EDUCATION CENTER
GTT RESOURCES: TRADER TYPES: NON-RESIDENT

Many international traders, who otherwise do not pay taxes in the United States, have opened U.S.-based brokerage accounts and have questions about what taxes they owe in the U.S. Below, we provide a full set of resources for international investors, traders and proprietary traders.

We also have some good information for U.S. citizens and residents who want to trade abroad. See Green's below article on the subject.
" Trading Across Borders: The Tax Issues" by Robert A. Green, CPA
Don’t leave home without them. Click here for Green's original submission. The final SFO article is available on the SFO site for purchase, or pick up the print magaine.

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In 2003, I lived outside the U.S., but my business was trading in U.S.-based securities with a U.S.-based "direct-access" brokerage firm. In addition to that trading account, I also joined a U.S.-based "proprietary trading firm," which is organized as a U.S.-based Limited Liability Company and taxed as a partnership.

When I opened my direct-access brokerage account, I notified the broker that, for tax purposes, I was not a U.S. resident. The broker said it was required to withhold taxes on my interest and dividend income in accordance with tax law and tax treaty rates, if applicable. The good news was the broker told me it would not withhold taxes on my capital gains. At tax time, the broker sent me a Form 1042-S, reporting my U.S. tax withholding on interest and dividend income. I also understand that I don't have to file a U.S. non-resident tax return (Form 1040NR), because the tax withholding took care of my responsibilities to pay U.S. taxes.

My proprietary trading firm sent me a Form K-1, reporting my share of trading gains in the firm, based on my sub-trading account performance (see information on proprietary trading here). What shall I do with this K-1? Am I required to file a U.S. tax return and pay taxes on this income?

Quick Answer:

Based on the information provided above (and assuming the trader doesn't have a green card, meaning he isn’t a legal resident and doesn’t meet the "substantial presence test"), the IRS will consider the trader a "non-resident" for U.S. tax purposes. Click here to see the general "residency" rules.

Good news: Since the trader did not spend more than 183 days in the U.S. in 2003, his capital gains income is not taxable. Click here to see special rules for capital gains, which apply to "investors" and "traders."

Good news: The IRS exempts the income generated by the foreign trader’s "direct-access" business income from the "effectively connected income" (ECI) rules for operating a business in the U.S. Click here to see the ECI rules.

Other types of businesses operated in the U.S. are deemed to have ECI income, and they must pay U.S. taxes on that ECI income. We believe the IRS exempted traders because it would be hard to determine where the business was operated from. Many international taxpayers trade remotely from abroad, and it would have been unfair to tax them on ECI income in the U.S. One note of caution: If you come to the U.S. to trade, you may trigger residency. If this occurs, you will have to pay taxes on your trading income based on the residency rules rather then the ECI rules for non-residents.

Bad news (which may not be too bad after a foreign tax credit): The IRS does not exempt a foreign trader’s K-1 income from his proprietary trading business activity from the "effectively connected income" rules for operating a business in the U.S. In this case, you are required to prepare a U.S. income tax return for non-residents, Form 1040NR. You should report this K-1 income and pay the appropriate U.S. taxes on this income. If your proprietary trading firm is located in a high-taxing state, you are not a resident of that state and don't need to pay state taxes, nor file a state tax return.

Don't be alarmed by paying U.S. taxes. Be aware that your home country most likely allows you to claim a "foreign tax credit" for the U.S. taxes you pay on this ECI K-1 income. If your home country has a higher tax rate then in the U.S., then you may get a dollar-for-dollar tax credit.

Another note of caution:

Answers to international tax questions for traders, investors and others are complex, and the answers depend on each taxpayer's individual facts and circumstances. Many countries have "income tax treaties" with the U.S., and taxpayers may find relief provisions in those treaties. Each treaty varies considerably.

Executive Summary:

International taxpayers who are deemed "non-residents" (no U.S. green card and do not meet the "substantial presence test") are subject to U.S. taxes in the following situations.

