THE GENERAL RULE

Some history may be necessary for the understanding of rules for taxing nonresidents on investment income. When the income tax was implemented in the United States, nonresidents were treated the same way as residents but were taxed only on their U.S.-source income; the tax rate and ability to take deductions were the same. Over time, the Internal Revenue Service discovered that it was not really possible to audit foreigners' tax returns or to establish what kind of deductions they should or should not take.

By the mid-1930s, the present system was developed, under which nonresident income is divided into two categories – passive income and active income. Passive income is subject to a flat 30 percent tax on gross income, without any deductions, whereas active income is subject to graduated rates, which vary depending on whether the taxpayer is an individual or a corporation. Deductions are allowed on active income because the IRS can audit businesses earning active income in the United States to verify the validity of deductions.

The 30 percent gross tax rate on passive income has remained more or less unchanged since the 1940s. By contrast, the net rates (which are the same rates that apply to Americans) have been changing every time there is a new tax law and in almost every election. For example, tax rates were raised in 1993 after Clinton's election and then lowered in 2001 after Bush's election.