FDAP: How Fixed, Determinable, Annual & Periodic Income is Taxed
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FDAP: Fixed, Determinable, Annual & Periodic Income Tax Rules
FDAP: International Tax is always heavy with the acronyms. Two important IRS acronyms are FDAP and ECI. FDAP refers to Fixed, Determinable, Annual and Periodic. It essentially means passive income. ECI on the other hand refers to Effectively Connected Income, which includes income generated from a trade or business connected to the U.S. The same income can qualify for both. How the income is taxed will vary based on whether the income is categorized as FDAP or ECI.
This article will focus on FDAP.
Definition of FDAP
Technically, it refers to Fixed, Determinable, Annual and Periodic – but we realize that is not much help, so let’s dive a bit further with examples.
What does the IRS say:
- “Income is fixed when it is paid in amounts known ahead of time. Income is determinable whenever there is a basis for figuring the amount to be paid. Income can be periodic if it is paid from time to time. It does not have to be paid annually or at regular intervals. Income can be determinable or periodic, even if the length of time during which the payments are made is increased or decreased.”
Generally, passive income (although it may qualify for a tax reduction under treaty benefits) is withheld at 30% and there are no deductions available (e.g., such as deductions a property owner takes for rental income).
Some common examples of FDAP, includes:
- Compensation for personal services (such as commissions and gross proceeds from performances)
- Dividends
- Interest
- Original issue discount
- Pensions and annuities
- Alimony
- Real property income, such as rents, other than gains from the sale of real property
- Royalties
- Scholarships and fellowship grants
- Other grants, prizes and awards
- A sales commission paid or credited monthly
- A commission paid for a single transaction
FDAP Tax Treatment
As provided by the IRS:
- “Tax at a 30% (or lower treaty) rate applies to FDAP income or gains from U.S. sources, but only if they are not effectively connected with your U.S. trade or business. The 30% (or lower treaty) rate applies to the gross amount of U.S. source fixed or determinable, annual or periodical gains, profits, or income. Deductions and netting are not allowed against FDAP income.”
What does this mean?
This refers to the general straight or flat tax on FDAP income from U.S sources. But, if the income is ECI and FDAP it is not taxed at 30% straight – and different rules apply.
Let’s Focus on FDAP Periodic and Dividends
Something is Periodic when it is received from time to time. Once example would be dividends, which are issued by companies generally when certain milestones are met. Since dividends are a type of periodic income, it would qualify as FDAP.
Capital Gains
As indicated above, capital gains generated from U.S. companies is generally not taxable to the NRA and therefore FDAP does not apply. But, there are some exceptions:
- U.S. real estate
- 183 day rule
The 183 Day Rule
The 183 day rule is not the same as the substantial presence test. Rather, it refers specifically to the current year and presence in the U.S.
As provided by the IRS:
- If you were present in the United States for 183 days or more during the tax year, and you are still a nonresident alien, your net gain from sales or exchanges of capital assets is taxed at a 30% (or lower treaty) rate.
- For purposes of the 30% (or lower treaty) rate, net gain is the excess of your capital gains from U.S. sources over your capital losses from U.S. sources. This rule applies even if any of the transactions occurred while you were not in the United States.
- The183-day test mentioned above is not the same as the 183-day test used in the substantial presence test. See The Taxation of Capital Gains Of Nonresident Alien Students, Scholars and Employees of Foreign Governments for further information.
As further provided by the IRS:
- “If you were in the United States for less than 183 days during the tax year, you will not be taxed on your capital gains, except for the following types of gains:
- Gains that are effectively connected with a trade or business in the United States during your tax year
- Gains on the disposal of timber, coal, or domestic iron ore with a retained economic interest
- Gains on certain contingent payments received from the sale or exchange of patents, copyrights, and similar property
- Gains on certain transfers of all substantial rights to, or an undivided interest in, patents
- Gains on the sale or exchange of original issue discount obligations
- Many tax treaties contain provisions which reduce or eliminate taxation on capital gains.
What Capital Gains Are Taxed?
- These rules apply only to those capital gains and losses from sources in the United States that are not effectively connected with a trade or business in the United States. They apply even if you are engaged in a trade or business in the United States. These rules do not apply to the sale or exchange of a U.S. real property interest, or to the sale of any property that is effectively connected with a trade or business in the United States.