If the non-resident has a U.S.-based brokerage account as a "trader" (in the business) or "investor," their U.S. broker will withhold taxes on interest and dividends only (using lower tax treaty rates if applicable). There won't be any withholding on capital gains. The international taxpayer does not need a U.S. tax identification number, and they are not required to file a U.S. non-resident tax return, Form 1040NR.

If the non-resident has a U.S.-based brokerage account as a "trader" (in the business) or "investor," and they spend more than 183 days in the U.S., they owe U.S. taxes on their net U.S. source capital gains. Click here for more details. Many tax treaties contain provisions that reduce or eliminate taxation on capital gains.

If the non-resident has a U.S.-based brokerage account and qualifies as a "trader" (in the business), they are exempt from the "effectively connected income" (ECI) rules for international taxpayers conducting business activities in the U.S. Click here for more details.

If the non-resident is a member of a U.S.-based "pass through" taxable entity (such as a Limited Liability Company [LLC] taxed as a partnership, a general partnership or a limited partnership), in the business of trading securities or commodities, then that person has "effectively connected income" (ECI). That person must file a non-resident tax return, Form 1040NR, to report their ECI income and pay U.S. taxes on that income. Click here for more details.

An international "proprietary trader" who is an LLC member in a U.S.-based LLC proprietary trading firm (taxed as a partnership) has ECI income (their K-1) and must file a Form 1040NR and pay tax on that ECI K-1 income. See ideas for foreign tax credits above.

An investor in a U.S.-based hedge fund limited partnership (or other pass-through entities like a LLC) with trader tax status also has this ECI problem, and that is why foreign investors chose to invest in “offshore” hedge funds instead.

Here are the tax law details with key GTT Observations:

General tax rules for "non-resident" aliens. Click here.

Tax rules for "non-resident" investors, not rising to the level of trading as a business. Click here.

Tax rules for "non-resident" traders who trade U.S. securities as a business; either with direct-access firms and/or proprietary trading firms organized as U.S. Limited Liability Companies. Click here.

If you have any questions on U.S. taxation for non-resident taxpayers, feel free to e-mail us at info@greencompany.com or call us. We recommend a consultation.

General tax rules for "non-resident" aliens

Foreign aliens who have a U.S. green card are considered "legal" U.S. residents, and they are taxed like any other U.S. citizen or resident on their worldwide income. Foreign aliens, without a green card, may also be considered U.S. residents if they meet the "substantial presence test" in the U.S.

There is useful information on the IRS Web site. Do searches for such topics as:

Topic 851: Resident and Nonresident aliens..
International Taxpayers.
Green cards.

Tax rules for "non-resident" investors, not rising to the level of trading as a business.

If a non-resident alien opens a U.S. brokerage account and buys and sells U.S.-based securities as an investor or a trader, and that person does not spend 183 days or more in the U.S. in a given tax year, that non-resident alien is not subject to U.S. taxes on their U.S. brokerage account capital gains.

If the non-resident does spend more than 183 days in the U.S., they owe U.S. taxes on their net U.S. source capital gains. See an excerpt from "International Taxpayer - The Taxation of Capital Gains Of Nonresident Alien Students, Scholars and Employees of Foreign Governments," published on the IRS Web site.

In general, all non-resident alien investors are subject to U.S. tax withholding by their U.S.-based brokerage firms on their interest and dividend income, and certain master limited partnerships (e.g.. oil & gas deals) from U.S. securities. Search the IRS Web site for Form 1042-S.

Tax rules for non-resident traders, who trade U.S. securities as a business; either with direct-access firms and/or proprietary trading firms organized as U.S. Limited Liability Companies.

International Taxpayer - Effectively Connected Income (ECI; published by the IRS)
Generally, when a foreign person engages in a trade or business in the United States, all income from sources within the United States other than certain investment income, is considered to be Effectively Connected Income (ECI). This applies whether or not there is any connection between the income and the trade or business being carried on in the United States during the tax year.

Generally, you must be engaged in a trade or business during the tax year to be able to treat income received in that year as ECI. You usually are considered to be engaged in a U.S. trade or business when you perform personal services in the United States. Whether you are engaged in a trade or business in the United States depends on the nature of your activities. Deductions are allowed against ECI, and it is taxed at the graduated rates or lesser rate under a tax treaty. The discussions that follow will help you determine whether you are engaged in a trade or business in the United States.

