Source: http://www.baln.org/taxation-of-foreign-students-and-scholars.html
Timestamp: 2018-09-21 20:08:00
Document Index: 480814959

Matched Legal Cases: ['§ 214', '§ 3121', '§ 1001', 'Art. 20', 'Art. 19', 'Art. 19', 'Art. 20']

Taxation Of Foreign Students And Scholars - Bay Area Lawyers Network
Taxation Of Foreign Students And Scholars
Tax Avoidance Strategies For The Immigration Practitioner
By James A. Bach, Esq., 1991
Congress has provided for favorable tax treatment of foreign students and scholars to provide additional incentive for them to pursue their studies, training, research and teaching in the United States. Those advising foreign students and scholars should be aware of the opportunities for taking advantage of this favorable tax treatment and the pitfalls that may lead to its loss.
EXEMPTION FROM FICA WITHHOLDING
Many foreign students and scholars in F-1 and J-1 status choose to remain and work in the United States upon completion of their studies or exchange program. Many will later apply for H-1B or permanent residence status. Depending on the timing of those applications, F-1 and J-1 nonimmigrants and their employers can realize significant savings from FICA (social security and medicare) withholding.
Students, scholars and other exchange visitors in F-1 or J-1 status and their employers are exempt from FICA withholding. In most cases, immigration practitioners should maximize the benefit of this exemption by advising their clients to remain in F-1 or J-1 status as long as possible.
The tax savings can be significant. Employees must otherwise pay a FICA tax equal to 7.65 per cent of their salary, up to a maximum of $5,123.30, and their employers must pay a matching amount. An employee with an annual salary of $30,000 thus can save $2,295 by remaining in F-1 or J-1 status for a year. For large corporate employers, the savings can be even more dramatic. For example, a large high technology company that hires fifty engineers in F-1 and J-1 status at annual salaries of $30,000, could save $114,750 (the salaries of three additional engineers!) simply by postponing their change or adjustment of status.
Many employers, especially those who seldom employ F-1 and J-1 nonimmigrants, are unaware of the FICA withholding exemption. Often they are reluctant to reprogram their payroll system to accommodate the exemption for one or few employees. That reluctance will usually disappear, however, when the substantial monetary savings is explained to them.
A nonimmigrant in F-1 or J-1 status is authorized to accept employment upon completion of studies or exchange program only if he or she has been granted “practical training.” Students in F-1 status may be granted post-completion practical training for a period of one year and must complete the practical training within a fourteen month period following completion of studies. Students in J-1 status may be granted post-completion practical training for up to eighteen months. Business, industrial and medical occupation trainees in J-1 status also may obtain up to eighteen months of practical training.
If your client wishes to change from F-1 or J-1 status to H-1B status, the application should request that H-1B status commence upon termination of the practical training period to maximize the FICA exemption. The application for change of status should be submitted sufficiently in advance of the practical training expiration date to give the INS time to adjudicate it. Otherwise there may be a gap in employment authorization that could force the employee to take a vacation until the application is approved, or continue to work and risk employer sanctions and denial of a later application for adjustment of status. Fortunately, you may submit the application for change to H-1B status up to six months in advance, enough time for all regions of the INS to adjudicate it.
With all the other problems attendant upon H-1B petitions under the Immigration Act of 1990, in some cases you may wish to consider skipping H-1B status altogether. Instead, immediately upon commencement of employment, the employee could begin the process of applying for permanent residence status. This approach makes sense only in those jurisdictions where it is reasonable to expect that both labor certification and visa petition approvals can be obtained within the period of practical training. Also, you should also consider whether the employee intends to apply for adjustment of status or for an immigrant visa at a U.S. embassy or consulate abroad, since most likely the practical training willnot cover the time necessary for labor certification approval, visa petition approval and consular processing. Even in the most favorable circumstances, time may still run out, and both attorney and client should fully expect to later submit a timely application for H-1B status.
There does not seem to be a very compelling policy reason for exempting foreign students and scholars from FICA withholding, especially since so many stay in the United States and eventually receive the benefits of the social security and medicare systems. That is especially true considering the extensive sweep of the FICA withholding obligation. For example, retired U.S. government workers who pursue a second career must pay FICA taxes, even though they are precluded from ever receiving social security and medicare benefits. The policy question, however, is for Congress to decide. Immigration lawyers and international student advisors are well-advised to recognize the exemption and help their clients take advantage of it.
EXEMPTION FROM TAX ON FOREIGN-SOURCE INCOME
Many foreign students and scholars come from wealthy families or otherwise have substantial foreign-source income. For those individuals, change to another nonimmigrant status or permanent residence status could have significant tax consequences.
All lawful permanent residents, and most nonimmigrants who are physically present in the United States for 183 days or more in any given year, are U.S. residents for tax purposes and are subject to U.S. tax on their foreign-source income. F-1 and J-1 nonimmigrants, however, are exempt from income tax on their foreign-source income. Spouses and unmarried children under the age of twenty-one (21) who live in the same household are also exempt.
This exemption is limited in time. “Students” (in F-1 or J-1 status) are insulated from the tax consequences of U.S. residence only up to five years, unless they can establish to the satisfaction of the IRS that they do not intend to reside permanently in the United States. “Teachers and trainees” (in J-1 status) are exempt for two of any seven calendar years.
Assuming the tax structure of the foreign country is more favorable than that of the U.S., the F-1 or J-1 nonimmigrant should be advised to accelerate income before changing to another nonimmigrant status or permanent residence status. Some possibilities for accelerating income before becoming a U.S. tax resident include the following:
1. Sell a foreign residence or other appreciated assets to realize a capital gain before changing or adjusting status. However, if the student or scholar intends to purchase a residence in the United States, he or she may wish to sell the foreign residence after change or adjustment of status to take advantage of tax-free rollover of the gain.
2. Secure payment of bonuses or deferred compensation for past services.
3. Elect out of installment reporting on income from installment sales.
4. Recognize income from stock purchased under a restricted stock option plan.
On the other hand, loss recognition and payment of deductible expenses should be deferred until after the change or adjustment of status, to later reduce U.S. taxable income.
The foreign student or scholar also may wish to reduce his or her interest in a foreign entity that would become a “foreign personal holding company” or “controlled foreign corporation” upon acquiring a tax residence in the United States. Substantial interests in certain foreign companies could subject the U.S. tax resident to U.S. federal income tax on a portion of the company’s earnings, even though no dividend is actually paid to the taxpayer. Restructuring the foreign entity could eliminate U.S. taxation on such attributed income.
For those students and scholars who do not have significant foreign income or assets, or who have foreign losses, U.S. tax residence might be advantageous. Normally, a tax nonresident is subject to withholding at a flat rate of 30 per cent on his or her U.S.-source income. However, as a tax resident, the student in practical training status is taxed at graduated rates that may yield a much lower tax. Also, as tax residents, those who have children, pay alimony or who wish to purchase a house can take advantage of a full range of deductions.
Generally, the decision to become a tax resident should take into consideration the possible loss of the FICA withholding exemption, discussed above. That exemption, however, does not depend on whether the student or scholar is a tax resident. A student in practical training status may be a tax resident (e.g., by virtue of remaining in F-1 status for more than five years), but is still exempt from FICA withholding.
FAVORABLE TAX TREATMENT OF U.S.-SOURCE INCOME
Foreign students and scholars are considered to be conducting a “trade or business” in the United States. One important consequence of this classification of their activity is that they may deduct “business expenses” (such as books, personal computers, and travel expenses) from gross income.
Normally, a tax nonresident who conducts a trade or business in the United States is taxed on income that is “effectively connected” with the U.S. trade or business, which may include compensation from a foreign employer. Nonimmigrants in F-1 and J-1 status, however, are specifically exempt from U.S. tax on compensation received from foreign employers. An example provided by the regulations is a French citizen employed in the Paris branch of an U.S. bank: he can continue to receive a salary exempt from U.S. tax while studying monetary theory in the United States.
Like their U.S. counterparts, foreign students are entitled to exclude from their gross income scholarships and fellowships used for tuition, fees, books, supplies and equipment. This exclusion does not include the portions of the scholarships or fellowships used for living and other expenses, and does not include compensation received by researchers and teachers.
That compensation is taxed by U.S. authorities, but at a favorable rate. The normal withholding rate of thirty (30) per cent is reduced to fourteen (14) per cent for the taxable components of scholarships and fellowships received by visiting scholars.
A tax treaty may exempt the scholar’s compensation from U.S. tax altogether. For example, the treaty with the United Kingdom provides that a teacher or researcher at a recognized U.S. educational institution is exempt from income tax on the salary received from the educational institution. This exemption is limited to two years. If the teaching or research assignment exceeds two years the exemption is lost entirely.
The immigration attorney may wish to refer to an international taxation specialist many of the planning opportunities suggested above. However, those advising foreign students and scholars at least should be aware that change or adjustment of status may have significant tax consequences.
INA Section 101(a)(15)(F), 8 U.S.C. Section 1101(a)(15)(F).
INA Section 101(a)(15)(J), 8 U.S.C. Section 1101(a)(15)(J).
Internal Revenue Code Section 3121(b)(19).
As discussed below, in some cases it might be prudent to change to another status to become a tax resident, even though the FICA exemption will be lost. That situation could present a potential conflict of interest for the immigration practitioner who represents both the alien and the employer. See, generally, Bernsen, “Ethical Considerations in Multi-Client Representations: Questions to Ponder” and Hake, “Dual Representation in Immigration Practice: The Simple Solution is the Wrong Solution,” 1991 – 1992 Immigration and Nationality Law Handbook, Vol. 2, pp. 1-43 (American Immigration Lawyers Association). Because of the FICA exemption, it is always in the employer’s interest for the alien to remain in F-1 or J-1 status as long as possible, whereas in some situations the alien may do better by becoming a tax resident.
Internal Revenue Code Sections 3101 & 3102. The social security portion of the tax is 6.2 per cent of salary up to $53,400; the medicare portion is 1.45 per cent of salary up to $125,000. Id.
