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Taxation of foreign nationals.

The rules governing the U.S. taxation of income earned by foreign nationals are often overlooked in a traditional tax practice. They are seen as an area of tax law that has fairly limited applicability and, consequently, they are the kind of thing a tax advisor will research only when the need arises.

However, with the expansion of foreign investment in the United States, the increasing numbers of foreign students and educators taking advantage of our universities and colleges, and a continuing stream of immigrants coming to America with the hope of eventually becoming citizens, the tax practitioner can expect to be called upon much more frequently to render advice regarding these issues. This article is designed to give a quick primer on the basic scheme under which the income of foreign nationals is taxed.

Classification: RA vs. NRA

The tax practitioner must first determine whether the foreign national is classified for tax purposes as a "resident alien" (RA) or as a "non-resident alien" (NRA). This classification is critical since it determines what income is subject to tax, what deductions will be allowed, which rates will be applied and how the particular individual will be treated under other sections of the Internal Revenue Code.

The definition of an NRA is essentially a negative one--i.e., an NRA is an individual who is not a U.S. citizen or a resident alien |Sec. 7701(b)(1)(B)~. The definition of an RA has recently been clarified by final regulations |Reg. Sec. 301.7701(b)-2(c)~ and applies two tests. If either test is satisfied, the taxpayer is considered to be an RA.

The first test--the so-called "green card" test--is satisfied if the taxpayer is "a lawful permanent resident of the U.S. at any time during the calendar year" |Sec. 7701(b)(A)(i)~. This is evidenced by the issuance of an alien registration card (i.e., a "green card") by the Immigration and Naturalization Service. Failing the green card test, an individual will still be classified as an RA if he or she has had a "substantial presence" by being physically present in the U.S. at least 31 days during current year and 183 days during the last three-year period (current year plus prior two years).

In adding up the "days present" for the 183-day requirement, not all days are counted equally. Instead, all the days of the current year are given full weight while days of the last year count 1/3 and days of two years ago count only 1/6 |Sec. 7701(b)(3)(A)~. For example, if Sebastian, a British citizen, was in the U.S. for 180 days in 1990, 99 days in 1991 and 120 days in 1992, he would be considered an RA for the 1992 tax year. This is because he was physically present in the U.S. for more than 31 days in 1992 and he also was present for at least 183 days during the last three years--in Sebastian's case, exactly 183 days |(1 x 120 days in 1992) + (1/3 x 99 days in 1991) + (1/6 x 180 days in 1990)~. Had Sebastian's stay in the U.S. been reversed during 1991 and 1992, he would be treated as an NRA for tax purposes since he would only have been present for 169 days under the three-year counting rule |(1 x 99) + (1/3 x 120) + (1/6 x 180)~.

There are two major exceptions to the "substantial presence" test. One is for "exempt individuals." An exempt individual is a foreign national whose stay in the U.S is only temporary while he or she pursues a particular goal (e.g., employee or diplomat of a foreign government, teacher, student, athlete) |Sec. 7701(b)(5)~. Exempt individuals will be treated as NRAs regardless of the number of days they are actually physically present in the U.S.

Similarly, even though a foreign national would otherwise satisfy the substantial presence test, if he can show that he has a "tax home" outside the U.S. and was present in the U.S. for less than 183 days during the current year, then he will continue to be treated as an NRA due to this "closer connection to another country" |Sec. 7701(b)(3)(B)~.

For any given year, a foreign national could be classified as an NRA, an RA or as a dual status taxpayer. This last classification would occur when there has been a change in the residence of the taxpayer during the year. This happens most frequently during the individual's year of arrival or departure, since an alien is only treated as a resident after he or she is actually physically present in the U.S. and ceases to be a resident when he or she leaves the country. The result of this dual status is that the foreign national will be taxed during part of the year as an NRA and part of the year as an RA |Sec. 7701(b)(2)~.

An NRA can also elect to be treated as an RA for a particular tax year if his or her spouse is a U.S. citizen or RA as of the end of that year |Sec. 6013(g)~. The election, while revocable for future tax years (at which time it is no longer available |Sec. 6013(g)(6)~), should only be made after careful consideration of all its tax consequences. For example, as will be discussed later, unlike an NRA, an RA will be able to take personal and dependency exemptions for his or her spouse and children and will be able to file a joint return, thereby gaining the advantage of the income averaging that results from that filing status. However, this election would also lead to the inclusion of both spouses' worldwide income. By contrast, NRAs pay tax only on their U.S. income. Also, if the election is made, neither spouse can claim any benefits that might otherwise be available under a U.S. tax treaty. Whether these factors outweigh the benefits of the RA election can only be decided on a case-by-case basis.