Certain kinds of Fixed, Determinable, Annual, or Periodical (FDAP) income are treated as ECI income because: (see below)

Certain Internal Revenue Code Sections require the income to be treated as ECI,
Certain Internal Revenue Code Sections allow elections to treat the income as ECI,
Certain kinds of investment income are treated as ECI if they pass either of the two following tests:

The Asset-Use Test - The income must be associated with U.S. assets used in, or held for use in, the conduct of a U.S. trade or business.
Business Activities Test - The activities of that trade or business conducted in the United States are a material factor in the realization of the income.

In limited circumstances, some kinds of foreign source income may be treated as effectively connected with a trade or business in the United States. Refer to Publication 519, U.S. Tax Guide for Aliens.

The following categories of income are usually considered to be connected with a trade or business in the United States.

You are considered to be engaged in a trade or business in the United States if you are temporarily present in the United States as a nonimmigrant on an "F," "J," "M," or "Q" visa. The taxable part of any U.S. source scholarship or fellowship grant received by a nonimmigrant in "F," "J," "M," or "Q" status is treated as effectively connected with a trade or business in the United States.

If you are a member of a partnership that at any time during the tax year is engaged in a trade or business in the United States, you are considered to be engaged in a trade or business in the United States.

If your only US business activity is trading in stocks, securities, or commodities (including hedging transactions) through a US resident broker or other agent, you are not engaged in a trade or business in the United States.

You usually are engaged in a US trade or business when you perform personal services in the United States.
If you own and operate a business in the United States selling services, products, or merchandise, you are, with certain exceptions, engaged in a trade or business in the United States. For example, profit from the sale in the United States of inventory property purchased either in this country or in a foreign country is effectively connected trade or business income.
Gains and losses from the sale or exchange of US real property interests (whether or not they are capital assets) are taxed as if you are engaged in a trade or business in the United States. You must treat the gain or loss as effectively connected with that trade or business.
Income from the rental of real property may be treated as ECI if the taxpayer elects to do so.

NOTE: Certain kinds of income which are normally treated as ECI or FDAP may not be treated as ECI or FDAP for withholding tax purposes.

Applicable Tax Rate
Income you receive during the tax year that is effectively connected with your trade or business in the United States is, after allowable deductions, taxed at the rates that apply to US citizens and residents.

Tax Year
Generally, you can receive effectively connected income only if you are a nonresident alien engaged in a trade or business in the United States during the tax year. However, income you receive from the sale or exchange of property, the performance of services, or any other transaction in another tax year is treated as effectively connected in that year if it would have been effectively connected in the year the transaction took place or you performed the services.

GTT Observations:
If you are a member of a partnership that at any time during the tax year is engaged in a trade or business in the United States, you are considered to be engaged in a trade or business in the United States.

This is the law that requires a non-resident member of a proprietary trading firm, organized as a Limited Liability Company (LLC) in the U.S. (taxed as a partnership), to pay U.S. taxes on this "effectively connected income" on a Form 1040NR non-resident tax return.

If your only U.S. business activity is trading in stocks, securities, or commodities (including hedging transactions) through a U.S. resident broker or other agent, you are not engaged in a trade or business in the United States.

This is the rule that saves direct-access traders from paying taxes in the U.S. Other types of businesses operated in the U.S. are deemed to have ECI income, and they must pay U.S. taxes on that ECI income. We believe the IRS exempted traders because it would be hard to determine where the business was operated from. Many international taxpayers trade remotely from abroad, and it would have been unfair to tax them on ECI income in the U.S. One note of caution: If you come to the U.S. to trade, you may trigger residency. If this occurs, you will have to pay taxes on your trading income based on the residency rules rather then the ECI rules for non-residents.

Notice above that "investment income" is exempt from "effectively connected income." See rules on investment capital gains below.

These ECI rules only deal with business income and they recognize "U.S. business activity is trading in stocks, securities, or commodities (including hedging transactions) through a U.S. resident broker or other agent," as being exempt from ECI.

