U.S. federal tax law categorizes income earned by foreign corporations in the U.S.:
– effectively connected income (ECI) with U.S. trade or business; and
– certain fixed or determinable annual or periodical (FDAP) income that may not be effectively connected to U.S. trade or business.
The key difference between the above categories is that the first one (i.e. ECI) is taxable at corporate tax rate on net basis, while the second one (i.e. FDAP) is taxable at a fixed rate on gross basis. We have covered the U.S. taxation of ECI for Indian or foreign corporations in our blog ‘Indian entities and U.S. taxation: Effectively connected U.S. income’. In this blog, we will focus on the U.S. taxation of second category i.e. FDAP.
Generally, FDAP income includes interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other gains, profits and income. While categorization of an income as FDAP is quite broad and there is no exhaustive list, but capital gains on sale of a property is specifically excluded.
Certain income that are generally categorized as FDAP are:
– U.S. sourced interest excluding interest received on an eligible bank deposit or portfolio debts;
– Dividend distribution classified as non ECI and does not include return on capital;
– Royalty and other income from the use of intangible property in the U.S. excluding gains on sale of intangible property unless it is from contingent upon the use, productivity or sale of the property;
– Distributions by an estate or trust or partnership that is non ECI.
It should be noted that the fixed tax rate of 30 percent is applied on gross basis on FDAP income under the U.S. domestic tax code. This domestic tax rate can be further reduced in terms of a tax treaty between the U.S. and home jurisdiction of a foreign corporation. For example, 15 percent tax rate applies in relation to non-portfolio dividends received by an Indian corporation that owns at least 10 percent or more of the voting stock in a U.S. corporation, under the terms of tax treaty between India and the U.S. Certain tax treaties reduce this percentage to zero but specify conditions to be fulfilled in determining their eligibility for a lower tax rate to apply.
The nature and sector in which a foreign corporation invests may add or reduce the tax cost on the investment. For example, rental income from a property in the U.S. is generally classified as FDAP income and taxable on gross basis. However, where a foreign corporation elects to treat rental income as ECI, then it would be taxable on net basis.
Foreign investors should therefore think through the U.S. tax considerations in classifying income as ECI or FDAP, while structuring investment in the U.S. in addition to home country regulatory and tax framework.