Exempt Individuals

Within the broad category of NRAs are special classes of individuals who are treated as being exempt from U.S. taxation, including foreign teachers, students, trainees and cultural and educational exchange program participants |Sec. 7701(b)(5)~. In many cases, special treaty provisions even provide for the non-taxability of personal service income. For example, under Article XII of the treaty the U.S. has with Pakistan, a visiting Pakistani professor at an American university can receive his salary tax-free for two years; a professor from the Peoples Republic of China enjoys a three-year exclusion under PRC Treaty Article 19. (See Exhibit 1 for a partial listing of countries with which the U.S. has a treaty providing certain exemptions from taxation.)
Exhibit 1:
Tax Treaties (Selected Provisions)--Exemptions from U.S.
Taxation
 For Students For Teachers &
 Researchers
Austria ______ Article XII
Belgium Article 21 Article 20
Peoples Republic of China Article 20 Article 19
Cyprus Article 21 ______
Denmark ______ Article XIV
Egypt Article 23 Article 22
Germany ______ Article XII
Finland Article 21 Article 20
France Article 18 Article 17
Greece ______ Article XII
Hungary ______ Article 17
Iceland Article 22 Article 21
Ireland ______ Article XVIII
Italy ______ Article 20
Jamaica ______ Article 22
Japan Article 20 Article 19
Korea Article 21 Article 20
Luxembourg ______ Article XIII
Morocco Article 18 ______
Netherlands Article XVIII Article XVII
Norway Article 16 Article 15
Pakistan Article XIII Article XII
Philippines Article 22 Article 21
Poland Article 18 Article 17
Romania Article 20 Article 19
Sweden ______ Article XII
Switzerland ______ Article XII
Trinidad and Tobago Article 19 Article 18
USSR (former) ______ Article VI
United Kingdom ______ Article 20


Taxation Schemes: RA vs. NRA

Once the foreign national's tax status is determined, a basic scheme of taxation is imposed. If the individual is classified as an RA, he or she will be taxed just the same as a U.S. citizen would be, i.e., on the income earned worldwide, at the graduated rates set by the Internal Revenue Code.

NRAs are taxed under more complex rules that turn on both the type and the source of the particular items of income (see Exhibit 2). Generally speaking, there is no U.S. tax imposed on items of income from foreign (non-U.S.) sources. The sourcing rules are quite intricate. For example, income from a trade or business (other than from personal services) is sourced by applying an asset-use and/or a business activities test |Sec. 864(c)(2)~. On the other hand, compensation for personal services is generally sourced according to where those services are performed |Sec. 861(a)(3)~. Finally, investment income is usually sourced according to the location of the payor |Sec. 861(a)(1) & (2)~. (It should be noted that these are only general rules and have many exceptions and complications. However, a more detailed explanation of their application is beyond the scope of this article.)

Even after a determination has been made that particular items are U.S.-source income, further analysis is necessary because several different rules apply depending on the type of income involved. Income effectively connected with a trade or business conducted in the U.S. is taxed on a net basis at the same graduated tax rates that would normally apply to other U.S. taxpayers |Sec. 871(b); Sec. 882(a)~. This is important to note since ordinary business deductions are generally not allowed to an NRA. Such deductions are only available for his or her "effectively connected" income |Sec. 873(a)~. Fortunately, compensation for personal services performed within the U.S. are generally treated as effectively connected income, so the NRA will be permitted to take deductions associated with those wages or salaries.

Complicating already complex matters, even foreign source income will be taxed as effectively connected if the NRA has a fixed place of business within the U.S. to which the income is attributed and that is a material income-producing factor in producing that income |Sec. 864(c)(5)~. This is one of only two situations in which foreign source income of the NRA will be subject to U.S. income taxation. (The other is dividend income from a foreign corporation that derives at least 25% of its gross income from a U.S. trade or business |Sec. 861(a)(2)(B)~.

A second type of U.S. source income is taxed at a flat rate of 30%. This so-called "FDAP" ("fixed or determinable annual or periodic") income includes interest, dividends, rent, salaries and wages and most other forms of compensation that are not effectively connected with a U.S. trade or business. FDAP income is taxable on its gross amount, with the tax being extracted by withholding at its source |Sec. 871(a); Sec. 881~. Since the flat rate of 30% may be reduced by a treaty between the U.S. and the country in which he or she is a resident, an NRA is well advised to find out whether such a treaty exists. (Note: Citizenship in the treaty country is generally not required, only residence; however, some treaties do require that the NRA be a citizen, national or subject of the treaty country.)

Important exceptions to the tax on FDAP income exist for portfolio interest (i.e., interest on obligations targeted and sold to non-U.S. persons), interest on bank deposits not effectively connected with a U.S. trade or business and certain dividends paid by domestic corporations (i.e., those with 80% or more of their income from foreign operations) |Sec. 871(h) & (i); Sec. 881 (c) & (d)~. As a result, many of the most common forms of an NRA's investment income will not be subject to U.S. income taxation at all.

Whether a gain on the sale or exchange of property is taxed depends on the type of property involved. Sales of real property are subject to the same rules that apply to U.S. taxpayers |Sec. 897: the "FIRPTA" tax~. However, since the tax is imposed only on the excess of aggregate gains over aggregate losses, a netting of real estate losses against gains that occurred during the taxable year in question is permitted.

The greatest tax break an NRA receives is that there is generally no tax on gains from sales of personal property (as opposed to gains from sales of real estate). Consequently, most sales or exchanges not effectively connected with U.S. trade or business and that would normally give rise to capital gains are non-taxable to the NRA. However, if the NRA has been in the U.S. for 183 days or more during the tax year in question, then his or her capital gains are netted against his or her capital losses, with the resulting net gain being taxed at the flat 30% rate |Sec. 871(a)(2)~.

In any case, the NRA will not be able to deduct a net capital loss, nor will he or she be able to use a capital loss carry-over to offset future net capital gains. In addition, an NRA will not be able to offset non-effectively connected losses against effectively connected gains |Sec. 871(a)(2)~.

Deductions

Not only are the inclusions in gross income for RAs significantly different from those of NRAs, but the deductions and credits allowed are also quite different. Following the pattern for U.S. citizen taxpayers, RAs not only get a personal exemption for themselves but also for their spouses. This is true even if no joint return is filed as long as the spouse has no gross income and is not the dependent of another taxpayer; and this remains the case even if the spouse is an NRA |Sec. 151(a) & (b)~.

An NRA, on the other hand, only gets one personal exemption. However, if the NRA is a resident of Canada or Mexico, he or she may also claim a personal exemption for his or her spouse |Sec. 873(b)(3)~. In addition, residents of Japan and the Republic of Korea may also claim an exemption for his or her spouse if that spouse lived with the NRA in the U.S. at some time during the year. This exemption is prorated based on the ratio of the NRA's gross income from effectively connected U.S. trade or business to his or her total income from all sources |IRS Publication No. 519, p. 12 (1992)~.

Insofar as dependency exemptions are concerned, an RA can qualify for this deduction for anyone who is a U.S. citizen or resident of U.S., Mexico or Canada for some part of the year. An NRA will not be able to get a dependency exemption unless he or she is a Japanese or Korean resident, in which case the same limitations as those placed on the personal exemption apply.

One of the greatest disparities in the treatment of RAs vs. NRAs is the fact that NRAs do not have the standard deduction available to them. If they don't or can't itemize their deductions, NRAs lose out altogether.

While RAs have available to them the full range of itemized deductions and credits that U.S. citizens have, NRAs are much more limited. Only deductions for charitable contributions and casualty and theft losses on property located within the U.S. are available without a showing that the deductions are effectively connected to a U.S. trade or business |Sec. 873(b)(1) & (2)~.

Travel and moving expenses, even if not effectively connected, may also be deducted by an NRA if he or she shows that such expenses were incurred while temporarily in the U.S. performing personal services. For these purposes, an assignment in the U.S. is temporary if it is not expected to last more than one year; it is not temporary if it is expected to last more than two years; and it is rebuttably presumed to not be temporary if it is between one and two years |Rev. Rul. 83-82, 1983-1 C.B. 45~.

As was previously discussed, while an RA can take ordinary and necessary business deductions, an NRA is limited to deductions that are effectively connected with a U.S. trade or business |Sec. 873(a)~. Furthermore, an NRA will only be entitled to receive the benefit of such credits and deductions if he or she has filed a return in a timely manner (see Reg. Secs. 1.874-1(a) & 1.882-4(a)(2), discussed below).

A summary of deductions available to NRAs appears in Exhibit 2.

Like an NRA, an alien who has a dual status for a particular tax year must itemize his or her deductions since no standard deduction is available to him or her. Any exemptions for spouse or children are limited to the amount of income received during that part of the year that the taxpayer was a resident. Otherwise, the dual status taxpayer only has available one personal exemption for himself or herself.