International Taxpayer - Fixed, Determinable, Annual, Periodical (FDAP)

Fixed, Determinable, Annual, or Periodical (FDAP) income is all income except:

Gains derived from the sale of real or personal property (including market discount and option premiums but not including original issue discount)

Items of income excluded from gross income without regard to the U.S. or foreign status of the owner of the income, such as tax-exempt municipal bond interest and qualified scholarship income

Income is fixed when it is paid in amounts known ahead of time. Income is determinable whenever there is a basis for figuring the amount to be paid. Income can be periodic if it is paid from time to time. It does not have to be paid annually or at regular intervals. Income can be determinable or periodic even if the length of time during which the payments are made is increased or decreased.

Tax Treatment of FDAP Income which is not Effectively Connected Income (ECI)
Tax at a 30% (or lower treaty) rate applies to FDAP income or gains from U.S. sources but only if they are not effectively connected with your U.S. trade or business. The 30% (or lower treaty) rate applies to the gross amount of U.S. source fixed or determinable annual or periodic gains, profits, or income. Deductions are not allowed against FDAP income.

The following items are examples of FDAP income:

Compensation for personal services
Dividends
Interest
Original issue discount
Pensions and annuities
Alimony
Real property income, such as rents, other than gains from the sale of real property
Royalties
Scholarships and fellowship grants
Other grants, prizes and awards
A sales commission paid or credited monthly
A commission paid for a single transaction
The distributable net income of an estate or trust that is FDAP income and that must be distributed currently, or has been paid or credited during the tax year, to a nonresident alien beneficiary
A distribution from a partnership that is FDAP income, or such an amount that, although not actually distributed, is includible in the gross income of a foreign partner
Taxes, mortgage interest, or insurance premiums paid to or for the account of, a nonresident alien landlord by a tenant under the terms of a lease
Prizes awarded to nonresident alien artists for pictures exhibited in the United States
Purses paid to nonresident alien boxers for prize fights in the United States
Prizes awarded to nonresident alien professional golfers in golfing tournament in the United States

GTT Observation: Notice capital gains income does not fit into any of the above "FDAP definitions." Rather, there are special rules for "Capital Gains" below. Further note that those special rules apply to investment activities with further complications arising for trading business activities.

Social Security Benefits
A nonresident alien must include 85% of any U.S. Social Security Benefit (and the social security equivalent part of a tier 1 railroad retirement benefit) in US source fixed or determinable annual or periodic income. This income is exempt under some tax treaties. Refer to Table 1 in Publication 901, U.S. Tax Treaties, for a list of tax treaties that exempt U.S. social security benefits from U.S. tax.

Capital Gains
If you were present in the United States for 183 days or more during the tax year, and you are still a nonresident alien, your net gain from sales or exchanges of capital assets is taxed at a 30% (or lower treaty) rate. For purposes of the 30% (or lower treaty) rate, net gain is the excess of your capital gains from U.S. sources over your capital losses from U.S. sources. This rule applies even if any of the transactions occurred while you were not in the United States. The183-day test mentioned above is not the same as the 183-day test used in the substantial presence test. See The Taxation of Capital Gains Of Nonresident Alien Students, Scholars and Employees of Foreign Governments section for further information.

If you were in the United States for less than 183 days during the tax year, you will not be taxed on your capital gains except for the following types of gains:

Gains which are effectively connected with a trade or business in the United States during your tax year,
Gains on the disposal of timber, coal, or domestic iron ore with a retained economic interest,
Gains on contingent payments received from the sale or exchange of patents, copyrights, and similar property after October 4, 1966,
Gains on certain transfers of all substantial rights to, or an undivided interest in, patents if the transfers were made before October 5, 1966, and
Gains on the sale or exchange of original issue discount obligations.

Many tax treaties contain provisions which reduce or eliminate taxation on capital gains.

Capital Gains from the Sale of Property
These rules apply only to those capital gains and losses from sources in the United States that are not effectively connected with a trade or business in the United States. They apply even if you are engaged in a trade or business in the United States. These rules do not apply to the sale or exchange of a U.S. real property interest or to the sale of any property that is effectively connected with a trade or business in the United States.

