Many foreigners plan to conduct investment-related activities in the U.S. As a result, they may generate certain investment income, including interest payments, dividends, capital gains, and other profits.
In the U.S, investment income is considered passive income. This means it is not effectively connected with trade or business within the US. Suppose a foreign individual or entity receives such passive income from U.S. sources not connected to any trade or business. In that case, such income qualifies as Fixed, determinable, annual, or periodical (FDAP) income. Such FDAP income is subject to a flat 30% withholding tax on the gross amount of U.S. source income unless an applicable tax treaty specifies a lower rate. At the end of the year, the withholding tax will be adjusted based on the actual tax rate.
This is an important detail as it indicates that passive income is taxed differently from effectively connected income. Effectively connected income, or ECI, refers to income from a U.S. trade or business. If you are actively engaged in business in the U.S. and generate income from those activities, that income is considered ECI. This ECI income is generally subject to graduated tax rates for foreign individuals. Foreign corporations are subject to corporate tax rates on their ECI. Please note that a reduced rate may apply to individuals and entities under the applicable tax treaty.
The following activities constitute investment income activity in the U.S, as per the IRS.: