FDAP income

When foreign investors receive certain types of income from U.S. sources, the U.S. government requires them to pay taxes on that income. FDAP income refers to investment income that is "fixed, determinable, annual, or periodical"—meaning it's predictable and recurring rather than one-time or speculative.

The U.S. government automatically collects a 30% tax on this income through a process called withholding taxesTaxes deducted from payments at the source, particularly relevant for foreign investors or entities receiving U.S.-sourced income.. This means the tax is deducted before the foreign investor even receives their payment. Common examples include dividends from stocks of U.S. companies, interest from U.S. corporate bonds, and rental income from U.S. properties.

However, this withholding tax does not apply to capital gainsProfits realized from the sale of capital assets, typically taxed at preferential rates compared to ordinary income.—the profits made when foreign investors sell U.S. investments for more than they paid for them. Whether these gains are short-term or long-term doesn't matter; foreign investors can generally avoid U.S. taxes on capital gains from their offshore funds.

FDAP income covers a wide range of payments that foreign investors might receive from U.S. sources. The most common types include:

Investment income: This includes dividends from U.S. stocks, interest payments from bonds, and similar returns on investments. It also covers more complex instruments like original-issue-discountThe difference between a bond's face value and its lower original issue price, treated as interest income for tax purposes. bonds and dividend-equivalent payments from certain financial products.

Other income streams: Beyond investment returns, FDAP income includes rents from U.S. properties, royalty incomePayments received for the use of intellectual property, patents, copyrights, or natural resources. from intellectual property, salaries and wages earned in the U.S., insurance premiums, annuity payments, and various forms of compensation.

This broad definition ensures that most types of passive income—money earned without active business operations—fall under the withholding tax system when paid to foreign entities, including offshore hedge funds.

Foreign entities that don't actively conduct business in the United States face a straightforward tax situation: they pay a flat 30% tax on the gross amount of qualifying U.S. income they receive. This applies whether the foreign fund receives the income directly or through partnership arrangements.

The U.S. tax system makes this process automatic by requiring the company or organization making the payment—called a withholding-agentA U.S. person required to withhold tax from payments made to foreign persons and remit that tax to the IRS.—to deduct the tax before sending money to the foreign recipient. For example, if a foreign hedge fund owns shares in a U.S. company, that company must withhold 30% of any dividend payment before sending the remainder to the fund.

This withholding system ensures tax collection even if the foreign recipient never files a U.S. tax return or has no other connection to the U.S. tax system.

While most interest income from U.S. sources faces the 30% withholding tax, some important exceptions exist. Interest from federal government bonds, U.S. corporate bonds, and certain other sources typically requires withholding, but there are notable exemptions.

Bank deposits: When offshore funds deposit money in U.S. banks, the interest they earn on those deposits is generally exempt from withholding tax. This exemption applies to standard bank accounts, certificates of deposit, time deposits, and money market accounts. Interestingly, this exemption even extends to deposits made with overseas branches of U.S. banks.

This exception recognizes that basic banking relationships shouldn't discourage foreign investment in U.S. financial institutions.

One of the most significant exceptions to FDAP withholding is the portfolio-interest-exemptionA tax exemption that allows foreign investors to receive interest from certain U.S. debt securities without withholding tax., which allows many foreign investors to receive interest payments from U.S. sources without any withholding tax.

Qualifying requirements: To qualify for this exemption, several conditions must be met. First, the debt obligation must be properly registered, meaning all owners are recorded in official books and any transfers of ownership are documented. Second, the debt must have been issued after July 18, 1984. Third, the person receiving the interest cannot have any special relationship to the company that issued the debt—they must be a regular, independent investor.

Certification process: Foreign investors must also certify their non-U.S. status using appropriate IRS forms. This paperwork requirement helps the IRS distinguish between U.S. and foreign recipients.

Practical impact: This exemption covers most U.S. corporate bonds and treasury-securitiesDebt obligations issued by the U.S. Department of the Treasury, including bills, notes, and bonds backed by the full faith and credit of the U.S. government. issued after 1984, making it much easier for foreign investors to earn interest from U.S. debt investments. However, some complex or contingent-debt-instrumentsDebt securities whose payments depend on specified conditions or contingencies, often subject to different tax treatment than traditional bonds. may not qualify for this favorable treatment.

The Foreign Account Tax Compliance Act (FATCA) FATCA The Foreign Account Tax Compliance Act (FATCA) is U.S. legislation requiring foreign financial institutions, including offshore hedge funds, to report information about financial accounts held by U.S. taxpayers or foreign entities in which U.S. taxpayers hold substantial ownership, with non-compliance resulting in significant withholding penalties. works alongside the FDAP system to ensure proper tax collection from foreign entities. Under FATCA, FDAP payments represent the primary category of withholdable paymentsUnder FATCA, certain U.S. source payments subject to 30% withholding tax if made to non-compliant foreign financial institutions. that trigger additional reporting and compliance obligations.

Expanded scope: FATCA broadens the withholding system beyond traditional FDAP income. It includes not only the typical interest, dividends, and other periodic payments, but also gross-proceedsThe total amount received from the sale or disposition of property before deducting any costs, expenses, or taxes. from sales of certain types of property that could generate U.S.-source income.

Foreign financial institution obligations: FATCA requires foreign financial institutions to report information about their U.S. account holders and comply with withholding requirements on these payments. However, recent Treasury regulations indicate that withholding on gross proceeds from sales will not be required, simplifying compliance for many institutions.

The FDAP withholding system places the responsibility for tax collection on U.S. entities rather than foreign recipients. Companies that issue securities, banks that pay interest, and other organizations that make payments to foreign persons become "withholding agents" under U.S. tax law.

Automatic collection: These withholding agents must identify when they're making payments to foreign persons and automatically deduct the appropriate tax before sending the payment. This system ensures tax collection regardless of whether the foreign recipient ever files a U.S. tax return or has any other interaction with the U.S. tax system.

Systematic approach: This structure represents a fundamental component of how the U.S. taxes foreign investment in domestic assets. Rather than relying on foreign entities to voluntarily comply with U.S. tax obligations, the system captures taxes at the source of the income, making collection more reliable and efficient.