impose taxes on net worth (generally, total assets less total liabilities) in the state as well.
C. Combined Reporting and Water’s-Edge Elections
For foreign corporate groups with U.S. subsidiaries:
- Worldwide combined reporting: Some states (e.g., California) require or allow combination of worldwide income, including foreign affiliates.
- Water’s-edge election: Available in certain states (notably California) to limit combined reporting to U.S. entities and controlled foreign corporations (CFCs) meeting specific ownership thresholds.
- These elections are often binding for 7 years and must be carefully modeled before election — they can dramatically change state tax bases.
D. Apportionment
Most states use a single-sales factor or three-factor formula (sales, property, payroll) to determine what portion of income is taxable. The rules vary widely — meaning two states may tax the same income differently.
8. Common Pitfalls
1. Accidental U.S. Trade or Business: Taking an active role in management, hiring U.S. agents, or signing contracts in the U.S. can trigger ECI.
2. Overlooking FIRPTA: U.S. real estate is always within U.S. tax jurisdiction.
3. Neglecting State Taxes: Many foreign investors assume federal treaties cover states — they don’t necessarily as states may follow or not follow federal tax treaties, so a state-specific review is necessary.
4. Missing or Late Filings: Non-filing penalties can exceed the tax itself and be imposed on information-reporting only (no tax-due) filings that are missed or filed late.
5. Treaty Misuse: Claiming treaty benefits without satisfying LOB tests invites IRS scrutiny.
6. Improper Entity Selection: Legal entity form and tax treatment can differ (e.g., LLC treated as a corporation, partnership, or disregarded entity for tax purposes). These differences can have varying tax implications for inbound investors, so it is important to structure carefully.
9. Getting Started — A Practical Checklist
Before your first investment:
1. Confirm tax residency of all investors and entities.
2. Identify expected income types (ECI vs FDAP).
3. Review potentially applicable treaty benefits, document applicability with a tax opinion.
4. Model federal and state tax exposure, including combined reporting effects.
5. Select optimal entity structure and make elections early.
6. Implement withholding and filing procedures.
7. Keep contemporaneous records to support treaty positions and LOB compliance.
Coming Next
Part 2: Structuring the Investment — Entity Choice & Tax-Efficient Entry Point: In our next article, we’ll examine entity options for inbound investors, how to manage Branch Profits Tax, treaty planning, and how different structures affect ongoing operations and repatriation strategies.
Thinking about investing in the U.S.? Start with a consultation to evaluate your company’s readiness and identify strategies for success. Connect with Nick Eusanio, Tax Planning & Compliance Partner at DBL Law, to learn how proper tax planning and investment structure can help you achieve the best possible outcome.
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