Capital gain tax and nonresident investors

Dear Tax Talk,
My question is related to the question you answered in 2004 on capital gains tax and the nonresident investor. I’ve seen this in several websites saying nonresident aliens do not have to pay tax on capital gain on U.S. stocks, but I couldn’t find where this is posted on the Internal Revenue Service website. I had a U.S. trading account when I worked in the U.S., but I worked and lived in China for all of 2011. I am a Canadian citizen. In 2010, I filed my taxes as a resident alien; I will file my taxes for 2011 as nonresident alien. I thought I would have to pay a 30 percent tax on the capital gain, but I’ve been reading that nonresidents do not have to pay tax on capital gain on stocks, just interest and dividends.

Thanks for your help.
— Tan

Dear Tan,
The tax law is complex, and there are certain terms that need to be understood to arrive at the conclusion your investment account gains are tax-free. IRS guidance on taxation of aliens is provided in Publication 519. Discussion of the relevant manner in which aliens are taxed begins at Page 18. Generally a foreigner is taxed in the U.S. on effectively connected income and fixed and determinable annual or periodic income. In short, this is referred to as ECI or FDAPI. ECI arises when you have an operating business in the U.S. ECI also includes gain on the sale of real property or the sale of stock in a U.S. corporation owning real estate. FDAPI is interest, dividends, rents and royalties, and it is discussed on Page 19 of the publication.

ECI is taxed on a net basis — meaning your gross income less deductions taxed at progressive rates that apply to U.S. citizens. FDAPI is taxed on a gross basis (i.e., no deductions or offset) at a flat rate generally 30 percent unless a lower tax treaty rate applies. As a Canadian citizen, your dividend income should be taxed at 5 percent by treaty.

Capital gains or losses on the sale of shares of publicly traded companies are not considered real estate gains unless the investment is in real estate investment trust, or REIT. If you read from Page 18 to 22 very carefully, and try not to get too confused, you come to the second paragraph on Page 22 that says the following:

If you were in the United States for less than 183 days during the tax year, capital gains (other than gains listed earlier) are tax-exempt unless they are effectively connected with a trade or business in the United States during your tax year.

The gains listed earlier are:

The following gains are subject to the 30 percent (or lower treaty) rate without regard to the 183-day rule, discussed later.

1. Gains on the disposal of timber, coal or domestic iron ore with a retained economic interest.
2. Gains on contingent payments received from the sale or exchange of patents, copyrights and similar property after Oct. 4, 1966.
3. Gains on certain transfers of all substantial rights to, or an undivided interest in, patents if the transfers were made before Oct. 5, 1966.
4. Gains on the sale or exchange of original issue discount obligations.

Since your investment account probably does not consist of these, your account’s realized gains are tax-exempt.

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