Capital Gains Tax Exemption for Non-Resident Traders in the U.S.

More and more private investors access international financial markets online. All of them have to deal with foreign tax issues. The result of that are numerous questions. Following our recent article “Why a Private Investor May Need an Offshore Company” we answer questions on taxation and reporting of U.S. traders using offshore companies.

We are considering here a common situation when:

  1. You are a non-citizen and not a U.S. resident and classified as non-resident alien (NRA) for taxation purposes.
  2. You incorporate an offshore company in jurisdictions like Dominica, Belize, Seychelles or another tax haven jurisdiction having no double taxation agreement with the U.S.
  3. Your offshore company further opens a trading account with a U.S. registered broker and you have no other business activity in the U.S.
  4. The company is involved in day trading and never holds more than 5% of stock in one particular U.S. company.

Offshore Company is Free from Taxation and Reporting in Jurisdiction of Incorporation

An offshore company (being an International Business Company) is exempt from local taxation of any of its worldwide income generated outside of its jurisdiction of incorporation, including from the U.S. sources, neither it is required to file financial reports with its local tax authorities. The only requirement is to pay its annual governmental fee to the Registry.

Capital Gains Tax (CGT) Exemption in the U.S.

Capital gains are probably the major part of trading income. Under the general rule capital gains of non-residents received from U.S. sources are not taxed with the U.S. This rule should also apply to Forex ordinary income with IRC 988 and short-term capital gains from securities.

Basically, you are considered to be nonresident if you didn’t meet the green card test or the substantial presence test for the calendar year (January 1 – December 31) for individuals, and if you don’t have a U.S. office, business place or relationship that can be classified as a permanent residence for legal entities.

U.S. Interests and Dividends are Subject to Withholding Tax at a Flat 30% Rate

The other income including interests and dividends is subject to different taxation depending on whether it is Effectively Connected Income (ECI) or not.

According to the IRS, “if your only U.S. business activity is trading 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”. It means that this part of your income is not effectively connected.

“Income that is not effectively connected is taxed at a flat 30% (or lower treaty) rate”. Since there is no double tax treaty in our case, the 30% tax rate is applicable to interests and dividends income.

“Nonresident aliens are taxed based on the source of their income and whether or not their income is effectively connected with a U.S. trade or business”. It means that your taxes on interests and dividends are subject to withholding by the paying agent – U.S. broker.

Same tax rulings should apply to foreign entities including your offshore company.

You Don’t Have to File a Tax Return in the U.S.

You don’t have a permanent establishment in the U.S. nor your income is treated as effectively connected. As a result you don’t need to furnish a taxpayer identification number (TIN) nor employer identification number (EIN).

As this is your only U.S. source income, you do not have to file a tax return in the U.S., because your U.S. tax liability is satisfied by the withholding of tax.

However, you must provide Form W8-BEN (instructions for form W-8BEN) to establish that you are a non U.S. person and claim that you are the beneficial owner of the income for which Form W-8BEN is being provided. Your broker is to request it from you and you are to provide it to the broker, not to the IRS, before you are paid or credited. Failure to provide Form W-8BEN may lead to backup withholding rate.

Find the Right U.S. Broker

From the practical experience a lot may depend on the policy of a particular U.S. brokerage company you decided to work with. We would advise you to talk to your broker first before you open a trading account. If the broker tends to withhold the tax on capital gains from your foreign exchange and stock trading, it may be wiser to look for another broker. The “right” broker is supposed to understand the issues of taxation of non-resident U.S. traders and be ready to meet your business interests and tax rights.

In case of American taxpayers using an offshore company for the same purposes the situation is different. They may be subject to additional tax obligations and need to consult with a local tax advisor.

Disclaimer: pursuant to Internal Revenue Service (IRS) guidance, please be informed that any tax advice given in this article was not intended and is not to be used as an advice to any person or entity for the purpose of avoiding taxes and penalties imposed under the Internal Revenue Code (IRC).