When nonresident aliens (“NRAs”) invest in the US securities market they must take the bitter with the sweet. On the sweet side, the US entices NRAs by offering quite favorable income taxation on US securities: no income tax on US capital gains, income tax-free “portfolio” interest paid from US sources, and US dividend tax rates reduced from 30% to special rates as low as 5% (depending on country specific treaty provisions). The bitter side is that if an investment in US securities is not structured properly the US estate tax can take a 40% tax bite out of the fair market value of the NRA’s investment in US securities at time of death and create an administrative nightmare for transferring those assets to their rightful beneficiaries and heirs.
The US securities market continues to be a great investment opportunity for individuals and families from outside the United States (NRAs); however, many NRAs are not aware of or informed about the US estate tax exposure of 40% on all investments in US securities directly held by the NRA. As a result the NRA’s surviving family is often surprised by the application of the US estate tax to the NRA family’s investment in US securities (and other deemed US-situs assets, e.g., US real estate), which results in a high administrative burden for the heirs.
The Estate of Charania highlights the US estate tax problem for NRAs. The US Internal Revenue Service (“IRS”) assessed the Estate of Noordin M. Charania for US federal estate tax on the full value of 250,000 shares of Citigroup common stock held in safekeeping for Mr. Charania by Fortis Bank, Hong Kong until he died in 2002, which resulted in an increased estate tax deficiency of US $2,070,000, plus interest and penalties. Although the actual legal issue addressed by the case concerned what portion of the Citibank shares were includible in Mr. Charania’s estate for US estate tax purposes, even though he was an NRA at the time of his death and resident of Belgium, the case is a good example where had the US investment in the Citibank shares been structured properly, the likely US estate tax bill could have been 0.
We briefly cover below three critical issues for an NRA investing in the US: (1) US Income Tax (which includes the US capital gains tax), (2) US Estate Tax, and (3) US Gift Tax.
- US Income Tax
Generally, NRAs are taxed on only US source income. Subject to exceptions, US source income not effectively connected with a US trade or business received by an NRA is subject to a 30% withholding tax. That is, 30% is deducted and withheld from the gross amount of the US source income by the withholding agent (e.g., the payer). A reduced rate of withholding or an exemption may apply under the US tax code or income tax treaty between the NRA’s country of residence and the US.
The following example illustrates the withholding tax:
Mr. X is an NRA who is a resident of Singapore, which currently does not have an income tax treaty with the US. Mr. X owns 100 shares of US Co. US Co declares of a dividend of $1 per share. When US Co pays the $100 dividend to Mr. X., US Co is required to deduct and withhold $30 from the dividend and so Mr. X will receive $70 net. By contrast, if Mr. X were a resident of Switzerland, US Co would withhold $15 from the dividend and pay $85 to Mr. X because the income tax treaty between Switzerland and the US lowers the rate of tax to 15%.
The following table summarizes the taxation of three common categories of income derived from securities.
An NRA is not required to file a US federal income tax return (IRS Form 1040-NR) unless the tax is not fully withheld at the source or the NRA seeks to reclaim an amount that has been over-withheld. Ordinarily, the NRA will be asked by the withholding agent to provide documentation (e.g., IRS Form W-8BEN) to certify his/her non-US status and, if applicable, qualification for a reduced rate of withholding under a treaty. In addition, if the NRA directly invests in the US, e.g., in a US hedge fund, US private equity fund, or US venture capital fund, information concerning the NRA and his/her US investment may be disclosed to the NRA’s country of tax residence pursuant to an intergovernmental agreement between such country and the US to implement the provisions of US law commonly known as the Foreign Account Tax Compliance Act (FATCA).
- US Estate Tax
The US estate tax often takes an NRA’s family by surprise. During the NRA’s lifetime, there is a general belief that the US estate tax will not apply, or that the US Internal Revenue Service (“IRS”) will not discover that the NRA held the US assets. To the surprise of the NRA’s heirs, the most likely to take action to enforce the US estate tax is a non-US bank (which is not that surprising these days). With FATCA in place since July 2014, many non-US banks are beginning to enforce the US estate tax against unsuspecting NRA clients who only too late discover that the US will apply a 40% estate tax to the entire lot of US property. We have observed a remarkable increase in the amount of US estate tax enforcement by non-US banks where an NRA directly holds US shares (e.g., Google, Apple). NRA families should take action with their advisers to ensure that they take precautions against the application of the US estate tax.
The US estate tax applies to property situated in the US (“US situs property”) in which an NRA decedent had an interest at the time of his or her death is includible in his/her US gross estate. The excess of the value of the US gross estate at the time of the NRA decedent’s death less allowable deductions is subject to the US federal estate tax. Currently, the maximum estate tax rate for a taxable estate having a value over USD 1,000,000 is 40%. A credit of USD 13,000 is allowed against the estate tax liability. This credit is the equivalent of an exemption from taxation equal to USD 60,000 of US estate’s value. An applicable estate/inheritance tax treaty between the US and country of the NRA decedent’s domicile may modify the US taxation of the NRA decedent’s estate.
The following table summarizes the situs of common categories securities:
A NRA’s estate must file the US federal estate tax return (IRS Form 706-NA) if the US gross estate exceeds USD 60,000, whether or not tax is owed. To avoid tax liability and penalties, US corporations and their transfer agents must first obtain a “transfer certificate” before transferring such corporations’ stock registered in the name of a nonresident decedent. The US tax authority issues the transfer certificate only after it is satisfied that tax has been paid, is provided for, or is not owing. In many cases, we have observed a non-US bank freezing the US situs shares until a Federal transfer certificate is issued to the estate. This can mean a significant delay between the death of the NRA and the IRS’s issuance of the federal transfer certificate.
- US Gift Tax
A gift transfer of US real or tangible property by an NRA donor is taxed at the same rates as the estate tax if the value of the gift exceeds the annual exclusion amount. In 2017, the annual exclusion amount is USD 14,000. Accordingly, if an NRA transfers US real estate, then the NRA could trigger a significant US gift tax. In contrast, an NRA transferring US securities will not trigger any US gift tax as US securities are generally considered as intangible property. Accordingly, an NRA can donate US securities to family members and others without US gift tax. In the rare event that the gift tax is triggered, the US federal gift tax return is IRS Form 709-NA.
- Concluding Remarks
Planning opportunities are available to ensure that an NRA’s investment in US securities will be tax efficient or completely eliminate the exposure to the US estate and gift taxes. The solution will depend on the specific facts and circumstances concerning the NRA and may involve the use of a non-US company, partnership, or trust and/or invocation of treaty benefits. Planning becomes more complex if the NRA has US family members. Any solution for an NRA investing in the US securities markets must also contemplate the local jurisdiction as well, and we recommend that an NRA seek proper legal advice from both an experienced US tax attorney and a tax adviser in the NRA’s country of residence.