Filing Status

RAs have the full range of filing statuses available to them, including married filing jointly. In contrast, married NRAs generally cannot file a joint return |Sec. 6013(a)(1)~. Furthermore, since they are in fact married, they cannot file as single. Instead, they must use the tax-disadvantageous status of married, filing separately. (An anomoly exists for married NRAs who are residents of Mexico, Canada, Japan or Korea. These taxpayers can use the single filing status as long as their spouses do not reside with them at any time during the tax year.)

Similarly unavailable to an NRA is the head of household status |Sec. 2(b)(3)(A)~. A married NRA who would otherwise qualify as a head of household will be forced into filing as married, filing separately. However, the head of household status may still be an option for the NRA's spouse who is a U.S. citizen or RA, provided, of course, that this spouse satisfies the other requirements for being a head of household.

Dual status returns follow the same rules that apply to the NRA. Accordingly, the dual status taxpayer must file using either a single (if unmarried) or married filing separately status, with no joint returns permitted.

Filing Requirements and Deadlines

RAs follow the same rules for the filing of tax returns as U.S. citizens. This means they file forms in the regular 1040 series (1040, 1040A or 1040EZ), paying any tax due by April 15th (for calendar-year taxpayers).

NRAs file a Form 1040NR. It bears noting that this is the only form on which the NRA can claim tax treaty benefits. A dual status taxpayer generally files both Form 1040 and Form 1040NR, attaching one to the other and marking "Dual-Status Return" along the top. The filing deadline for NRAs is less clear since it depends on whether the NRA had wages that were subject to withholding. If so, the tax return is due on April 15th (i.e., 15th day of the fourth month following the close of the tax year). On the other hand, if an NRA has no such wages or compensation subject to withholding but has other income subject to U.S. tax, the return is due on June 15th (i.e., 15th day of the sixth month following the close of the tax year) |Sec. 6072(c)~.

A further complication in the timeliness of filing a return is caused by limitations on the deductions and credits an NRA can take. As was noted previously, such deductions are generally only allowed if they are related to effectively connected income; furthermore, they are only allowed if a true and accurate tax return has been filed |Sec. 874(a)~. Recently finalized Treasury regulations have added the requirement that such a filing must be made on a timely basis.

It may come as some surprise that "timely filed" in this regard is not the same as being filed by the due date. Instead, if a tax return had been filed for the year immediately preceding the current year or if the current year is the first tax year in which the individual is required to a file a return, the NRA must file within 16 months of the due date to be considered timely filed. Alternatively, if no return had been filed for the previous year, a return will be considered timely filed as long as it is filed before the earlier of 16 months of the due date or when a notice is mailed by the IRS to the NRA that no return has to be filed and no deductions or credits can be claimed |Reg. Sec. 1.874-1~. (Foreign corporations are subject to a similar rule, with 18 months from the due date substituted for the 16-month limitation that applies to individuals |Reg. Sec. 1.882-4~.)

These timeliness requirements create a dilemma for the NRA who may believe that he or she is not required to file a tax return at all. If at some later date, the IRS determines that the NRA was wrong and that he or she had taxable income and should have filed a return, the foreign taxpayer would now be subject to the U.S. tax without the benefit of any deductions or credits that he or she could otherwise have claimed on a timely-filed return.

Consequently, it is probably the safest course for an NRA to file a protective return as provided in the regulations (|Reg. Sec. 1.871-1(b)(4); for corporations, Reg. Sec. 1.882-4(a)(3)(iv)~). No items of income, deduction or credit need be reported on such a return; the sole purpose of filing the return is to protect the right to claim deductions should the NRA be mistaken in believing that he or she had no effectively connected income.

Finally, an NRA may have to file a return even though he or she had no taxable income during the year and, therefore, has no tax is due. Under Section 6114, an NRA must disclose any treaty-based position that overrules or modifies U.S. tax law. Failure to do so subjects the NRA to a $1,000-per-item fine (for corporations, the fine is up to $10,000 per item) |Sec. 6712~. A list of the treaty positions specifically singled out as requiring disclosure as well as common treaty exemptions appears in Exhibit 4.

Sailing Permits

The last requirement U.S. tax authorities impose on foreign nationals is that before leaving the United States, they must pay in full all U.S. taxes due. To evidence this fact, a so-called "sailing or departure permit" (certificate of compliance with U.S. tax laws) is issued after the RA or NRA files Form 1040C (a final year return) or Form 2063 (a statement that the foreign national had no taxable U.S. income in the year of departure). With some exceptions |Temp. Reg. Sec. 1.6851-2T~, a sailing permit is theoretically required of all aliens, RA and NRA alike |Sec. 6851(d)~. In practice, this is not enforced; in fact, there is no mechanism in place to implement or oversee compliance with this requirement.

