Foreign partners in a U.S. trading partnership can be tax free

By Robert A. Green CPA

Non-resident alien traders often ask us these two tax questions.

• “If I open an individual brokerage account in the U.S. to trade securities, futures and forex, will I be liable for U.S. taxes on my trading gains?”

• “If I become a partner in a U.S. proprietary trading firm filing a partnership tax return, do I owe U.S. taxes on my Schedule K-1 income?”

The answer to the first question is no. Trading gains are considered portfolio income which is not effectively-connected income (ECI) in the U.S. Generally, non-resident aliens are liable for U.S. tax on income from business and real property in the U.S. There is tax withholding on dividend payments and sales of master limited partnerships (MLPs). There is no withholding in connection with futures or forex trading.

The answer to the second question is more complex. Typically, foreign partners in U.S. partnerships generally are considered to have U.S. ECI on their Schedule K-1 income. But, if the partnership is a trading company - in financial markets, not goods - the income is portfolio income and the partner's share of that income is also considered portfolio income. Typically, U.S. partnerships withhold taxes on foreign partners, but that is not required if the foreign partner only has portfolio income not subject to U.S. tax. It gets more complicated with dividends in the partnership, since there was no withholding of dividends tax for the share owned by the foreign partner.

If the partnership is doing just forex trading (or other types of trading in stock, securities or futures), then it is probable that a foreign partner will not be subject to US tax based on the following:

Generally, under Section 875(1), if a partnership is engaged in a trade or business in the U.S. (“ETB”), a nonresident alien partner of the partnership is automatically ETB. However, Section 864(b)(2)(A)(ii)&(B)(ii), provides an exception to ETB if a nonresident alien trades for his own account—even if through a principal office located in the US. It seems that this exception overrides the general rule of Section 875(1); after all, a deemed presence under 875(1) should be no worse than an actual presence in a principal office.

See FSA 199909004: Section 1.864-2(c)(2)(iii) provides rules for determining whether the taxpayer's principal office is in the United States. . . . However, we note that the Taxpayer Relief Act of 1997, P.L. 105-34, section 1162(a), removed the requirement that the partnership have its principal office outside the United States. Therefore, for taxable years beginning after December 31, 1997, even if it was determined that USP [US partnership, with its principal office in the US] was a trader rather than investor in stocks and securities, FC [foreign corp, which was a partner in USP] nevertheless would not be subject to tax on its distributive share of USP's capital gains due to the section 864(b)(2)(A)(ii) safe harbor. After December 31, 1997, FC would fail the trading safe harbor in section 864(b)(2)(A)(ii) only if either FC or USP was also a dealer in stocks or securities.

The FSA is presumably basing itself on this language in Treas. Reg. 1.864-2(c)(2)(ii) (which was not yet amended to reflect the repeal of the principal office requirement, otherwise known as the Ten Commandments, in 1997):

Partnerships. A nonresident alien individual, foreign partnership, foreign estate, foreign trust, or foreign corporation

or solely because an employee of such partnership, or a broker, commission agent, custodian, or other agent, pursuant to discretionary authority granted by such partnership, effects transactions in the United States in stocks or securities for the account of such partnership. This subdivision shall not apply, however, to any member of (a) a partnership which is a dealer in stocks or securities or (b) a partnership (other than a partnership in which, at any time during the last half of its taxable year, more than 50 percent of either the capital interest or the profits interest is owned, directly or indirectly, by five or fewer partners who are individuals) the principal business of which is trading in stocks or securities for its own account, if the principal office of such partnership is in the United States at any time during the taxable year.

Presumably, after the regulation is amended, part (b) of the last quoted sentence will be removed.

Also, PLR 8850041 (not reliable for precedent) says that Section 864(b)(2)(B) "commodities" include forex.

Our other tax attorney Roger Lorence says, “It's my understanding that a non-US Person that is a member of a prop trading firm is subject to the exemption in 864 for trading for your own account provided that the prop trading firm is not a dealer. In some cases a prop trading firm is a member of a commodities exchange or a securities exchange, but this is as a customer member. The prop trader receives better fees and commissions, but is not actually making a market or otherwise trading. So long as the prop trading firm is a customer member, then no ETB issue. However, there can be state issues where the state diverges from the federal rules of 864.”