In an increasingly globalized society, it is not uncommon for families to have cross-border ties. Additionally, particularly since the 2008 global financial crisis, U.S. equity markets have meaningfully outperformed global equity indices–making the U.S. an attractive place to put capital to work.
However, non-resident aliens (NRA) may be surprised to learn of the tax implications of investing in U.S.-based securities. A non-resident alien is someone who, per the IRS, fails both the green card test and the “substantial presence” test over a regular calendar year. NRA status is established at the account custodian with a Form W-8. It does not matter if the account is registered as a U.S. account or an “offshore” account, as the citizenship and domiciliary status of the account holder is of primary importance as a tax determinant.
Specifically, tax withholding – typically 30% unless an international treaty specifies otherwise – is assessed on U.S.-source income. This includes dividends, interest, royalties, and short-term gain distributions from mutual funds (though non-U.S. accounts are usually prohibited from purchasing mutual funds in the first place). This might include, for example, equity ETFs that track either U.S. or international indices – as the ETF itself is treated as a U.S.-situs company.
Portfolio interest from U.S.-situs assets, however, is not subject to the same withholding requirements. Examples of such assets include:
- U.S.-source interest income that is not connected with a U.S. trade or business and that is portfolio interest on obligations issued after July 18, 1984
- Dividends and interest from tax-exempt obligations
- Bank deposit interest
Of perhaps greater impact, however, is the U.S. estate tax. U.S. citizens and permanent residents are entitled to an unlimited spousal exemption (meaning that spouses can transfer money freely to each other at death without incurring any tax), as well as the full federal exemption ($5.49M per person, or $10.98M per married couple as of 2017). Under current federal law, this exemption is also portable, meaning that any exemption not used at the first death may be transferred to the surviving spouse. Dollars in excess of this exemption are subject to tax as high as 40%, in addition to any estate taxes assessed at the state level.
In contrast, however, any U.S.-based property in excess of $60,000 owned by a non-resident U.S. alien at death is subject to U.S. estate tax (unless an in-force treaty explicitly provides otherwise). Additionally, the spousal deduction is limited to that same amount – which is to say that any U.S. property with a value greater than $60,000 that is individually registered at Spouse A’s death will be reduced by a 40% estate tax before it falls into Spouse B’s hands, as illustrated by the following graphic:
Under 2017 law, the IRS also limits inter-vivos spousal gifts (those made during life) to $149,000 annually – which prevents late-life bequests of property from Spouse A to Spouse B as an estate tax avoidance strategy. Note that these gift and estate taxes are levied only on U.S.-situs property, not on worldwide assets. Non-spousal gifts are limited to a $14,000 annual gift exclusion, similar to that enjoyed by U.S. citizens and permanent residents – though “gift splitting” is not permissible for NRA.
In spite of these significant tax drawbacks, because of the critical importance of diversification across both asset classes and geographical areas, there is still a case to be made for investing in U.S.-based assets as a NRA. Strategies to minimize U.S. tax include:
- Implementing a thoughtful asset location approach, such that fixed income/higher-yielding assets remain offshore in the NRA’s home residency, while growth-oriented assets with a lower yield (e.g. equities) are more U.S.-oriented
- Structuring account registration such that there is a degree of distance between the NRA and the assets (e.g. establishment of a non-U.S. corporation and/or trust, which may be appropriate depending on the investor’s individual circumstances)
Because of the magnitude of potential implications resulting from any missteps, it is imperative to engage a qualified attorney and/or tax professional who is familiar with the “ins and outs” of cross-border issues. Your financial planner should act as the “quarterback,” working within the legal and tax constraints to develop your financial plan and implement an investment strategy that supports this.