This article should serve as a reminder to foreign students, scholars and other foreign government employees in the USA.
Based on the F, J, Q or M visa categories, the above taxpayers are considered non- resident aliens even if they meet substantial presence test and would otherwise be considered US tax residents.
Internal Revenue Code specifically exempts US source capital gain income generated by the non-resident aliens. I am being often asked a question whether the capital gains are taxable for foreign students, scholars and other NRAs who are in “exempt” categories for the US residency purposes.
The tax law is very clear on this. A flat 30% tax applies on US source capital gain for the NRAs who are substantially present in US for more than 183 days. This 183-day rule bears no relation to the 183-day rule under the substantial presence test of IRC section 7701(b)(3).
For example, a foreign diplomat, consular officer, or other nonresident alien employee of a foreign government, or nonresident alien employee of an international organization, who is visiting the United States in A or G nonimmigrant status for a period longer than 183 days in a calendar year would be subject to the 30 percent tax on his/her U.S. source capital gains – even if he/she continues to be a nonresident alien per the “exempt individual” rules under the substantial presence test. The same rule applies to a foreign student or scholar visiting the United States in F, J, M, or Q nonimmigrant status whose presence in the United States equals or exceeds 183 days in any calendar year.
Tax professional community including CPA Global Tax & Accounting encountered issues in recent times regarding the filing of tax returns and receiving refunds for foreign students, grantees, researchers and similar foreign persons working temporarily in United States. In recent years number of tax returns filed by these taxpayers, whose US source income and tax withholding were reported on 1042-S, were either regularly audited or their refunds were delayed beyond a reasonable period of time. This was creating an undue hardship to such taxpayers. After several representations, IRS was convinced that in most cases there were no fraudulent or questionable claims and provided a reassurance that such refunds are being issued as soon as possible while IRS is working on redesigning the process in the interim.
Here is the news release issued by IRS today (2016-23):
“In response to concerns about the difficulties that some foreign students are experiencing in obtaining refunds of withholding tax reported on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, the IRS just completed a comprehensive review of the program. As a result, the IRS is taking steps to help foreign students at United States colleges and universities and other foreign taxpayers affected by this situation, including adjusting withholding and issuing refunds as appropriate.
No additional action is needed at this time by foreign students and other foreign taxpayers who filed Form 1040NR to request a refund of tax withheld on Form 1042-S.
The IRS review found several areas that are resulting in a significant number of “false positives” in our processing systems – meaning tax returns are being selected for review and validation for issues that present minimal risk of fraudulent or erroneous refunds. While some degree of false positives is inevitable in any compliance program aimed at detecting fraud and protecting revenue, our review indicated we are not achieving the proper balance in this area. Although we initially thought the issues were caused by tax software, upon a closer review these problems were minimal and easily corrected.
Steps the IRS is taking
We are taking several actions to resolve the accounts of those taxpayers who were affected by our existing verification process and to adjust the process going forward to help avoid further issues. We are working as quickly as possible to identify all the taxpayers whose refunds are being held as a result of this process. As they are identified, we will release the hold and issue the refunds (with interest, in instances where we have exceeded the 180 calendar day period for processing these refunds).
Taxpayers whose withholding credits were denied will have their withholding restored, eliminating any balance due and thus stopping the notices of levy. Also, we will not be holding any additional refunds until we have redesigned the process in place for detecting fraudulent or questionable returns and refunds. “)
Foreign investors are generally not subject to US tax on US source capital gain unless it is effectively connected with a US trade or business, or it is realized by an individual who meets certain physical presence requirements.
Gain from the disposition of a U.S. real property interest (USRPI), however, is treated as income effectively connected with a US trade or business under the Foreign Investment in Real Property Tax Act (FIRPTA). This FIRPTA gain is subject to tax and withholding under Code Sec. 897 and Code Sec. 1445.
Stock or a beneficial interest in a US real property holding corporation (USRPHC) is a USRPI.
Under pre-2015 PATH Act law, in the case of any disposition of a USRPI by a foreign person, the transferee was required to deduct and withhold at the rate of 10% of the amount realized on the disposition.
Effective dispositions made on or after February 16, 2016, the new PATH Act increases the FIRPTA withholding rate to 15% on the dispositions of USRPIs and other prescribed transactions.
However, the PATH Act provides for a reduced FIRPTA withholding rate of 10% in the case of a disposition of property which is acquired by the transferee for use by the transferee as a residence, and the amount realized for the property does not exceed $1,000,000, provided the exemption for a residence bought for $300,000 or less does not apply.
As readers may recall, in 2013 IRS launched a new foreign payment practices (FPP) division under the LB&I to specifically oversee withholding agents’ compliance activities. The short article is intended to make the withholding agents and other affected taxpayers/ tax professionals aware that FPP has recently begun proposing significantly higher penalties for late filing of Form 1042-S and 1042 by the withholding agents.
Generally, Form 1042 and 1042-S are required to be filed by the withholding agent with regard to the U.S. source income paid to the non-U.S. persons. The forms must be prepared for the calendar year regardless of the withholding agent’s taxable year. These Forms are due on or before March 15th of the following calendar year. They must also be furnished to the payees by the same date.