Conclusion

It is difficult enough for the foreign national to understand the subtleties of American culture, let alone the ins and outs of American tax law. To confound matters, U.S. income taxation of foreign nationals requires an understanding of many complex rules that may have escaped notice in everyday tax practice. This article has provided a basic overview of this area so the tax advisor can better assist in cutting through some of the confusion without causing an international incident.

Exhibit 2: Basic Scheme of Taxation of Foreign Nationals:
Resident Alien (RA) vs. Non-Resident Alien (NRA)
* Taxed on Worldwide Income * Taxed on U.S Source Income


@ Graduated Rates @ Varying Rates Depending on Type of Income (5 General Types) Taxation of NRAs

1) "Income Effectively Connected with U.S. Trade or Business"

--Net amount taxed at graduated rates

|Secs. 871(b) & 882(a)~

2) "FDAP Income" from U.S. sources

--Gross amount taxed at flat 30% (or lower) treaty rate

|Secs. 871(a) & 881~

3) Interest income

--Exempt from tax

|Sec. 871(h) & (i); 881(c) & (d)~

4) Gains from sales of real estate

--Net gains taxed under same rules as U.S. citizens

|FIRPTA tax: Sec. 897~

5) Gains from sales of personal property

--Exempt from tax unless NRA was present in U.S. |is less

than~ 183 days during the tax year

Exhibit 3: Limitations on Deductions/Losses

Non-Resident Alien not allowed:

* Standard Deduction

* Itemized Deduction for

- Medical Expenses

- Property Tax

- Interest Expense

- State & Local Income Taxes

unless these expenses are effectively connected with a U.S. trade or business

* Dependency Exemption (unless a resident of Canada, Mexico, Japan, Republic of Korea)

* Capital loss carry-over

Non-Resident Aliens are allowed deductions for:

* Charitable Contributions

* Casulty & Theft Losses

* Moving Expenses

* Travel Expenses

* Reasonable and Necessary Expenses, but only if effectively connected to U.S. trade or business

Exhibit 4 Common Types of Treaty-Based Positions(*)

Income earned in U.S. exempt from U.S. tax for:

* Visitors on a short stay--generally no more than 183 days, but some treaties have 180- or 90-day limits; frequently limited to $3,000 maximum exemption

* Teachers and professors from treaty country--usually two- but sometimes three-year exemption

* Employees of foreign governments--often must be national or subject of the employing foreign country

* Students, apprendices, trainees--exemption for scholarships and other payments received from abroad; also may include exemption of limited amount of compensation for services rendered

* Capital gains--exempt under certain conditions

Treaty-Based Positions Requiring Specific Disclosure Under Section 6114 |Reg. Sec. 301.6114-1(b)(5)~

* A non-discrimination provision that prevents the application of an otherwise applicable IRC provision

* A reduction or modification in tax on gain or loss from disposition of U.S. real property (the FIRPTA tax)

* An exemption or reduction of the tax of a foreign corporation from the branch profits tax or tax on excess interest

* A reduction or exemption of the tax due on U.S. source interest or dividends paid by a foreign corporation or on U.S. source FDAP income

* A provision that "effectively connected" income is not attributable to a permanent establishment in the U.S.

* A change in the source of an item of income or a deduction

* A credit for a specific foreign tax for which a foreign tax credit would not otherwise be allowed under the IRC

* For a complete listing of tax treaties currently in effect, see IRS Publication No. 901: U.S. Tax Treaties (Revised Nov. 1991).

W. Richard Sherman, JD, LLM, CPA, is assistant professor of accounting at Saint Joseph's University in Philadelphia, PA. He received his BA and JD from the University of Pennsylvania, his MBA with concentration in accounting from Temple University and his LLM from Villanova University. Professor Sherman has published in numerous professional and academic journals.

Thomas M. Brinker, Jr., CPA, is a tax partner at Brinker, Simpson & Nicastro, a suburban Philadelphia CPA firm. He is a graduate of Saint Joseph's University and holds a Master of Science (taxation) degree from Widener University and a JD from Columbia Pacific University. Prior to co-founding Brinker, Simpson & Nicastro, he was a member of both the audit and tax departments of Coopers & Lybrand and ArthurYoung & Company.
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Author:Sherman, W. Richard; Brinker, Thomas M.
Publication:The National Public Accountant
Date:Jul 1, 1993
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