International business transactions, the growth of new markets and the development of a global economy have made international tax questions much more common. International tax involves a number of issues, including the taxation of United States citizens who have income from foreign activities, and how foreign persons or entities that have income from sources within the US are taxed. International tax issues are complex and require consideration of US tax laws, foreign tax laws and international tax treaties. This article highlights a few main principles of international tax law.
US Citizens, Permanent Residents and Resident Aliens
US citizens, domestic corporations and resident aliens must pay US income tax on their worldwide income, including interest, dividends, wages, compensation for services, income from rental property and royalties. Foreign nationals who are considered resident aliens for US tax purposes are also subject to US tax on their worldwide income. Generally, a foreign national is considered a resident alien for tax purposes if that individual resides in the United States for a period in excess of 183 days. Except during years of entry and departure, such resident aliens are taxed the same as US citizens.
Even if US citizens or permanent residents live abroad, they must still pay US tax on their worldwide income. In addition, they will most likely be subject to tax in the foreign countries where they are living.
Because foreign countries may tax income from sources within those countries, there is a potential for double taxation. There are a number of provisions in the Internal Revenue Code that try to minimize this potential double taxation:
- Section 901: tax credit for US citizens, resident aliens and domestic corporations that pay or accrue foreign income tax
- Section 911: US citizens and resident aliens can exclude foreign earned income up to a set dollar amount if certain requirements are met
- Section 936: tax credit for domestic corporations on certain income earned in US possessions (e.g., Puerto Rico)
- Section 893: resident aliens employed by foreign governments or international organizations can exclude wages or salaries received for official services from gross income if certain requirements are met
Foreign nationals who are not residents of the United States are considered nonresident aliens for tax purposes. Such nonresident aliens are subject to US tax on US source income. Source income refers to where the income is earned, as determined by the Internal Revenue Code. Generally, income is US source if the income was derived from sales or services performed within the United States or from the rental or disposition of tangible property located within the United States.
Nonresident aliens are taxed on both US source income that is effectively connected with a trade or business in the United States and income that is not effectively connected with a trade or business in the United States — the difference is the rate. Effectively connected income is taxed at graduated rates after allowable deductions. Income that is not effectively connected is taxed at a flat rate of 30 percent (or a lower rate if a treaty applies) and there are no allowable deductions.
Tax treaties are in place between the United States and a number of foreign countries. These treaties generally provide that residents of foreign countries are exempt from tax or are taxed at reduced rates on US source income. The specific items of income and amount of the reductions or exemptions vary depending on the country. Treaty provisions apply to residents of both countries (they are reciprocal), so a treaty's provisions may affect the taxation of a US resident who has income from a foreign country that is a treaty member. Often, tax treaties have a savings clause. A savings clause prevents US residents from using the treaty to avoid income tax on US source income.
Preparing for a Meeting with Your Tax Attorney
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