The need-to-know for the beginner Israeli investor in the United States - Real estate, debt, infrastructure, renewable energy, oil and gas, etc. The possibilities are endless when investing in the world's largest market, but what does it mean for your taxes?
Investing offshore is always a risk. It is an unfamiliar investment in an unfamiliar market with unfamiliar tax regulations. Most importantly, when making an investment offshore, you should ensure your broker, partner, or operator has a lot of experience and a proven history. Once you get past that hurdle, the big tax questions come to mind; How much tax will I need to pay? Will I need to file a tax return? Will any taxes be withheld? Can I credit the taxes paid against my taxes in Israel?
This guide will give you the basics of taxation in the U.S. to help you decide whether this is the right investment for you.
FDAP or ECI
The Ins and Outs of FDAP and ECI
What about Israel
FDAP or ECI?
The first question any offshore investor in the U.S. should ask is, "What type of income does this investment generate? FDAP or ECI? This may sound as foreign to you as the investment itself, but the distinction between the two is crucial in understanding how the investment will ultimately impact you from a tax perspective.
Fixed, determinable, annual, and periodic income (AKA FDAP income) includes a wide range of income types. The U.S. tax code and regulations do not provide a proper definition of the term, however the basic examples given refer to income that is predetermined or determinable based on certain factors. Some clear examples include dividend, royalties, and interest. Rental income may also be included in this classification, although according to this definition there are certain elections that could exclude this income (this will be discussed later). Only gains from the sale of property is clearly excluded from this definition.
Effectively connected income (AKA ECI) refers to income of a foreign person which is effectively connected to a U.S. trade or business.
How is this relevant to the passive investor? Income earned through a passive investment generally maintains its classification. That seemingly harmless 1% interest in a partnership operating a textile business in the United States means you are earning income from operating a trade or business in the United States.
So now you know what each one refers to...but which one is better?
The Ins and Outs of FDAP and ECI
There is no correct answer to which type of income is better. Those averse to IRS exposure may opt for a FDAP investment, while those looking for some equity upside may lean towards the ECI investment.
FDAP Income
FDAP income earned by a foreign investor is subject to 30% tax in the United States. A tax treaty with the United States may reduce this rate, for example, dividends earned by an Israeli investor from a U.S. corporation is generally eligible for a 25% rate. Royalties are generally reduced to 15%.
The tax is on a gross basis, so that $100 of dividend income will be subject to $25 tax without the ability to deduct any expenses.
Most importantly, this income is addressed through withholding taxes and is not subject to filing requirements in the United States. That makes these types of investments ideal for the investor that does not want the headache of filing taxes outside of Israel.
Very important - Certain FDAP income may be reclassified as ECI if connected with a U.S. trade or business. For example, your investment in a joint venture with a U.S. based lending group may be classified as a trade or business unless structured properly. You have been warned...
ECI
ECI earned by a foreign investor is subject to ordinary tax rates in the United States as if the foreign investor is a U.S. person - marginal rates up to 37% for the individual or a 21% flat rate for the corporate investor. The corporate investor may be subject to an additional branch profits tax similar to a dividend, subject to an additional 12.5% for the Israeli corporation on the after-tax figure providing a federal effective tax rate of close to 31%. Additionally, the income may be subject to state taxation depending on where the activity takes place and how the state views the specific trade or business.
Nevertheless, this income is subject to tax on a net basis, so that $100 of ECI with $60 of ordinary and necessary expenses would only be subject to around $15 of tax (37% of $40), far lower than the $25 in the case of dividends, noted above. Due to the deductibility of the expenses, these investments can also generate losses which can be used to reduce taxable income in the future.
The downside of ECI is that it generates tax filing requirements for the investor, both at the federal level and at the state level. Please ask your U.S. tax advisor for assistance with these filings. Do not try this at home!
Capital Gains
Capital gains are not classified as FDAP and are generally not included in the definition of ECI. There is a special exemption in the United States, exempting foreign investors from taxation on their capital gains. The one exception to this is capital gains from the disposition of real estate. These capital gains are subject to a special tax regime which equates them to ECI (AKA the FIRPTA regime) and subjects them to tax accordingly.
Rental Income
Rental income would appear to be FDAP income. It is periodical income received for the use of property. The U.S. tax code allows for this income to be treated as ECI if elected by the investor. Remember the $25 vs $15? With real estate and the large depreciation expenses associated with real estate, the difference between the two approaches is much more extreme. Most investors elect to treat the income as ECI in order to benefit from these deductions.
What about Israel?
Back in Israel, the Israeli tax authorities will subject the same income to tax at Israeli tax rates. Israel classifies both federal and state taxes as eligible taxes to credit against the taxpayer's Israeli tax. Due to the high tax rates in the United States and the reduced rates in Israel for passive income, most of these investments - if structured correctly - would not require paying additional taxes in Israel. It is recommended confirming this with your tax advisor before finalising any investment to avoid unnecessary tax leakage.
In Short
The cleanest and simplest investments are those which generate FDAP income. For example, lending a U.S. entity generally can be completely exempt in the United States. There should also not be any filing requirements, and therefore the income could be reported in Israel without even needing to consider foreign tax credits to complicate matters.
That said, for those interested in taking a little bit more of a risk to get that equity upside and who are not afraid of a little extra reporting, the ECI approach can be the smarter approach which can open-up a wealth of new investment options that may not have been available to those opting for anonymity with the IRS.
Please contact us if you have a specific investment you would like to discuss, and we will be happy to assist in understanding the full tax impact so you can have the peace of mind that you need before committing to the investment.
Commentaires