Exiting A U.S. Venture: A Tax Guide For Non-U.S. Nationals

Introduction:

The United States remains a highly attractive destination for foreign investment, drawing substantial capital inflows annually. As reported by the Bureau of Economic Analysis, foreign direct investment (FDI) in the US reached approximately $4.5 trillion in 2023¹, underscoring the enduring appeal of the US market for overseas investors.

Preferred Corporate Structures for Foreign nationals:

Typically, Foreign nationals outside of USA typically prefer LLC or Inc. as structure for undertaking business activities in USA as it provides limited liability and does not expose the foreign national to USA tax and regulatory compliances. The comparative analysis of LLC and C Corp is listed below:

Pass through Taxation vs Taxed as Corporate:

Due to direct exposure in the USA, the C Corp is preferred structure for the foreign nationals as against Pass through.

A Foreign national contemplating to exit must have a thorough understanding of tax implications for optimizing return on investments. This article delves into the intricacies of exit taxation in the USA for foreign investors, focusing specifically on the sale of shares in US corporations.

Exit Taxation in the USA:

Generally, sale of shares or membership interest is taxed as Capital gains. In the USA, capital gains are taxed depending on whether they are short-term or long-term.

• Short-term capital gains: These are profits from assets held for one year or less and are taxed at the same rates as ordinary income, ranging from 10% to 37% in 2024.
• Long-term capital gains: These are profits from assets held for more than one year and are taxed at preferential rates, ranging from 0% to 20% in 2024, depending on the investor's income level and filing status.

Chargeability of the Capital Gains:

The Residential status in USA is essential to determine the taxability and rate of taxes in USA for capital gains on the sale of stock in US Corporation.

US Tax Residents: Generally, US Tax Residents/Citizen are taxed on the Global Income and capital gains are taxed at rates mentioned above.

Non-resident taxpayers: This category includes individuals who are not US citizens or permanent residents and do not meet the "Substantial Presence Test"². Non-resident taxpayers are generally only taxed on their US-source income. With regard to the taxation of capital gains on stock of US corporation, determination of "effective connection" is essential for determination of the taxability.

Effectively Connected Income (ECI): Capital gains that are ECI are generally taxed at the same rates as US citizens and residents. ECI typically arises from business activities conducted in the US.

The Investment incomes are considered as effectively connected to Trade in USA if either of the following tests are satisfied:

The Asset-Use Test: The Income must be associated with USA asset used in or held for use in conduct of a US Trade or Business.

Business Activities Test: The Activities of trade or business conducted in the United States are material factor for realization of Income.

Some of the examples of the Effectively connected Income are:

• Sale of US Real Property: Gains from the sale of US real property interests are automatically treated as ECI, regardless of whether the property was used in a US trade or business.
• Sale of Assets Used in a US Trade or Business: If a foreign investor sells assets that were used in their US trade or business, the gains are considered ECI.
• Sale of Stock in a US Corporation: If a foreign investor actively participates buying and selling of stocks of US corporation which constitute as trade or business, then the income shall be treated as effectively connected Income. This determination is highly fact specific, and not all investment activity are considered as U.S. trade or business.
• Sale of Membership Interest in LLC taxed as Partnership: The IRS applies an aggregate approach to determine the source and character of the income from the sale of a partnership interest. This means that the gain or loss from the sale of the partnership interest is treated as if the partner sold their proportionate share of the partnership's underlying assets. If the partnership's assets include U.S. trade or business assets, the gain attributable to those assets will be considered ECI.

If an asset is considered as effectively connected with business or trade in USA, the Gains are taxed at par with the US residents as mentioned above.

Not Effectively Connected Income (NECI):

Reading with Tax Treaty

Tax treaties are bilateral agreements between countries that aim to avoid double taxation and promote foreign investment. Treaties override the domestic Tax laws with regard to taxation of the non-resident.

USA-UK/Netherlands DTAA (OECD model convention):

Countries like UK, Netherlands etc. has double taxation framework which grants rights to USA to tax only the gains arising from sale of capital gains of stock of corporate which derives value from the immovable property situated in USA.

India-USA DTAA Taxation on Capital Gains

On the contrary to above, India-USA Double Taxation Avoidance Agreement provides comprehensive rights to both countries to levy capital gains tax on sale of the capital asset based on the domestic tax laws.

Non-Tax Treaty Jurisdictions

In the absence of a tax treaty, the capital gains earned by non-resident investors will be taxed in accordance with the US tax rules mentioned above.

Summary:

To summarize the tax implications for a foreign national,

Conclusion:

Understanding the taxation of capital gains in the USA is essential for determination of the post-tax returns. The rules can be complex, varying based on the type of income (ECI or NECI), structure of the investment (C-corp or Pass through entities), investor's residency status, and the existence of a tax treaty.

Further, there are other tax exemptions viz. Qualified small Business stock exemptions which exempts the capital gains subject to satisfaction of the prescribed conditions. Hence, a comprehensive understanding would help investors in well informed decision making.

Footnotes

1 https://globalbusiness.org/wp-content/uploads/2024/10/FDIUS-2024-8.pdf

2 The substantial presence test is a set of rules under U.S. tax law used to determine whether a non-U.S. citizen (alien) is considered a resident alien for U.S. federal income tax purposes based on the number of days they are physically present in the United States during a specific period. Meeting the substantial presence test generally means the individual will be taxed as a U.S. resident on their worldwide income, unless an exception applies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.