Many Americans living abroad purchase properties in their foreign country of residence. They often accomplish this with financing from a foreign financial institution. Later, they may return to the US and continue holding the property and meeting their mortgage payments. Similarly, many non-US citizens purchase properties with such financing in their home countries and later make a move to the US, perhaps for employment. Some get green cards, some don’t but they do spend enough time in the US to be treated as US tax “residents” taxable on their worldwide income. Regardless, they also continue meeting their debt obligations to the foreign lender.
Often, in multi-national families, a foreign parent or relative will make a loan to a US person family member and require that interest be paid on the loan. In some cases, the US debtor will be residing overseas. In other cases, he will be living in the US.
Generally speaking, when income is paid from “US sources” to a foreign payee, it is taxable by the United States and the US-payor will have to withhold US tax at a 30% rate on the payment. The withholding tax can possibly be eliminated due to a certain exception in the law or it can be reduced due to a favorable Income Tax Treaty negotiated between the United States and the lender’s foreign country. However, taking advantage of the exception or Treaty reductions is not automatic and proper paperwork has to be in place. If withholding is required, a failure to do so can result in personal liability for the tax that should have been withheld as well as significant penalties.
What happens with regard to the interest payments made to the foreign lender on the loans mentioned above? Is US withholding tax required by the individuals paying the interest?
What is the “Source” of Interest Income?
The withholding tax applies to items of US-source income. Section 861(a)(1) of the Internal Revenue Code (the “Code”) provides that interest shall be treated as income from US sources if it is “[i]nterest from the United States or the District of Columbia, and interest on bonds, notes, or other interest-bearing obligations of non-corporate residents or domestic corporations.”
The regulations under section 861 provide further rules for determining the source of interest. Treasury Regulation § 1.861-2(a)(1) provides, in relevant part, that “[g]ross income consisting of interest from. . . a resident of the United States on a bond, note, or other interest-bearing obligation issued, assumed or incurred by such person shall be treated as income from sources within the United States.”
The Litmus Test is the “Residence” of the Individual Paying the Interest
For purposes of Treasury Regulation § 1.861-2(a)(1), the term “resident of the United States” includes “an individual who at the time of payment of the interest is a resident of the United States” (emphasis added). The regulations under section 861 do not provide any special rule for sourcing interest based on an individual payor’s citizenship. The individual’s residence determines the source of the interest payment.
But, what is meant by “residence”? Is a US citizen living abroad treated as a “resident” of the United States? If not, how long must he be living overseas before his US “residence” is treated as terminated? What about other cases such as green card holders who live abroad, or whose cards have expired, or dual residents who make a so-called treaty-election to break US residence?
The US tax laws contain many nuances pursuant to which an individual can be treated as a “resident” of the United States for tax purposes. For example, spending significant time in the US can cause one to be treated as a “resident” under what is called the “Substantial Presence Test”. By way of another example, if an individual holds a green card, but he physically lives in a foreign country, the individual is still treated as a US “resident” for tax purposes. This remains so even if the card has expired long ago but was not properly relinquished. Another example is that of the non-citizen spouse of a US citizen who makes a special election under the Code to be treated as a US “resident” for tax purposes even if the individual has never set foot in the United States; or the dual-resident individual who breaks US residence by asserting a treaty benefit, yet who meets the Substantial Presence Test. If interest is paid by these individuals, does the interest have a US source because the individuals are treated as “residents” for certain purposes of the Internal Revenue Code?
“Substantial Presence Test” is Key
The Internal Revenue Service (IRS) has provided some guidance on these issues in Chief Counsel Advice CCA 201205007. While a CCA cannot be cited as precedent, it is very useful to know the view of the IRS with regard to these questions.
The IRS looks to the “Substantial Presence Test” in determining whether the payor of the interest is a US “resident”. If the Substantial Presence Test is satisfied at the time of the payment of the interest, then the source of the interest income will be treated as from the US, and, absent an applicable exception or Treaty benefit, the payor must withhold 30% of the payment and remit it to the IRS. Failure to do so can result in personal liability for the tax that should have been withheld as well as significant penalties.
Interest Payments by US Citizens
In the CCA, for example, the applicable test in the context of a US citizen was the Substantial Presence Test in Code Section 7701(b). Under this section, an individual is treated as a resident of the United States under the Substantial Presence Test if he or she has been present in the United States for more than 30 days during the current year and for at least 183 days during a three year look-back period that includes the current year. You can learn the mechanics of the Substantial Presence Test here. Interest paid by a US citizen who satisfies the Substantial Presence Test at the time of the interest payment is to be treated as US source income, while interest paid by a US citizen who does not satisfy the Substantial Presence Test at the time of payment is treated as foreign source income.
Interest Payments by Green Card Holders, Dual Residents
Interest paid by a lawful permanent resident (green card holder) who lives outside of the United States at the time of payment, is treated in the same manner. The emphasis that Code Section 861 and its related regulations place on an individual’s residence, rather than the individual’s legal or immigration status in a particular country or jurisdiction, suggests that sourcing of interest payments by an individual should be based on the individual’s place of physical residence. Similarly, dual resident taxpayers who make an election under Treas. Reg. § 301.7701(b)-7 to be treated as nonresident aliens but who meet the Substantial Presence Test in Code Section 7701(b) at the time of the interest payment are treated as “resident” payors of US source interest. While the CCA did not examine the case of the non-citizen spouse of a US citizen who makes a special election under the Code to be treated as a US “resident” for tax purposes even if the individual has never set foot in the United States, one can extrapolate that the Substantial Presence Test would be applied to determine “residence” and thus, the “source” of interest payments made by that individual.
An attention to detail is required to make sure one does not fall foul of the US tax rules mandating withholding on interest payments made to foreign lenders. This is a particularly important issue for non-US persons planning to immigrate to the United States and for US citizens living abroad who will return to the US. In both cases, any foreign loans should be carefully examined. As mentioned exceptions may apply or Treaty benefits be claimed to eliminate or reduce the withholding provided the proper paperwork is put in place prior to the payments.
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