Internal Revenue Code Section 3111.
8 C.F.R. Sections 274a.12(c)(3)(ii) and 274a.12(b)(11).
8 CFR Section 214.2(f)(10)(ii); published in Federal Register, Vol 56, No. 209, p. 55615, October 29, 1991.
22 C.F.R. Section 514.23(a)(1).
INA Section 245(c), 8 U.S.C. Section 1255(c); 8 C.F.R. Sections 274a.2(b)(1)(vii) & 274a.14a; but see, Salehpour v. INS, 761 F.2d 1442 (9th Cir. 1985).
8 C.F.R. § 214.2(h)(8)(B).
These problems primarily devolve from the new labor condition application requirement, which is burdensome, time-consuming and creates potential liability for the employer. INA Section 212(n); Interim Final Rule, Federal Register, Vol. 56, No. 204, pp. 54720 et seq., 10/22/91. See also, Lichtman, “H-1B Visas Status: Dramatic Changes in the Requirements for Temporary Professional Workers,” Immigration Journal, Vol. XIV, No. 2, p. 30 (April-June, 1991); Paparelli & Patel, “The Immigration Act of 1990: Death Knell for the H-1B?,” 68 Interpreter Releases 29 (January 14, 1991).
Since simultaneous filing of employment-based visa petitions and adjustment of status applications has been abolished. 8 CFR Section 245.2(a)(2)(i), Federal Register, Vol. 56, No. 191, p. 49841, 10/2/91.
An immigrant visa petition will not preclude a later application for H-1B status. INA Section 214(b) & (h), 8 U.S.C Section 1184(b) & (h).
citation; Internal Revenue Code § 3121(b).
Internal Revenue Code Sections 7701(b)(1)(A)(i) & 7701(b)(3). In addition to the bright line provided by these sections, nonimmigrants who are present in the United States for less than 183 days may also be subject to U.S. taxation on their foreign source income. Internal Revenue Code Section 7701(b)(3)(A). For an excellent discussion of this “weak form” of the substantial presence test, see 1 Isenbergh, International Taxation 3.8 at pp. 58 – 65 (Little, Brown & Co., 1990).
Internal Revenue Code Section 7701(b)(5)(C)(i), (D)(i). This exemption is available only to those who are in substantial compliance with INS regulations governing maintenance of F-1 or J-1 status. Id. The Internal Revenue Service does not consider itself bound by the fact that F-1 or J-1 status has not been revoked, and it is free to make its own inquiry into such matters as whether a student has accepted unauthorized employment or has failed to pursue a full course of study. Proposed Reg. Section 301.7701(b)-3(b)(6).
Proposed reg. Section 301.7701(b)-3(b)(8).
Internal Revenue Code Section 7701(b)(5)(E)(ii).
Internal Revenue Code Section 7701(b)(5)(E)(i).
See, Falcone, “A U.S. Tax Planning Checklist For Foreign Nationals on Assignment In the United States,” 39 Tax Executive 153, 156-59, 162-63 (1987).
Note that the tax basis of depreciable property is reduced as though it had been depreciated. Treas.Reg. Section 1.016-4(b).
Internal Revenue Code Section 1034.
Internal Revenue Code Section 453(d).
Internal Revenue Code Section 83(b).
Internal Revenue Code Sections 161 et seq.
Internal Revenue Code Section 552(a).
Internal Revenue Code Section 957(a).
Internal Revenue Code Sections 551(a), 951(a).
Internal Revenue Code Section 1441(a).
Internal Revenue Code Section 1.
See, Internal Revenue Code Section 7701(b)(5)(E)(ii).
See, Internal Revenue Code Section 3121(b)(19).
Internal Revenue Code Section 872(c).
Internal Revenue Code Section 1441(b).
Internal Revenue Code Section 864(c)(2).
Internal Revenue Code Section 872(b)(3). For this purpose, a foreign employer includes the foreign office of an U.S. corporation, domestic partnership, citizen or lawful permanent resident. Internal Revenue Code Section 872(b)(3)(B). The exemption includes payments drawn on a U.S. bank. Treas. Reg. Section 1.872-2(b)(2). By technical amendment, M-1 students were added to Section 871(c) (i.e., are considered to be conducting a trade or business) but not Section 872(b)(3). P.L. 100-647, § 1001(d)(2)(B)(i)-(ii). They are therefore taxed on compensation from foreign employers (at graduated rates rather than the flat rate), but can deduct the expenses associated with their studies or training.
Treas. Reg. Section 1.872-2(b)(2).
Internal Revenue Code Section 117(a).
Treas. Reg. Section 1.1441.2(c)(1).
United States – United Kingdom Income Tax Treaty, Art. 20.
Id. There are similar provisions in the tax treaties with Japan (Art. 19), the Netherlands (Art. XVII), China (Art. 19; [the exemption is three years rather than two]), and the Soviet Union (Art. VI(c) [no time limit on the exemption]). This list is intended to be representative, not exhaustive.
Treasury Technical Explanation of [U.S. -- U.K.] Treaty, Art. 20(1).