Reporting Gains and Losses
- Report your gains and losses from the sales or exchanges of capital assets that are not connected with a trade or business in the United States on Schedule NEC, Tax on Income Not Effectively Connected with a U.S. Trade or Business, of Form 1040NR. Report gains and losses from sales or exchanges of capital assets (including real property) that are connected with a trade or business in the United States on a separate Form 8949, summarized on Schedule D (from Form 1040) and page 1 of Form 1040NR. Attach Form 8949 and Schedule D to Form 1040NR.
Real Estate Sales FDAP Exception
Unlike other U.S. based capital gains, the sale of U.S. real estate and other real property interests are taxable. This is covered under FIRPTA (again with the acronyms), and we have a separate article on the Foreign Interest in Real Property Tax Act (FIRPTA).
U.S. Social Security
As provided by the IRS:
- U.S. source FDAP income includes 85% of any U.S. Social Security benefit (and the Social Security equivalent part of a Tier 1 railroad retirement benefit). This income is exempt under some tax treaties. Refer to Table 1 in Publication 901, U.S. Tax Treaties, for a list of tax treaties that exempt U.S. Social Security benefits from U.S. tax.”
What does this mean?
This refers to the 85/15 rule for FDAP and social security. It reduces the portion subject to social security down to 85% — and some treaty countries exempt tax.
The following are provided by the IRS, with a brief explanation put into layman terms by Golding & Golding.
Installment Payments
- “Income can be FDAP income whether it is paid in a series of repeated payments or in a single lump sum. For example, $5,000 in royalty income would be FDAP income whether paid in 10 payments of $500 each or in one payment of $5,000.”
What does this mean?
Even if income is paid via an installment payment, it can still otherwise qualify as FDAP.
Insurance Proceeds
- Income derived by an insured nonresident alien from U.S. sources upon the surrender of, or at the maturity of, a life insurance policy, is FDAP income. The proceeds are income to the extent they exceed the cost of the policy.
- However, certain payments received under a life insurance contract on the life of a terminally or chronically ill individual before death (accelerated death benefits) may not be subject to tax. This rule also applies to certain payments received for the sale or assignment of any portion of the death benefit under contract to a viatical settlement provider. See Publication 525, Taxable and Nontaxable Income, for more information.
What does this mean?
Certain life insurance policy may still be taxable to a nonresident alien — although there are exception, exclusion and limitations.
Racing Purses
- Racing purses are FDAP income and racetrack operators must withhold 30% on any purse paid to a nonresident alien racehorse owner in the absence of definite information contained in a statement filed together with a Form W–8BEN that the owner has not raced, or does not intend to enter, a horse in another race in the United States during the tax year.
- If available information indicates that the racehorse owner has raced a horse in another race in the United States during the tax year, then the statement and Form W–8BEN filed for that year are ineffective. The owner may be exempt from withholding of tax at 30% on the purses if the owner gives you Form W–8ECI, which provides that the income is effectively connected with the conduct of a U.S. trade or business and that the income is includible in the owner’s gross income.
What does this mean?
This a specific rules for income involving racing purses.
Covenant Not to Compete
- “Payment received for a promise not to compete is FDAP income. Its source is the place where the promisor forfeited his or her right to act. Amounts paid to a nonresident alien for his or her promise not to compete in the United States are subject to withholding.”
What does this mean?
A covenant not to compete may be taxable. For the NRA, it depends on whether or not the forfeited right occurred in the U.S. are not.
Signing On
- “A fee paid to a professional athlete, such as a soccer or hockey player for “signing on” with the effect of preventing any other team from negotiating with the player and preventing the player from negotiating with any other team is pay for a covenant not to compete. The source is the place where the right to play is given up. If a league is made up of both foreign and U.S. teams, the fee is from sources partly in and partly outside the United States. The part of the fee that is from U.S. sources is subject to withholding. If there is no reasonable basis for an allocation of the fee, the entire sign-on fee is income from the United States and is subject to withholding.”
What does this mean?
Similar to covenant not to compete, the signing on fee (to prevent an athlete from signing onto another team) is also considered payment for a covenant not to compete. If the right was given up in the US – FDAP may apply.
In conclusion, a nonresident alien who generates income in the US may still be subject to income tax. If the income is FDAP, then there is a 30% withholding unless an exception or treaty rule applies.
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