Reporting Gains and Losses
Report your gains and losses from the sales or exchanges of capital assets that are not connected with a trade or business in the United States on page 4 of Form 1040NR. Report gains and losses from sales or exchanges of capital assets (including real property) that are connected with a trade or business in the United States on a separate Schedule D (from Form 1040) and page 1 of Form 1040NR. Attach Schedule D to Form 1040NR.

GTT Observation: Most non-residents that are in the U.S. for more than 183 days meet the "substantial presence test" and they are taxed like U.S. residents, making this point moot.

International Taxpayer - The Taxation of Capital Gains Of Nonresident Alien Students, Scholars and Employees of Foreign Governments
The following discussion assumes that the capital gains in question are not effectively connected with the conduct of a trade or business in the United States.

Under the residency rules of I.R.C. § 7701(b) most foreign students, foreign scholars, and alien employees of foreign governments and of international organizations in the United States are considered to be "exempt individuals". That is, they are exempt for extended periods of time from counting days of presence in the United States for the purposes of determining their residency in the United States. Thus, most foreign students, foreign scholars, and the alien employees of foreign governments and of international organizations in the United States remain nonresident aliens in the United States for extended periods of time. Many of these nonresident aliens make personal investments in the United States which generate income from capital gains.

I.R.C. § 871(a)(2) imposes a flat tax of 30% on U.S. source capital gains in the hands of nonresident alien individuals physically present in the United States for 183 days or more during the taxable year. The 183-day rule of I.R.C. § 871(a)(2) bears no relation to the 183-day rule of the substantial presence test of I.R.C. § 7701(b)(3) and the exceptions to the residency rules, e.g., exempt individual/days not counted, of that section. Thus, there are situations in which the 183-day rule of I.R.C. § 871(a)(2) may apply to individuals who have not crossed the threshold of U.S. residence under of I.R.C. § 7701(b)(3). For example, a foreign diplomat, consular officer, or other nonresident alien employee of a foreign government, or nonresident alien employee of an international organization who is visiting the United States in A or G nonimmigrant status for a period longer than 183 days in a calendar year would be subject to the 30% tax imposed by I.R.C. § 871(a)(2) on his U.S. source capital gains. The same rule applies to a foreign student or scholar visiting the United States in F, J, M, or Q nonimmigrant status whose presence in the United States exceeds 183 days in any calendar year.

Because I.R.C. § 871(a)(2) applies only to U.S. source gains, the sourcing rules of I.R.C. § 865(g) must be considered when addressing the application of section 871(a)(2). If, under the rules of I.R.C. § 865(g)(1), an alien is determined to be a nonresident of the United States, then the aliens U.S. source capital gains would be treated as foreign-source and thus nontaxable. The key factor is whether the alien's "tax home" has shifted to the United States. Here, we must rely upon the tax home rules of I.R.C. § 162(a)(2), I.R.C. § 911(d)(3), Revenue Ruling 93-86, and Revenue Procedure 2000-9.

In general, under the tax home rules, a person who is away (or who intends to be away) from his tax home for longer than 1 year has shifted tax homes to his new location upon his arrival in that new location. Thus, under this rule, most foreign students and scholars and most alien employees of foreign governments and of international organizations have shifted tax homes to the United States on the day of their arrival in the United States unless the particular program or employment which brings them to the United States clearly terminates in less than one year and they have no intention to remain in the United States after the termination of such program or employment.

CONCLUSION

Nonresident alien students and scholars and alien employees of foreign governments and international organizations who, at the time of their arrival in the United States, intend to reside in the United States for longer than 1 year are subject to the 30% taxation on their U.S. source capital gains during any tax year if during such tax year (usually calendar year) they are present in the United States for 183 days or more, unless a tax treaty provides for a lesser rate of taxation. This assumes that such capital gains are not effectively connected with the conduct of a United States trade or business. These capital gains would be reported on page 4 (not page 1) of Form 1040NR and would not be reported on a Schedule D because they are being taxed at a flat rate of 30% under I.R.C. § 871(a) or at a reduced flat rate under a tax treaty.