Until recently IRS was granting a 30-day extension for filing Form 1042-S when they filed application for extension of time to file on Form 8809 on or before March 15th. Form 1042 can be extended for 6 months by filing Form 7004. IRS has recently proposed regulations that will limit granting the automatic extension with regard to Form 1042-S. IRS proposed regulations state that the extension will be allowed only under extreme circumstances and may be denied if no such circumstances exist. Withholding agents must be bear in mind that IRS may not grant extensions in future and it may be considered not only late but late with intentional disregard.
In case of intentional disregard of filing Form 1042-S, the penalty is greater of $250 per form or 10% of the amount required to be reported. Based on the facts and circumstances, in order to prove intentional disregard, IRS must show that 1) The filer was required to file an information return, 2) filer knew or should have known about the requirement to file, and 3) deliberately chose not to file or ignored the requirement to file (this occurs in case of repeated failures or delays in filings).
Now think about this in another perspective. In Notice 2015-10, IRS stated that it will consider the refund claim only if it can trace the withholding payment as actually paid. In case the IRS cannot trace that, no refund will be issued. This along with the difficulties in applying for 1042-S extensions and increased penalties, withholding agents are well advised going forward to implement a serious process to file the forms in a timely manner.
Last month IRS made changes to the instructions of Form 1042 – Annual Withholding Tax Return for US Source Income of Foreign Persons. As the readers may recall, IRS made some changes to Form 1042 earlier to coincide with the newly issued FATCA regulations under Chapter 3 and 4. The updated instructions were released to assist the withholding agents in preparing the Form. It is pertinent to note that although 2014 and 2015 versions of the Form are identical, IRS has made certain parts of the Form which were optional in 2014, as mandatory for 2015.
Following parts of Form 1042-S are accordingly mandatory for 2015:
- Withholding agent’s Chapter 3 and 4 status code must be entered on page 1 under the withholding agent’s name.
- Reconciliation of U.S. source fixed or determinable annual or periodical (FDAP) income in section 2 of Form 1042 must be completed. This schedule reconciles the total U.S. source FDAP income subject to withholding under Chapter 4 with the total amount of U.S. source FDAP income reported on Forms 1042-S.
- It is required that withholding agents now summarize the reasons why the amounts were not subject to Chapter 4 withholding such as amounts paid with respect to grandfathered obligations, amounts paid that were characterized as excluded nonfinancial payments, etc.).
In Reifler, TC Memo 2015-199TC Memo 2015-199, the Tax Court recently held that a joint return not signed by the wife was not a valid return and, as a result, imposed the failure-to-file penalty. In so doing, it rejected the taxpayer’s arguments that the return was valid either because it substantially complied with the valid return rules or because the wife intended to file a joint return and tacitly consented to the filing of a joint return.
Signatures on a tax return not only verify that a return has indeed been filed by the person indicated on the front page of a Form 1040 but also certify that all the statements in the tax return are made under penalty of perjury and are true, correct, and complete to the best of the taxpayers’ knowledge. (See Page 2 of Form 1040)
Taxpayers are advised to review this case carefully as the mistake can be extremely costly particularly in cases where the foreign reporting Forms such as 8938 and 5471 are part of Form 1040. Late filing of such Forms attracts heavy penalties. Practitioners should also ensure that the e-file authorization forms are signed by both taxpayer and spouse in case of joint tax returns.
Tax authorities worldwide distaste the word “treaty shopping” as such. In recent times, OECD has worked out guidelines for BEPS and most U.S. tax treaties have “Limitation of Benefit” clause that prevents abusive tax planning. However, there may still be some opportunities available to U.S. investors in India; one such avenue is investing via Mauritius Holdco structures.
A lot of foreign investors prefer to route their investment through Mauritius in India. Since the India- Mauritius double tax avoidance agreement offers exemption from capital gains tax to Mauritian residents. It has been the key incentive provided by the Indo-Mauritius tax treaty where by tax on capital gains is exempted for investors from Mauritius. As per the last finance bill almost 42% of the foreign direct investment into India is routed through Mauritius.
The Indian High Court recently upheld that The Tax residency Certificate issued by Mauritius authority would be sufficient in claiming the tax benefit.
In a recent verdict by Indian High Court against the advance ruling made to Serco BPO Private Limited, the court upheld: “Once it is accepted that the certificate has been issued by the Mauritian authorities, the validity thereof cannot be questioned by the Indian authorities.”
The Income Tax authority raised questions on the residency of Blackstone Mauritius and Barclays Mauritius and was of the opinion that selling of shares of SKR BPO was mere a tool of tax avoidance.
Few important takeaways from the court decision:
- The tax resident certificate is sufficient evidence to establish the taxpayer as resident of Mauritius.
- Capital gains routed through investment into India through Mauritius would remain not taxable.
Though 2013 Indian Budget bill raised the same issue that mere residency certificate though necessary but may not be sufficient to claim benefits of the India – Mauritius Income tax treaty. The Income tax authority might have wider discretion to determine whether a foreign investor had used treaty benefits for the only reason of tax avoidance.
Recent High Court verdict is welcome news for foreign inbound structures. Accordingly, once the Tax Residency Certificate is received from Mauritian authority, the treaty should not be questioned to.