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US taxation of foreign nationals

The US tax system for foreign nationals has elements of both residence- and source-based taxation. Just like US citizens, foreign nationals considered US residents are subject to US tax on all of their worldwide income, no matter where they are sourced. US non-residents are subject to US tax only on certain types of US-sourced income. Some foreign nationals are exempt from US tax regardless of residence in the US. This includes certain diplomats, teachers, and trainees. Professional athletes are exempt while temporarily in the US to compete in charity sports events.

Since being taxed as a US resident can subject a foreign national to the full range of US income tax implications, it is important to understand when a foreign national is considered a US resident. Since 1985, a foreign national is subject to tax as a US resident if he or she meets either of two tests:

• The Green Card test. A foreign national meets this test if he has been lawfully admitted to the US for permanent residency. Generally, US residency begins on the day the foreign national is first present in the US as a green card holder.

• The Substantial Presence Test (SPT). A foreign national may be taxed as a resident under the SPT if they were:

— in the US during 183 days in the year at issue;
— in the US at least 31 days in the year at issue and at least 183 days overall, counting each US day during the year at issue, plus 1/3 of all US days during the preceding year; or
— in the US at least 31 days in the year at issue and at least 183 days overall, counting each US day during the year at issue, plus 1/3 of all US days during the preceding year, plus 1/6 of all days during the year before that.

US days during which a foreign national is an exempt individual (diplomat, teacher, trainee, professional athlete competing in a charity event) are not included in the SPT count.

In general, the US tax residency period starts on the first day in the year that the foreign national was in the US. However, there is a de minimis exception: preliminary visits of 10 days or less during that first residency year do not trigger the start of the residency period.

To illustrate: assume a Filipino employee, Juan, is assigned to the US beginning May 1, 2011, and that Juan meets the SPT in 2011. Prior to his actual move on May 1, while still maintaining his tax home in the Philippines, Juan goes house-hunting in the US from April 1 through April 10. Under the de minimis rule, Juan’s residency would not include his April house-hunting visit. It would begin on May 1 instead, since his house-hunting US trip was not longer than 10 days. However, if Juan had stayed in the US one extra day to attend a friend’s birthday bash before leaving on April 11, his house-hunting trip would not fall under the de minimis rule. As a result, his US residency would start April 1.

The de minimis rule also applies in the year US tax residency is terminated. Generally, US tax residency ends on December 31. However, if a foreign national can show that he has closer connections to a foreign country for the remainder of the exit year, his US residency generally ends on the last day he is present in the US. Visits to the US later that year for up to 10 days would not extend the US residency period.

A foreign national, particularly one who is married, may pay less tax overall by filing as a US resident and getting the benefit of joint return rates (which are usually lower) and/or a credit or deduction for foreign taxes. A foreign national who does not meet the SPT in a given year but who will meet the SPT the following year may choose to secure these benefits by electing to be treated as resident in the first year.

This so-called 7701(b) election (or “first-year election”) is available to a foreign national who:

• does not meet the SPT for the year at issue;

• was not a US resident under the Green Card or SPT test for the previous year;

• meets the SPT in the following year;

• is present in the US for at least 31 consecutive days in the year at issue; and,

• spends at least 75{982ecbb84816c6d9f589e8211ea46f8047ba0a57e5c66df0879b0b268bf06ad5} of the days between the beginning of that 31-day period and the end of the year at issue in the US. A foreign national who might otherwise flunk the 75{982ecbb84816c6d9f589e8211ea46f8047ba0a57e5c66df0879b0b268bf06ad5} test by five days or less is treated as passing the test. A foreign national who expects to qualify for this election after the normal filing date of his or her return may request a filing extension.

A foreign national who prefers not to be treated as a US resident under the SPT may invoke either —

• The closer-connection exception — this is available to a foreign national who meets the SPT but (1) is present in the US for fewer than 183 days in the year at issue, and (2) can demonstrate ties to a single home country or to some other single country that are stronger than his or her ties to the US. To claim this exemption, a foreign national must file a statement (Form 8840 “Closer Connection Exception Statement”) with his or her US return.

• Tax treaty tie breaker provisions — this comes into play when a foreign national is a resident of both the US and a foreign country under each country’s domestic tax rules. A foreign national in this situation who does not wish to be treated as a US resident for income tax purposes must file a non-resident return (Form 1040NR) and attach to the return Form 8833, Treaty-Based Return Position Disclosure, identifying the relevant treaty provision and citing the facts that support his or her claim of US non-residency.

It is important to note that a foreign national with a pending green card application should consult an immigration lawyer before claiming non-resident status. Filing a non-resident return (Form 1040NR) may have an effect on the application for permanent residence.

In next week’s article, we will explain why these specific points are significant, notably because of the way that US FNs are taxed.

Jocelyn M. Magaway is tax senior director of SGV Co. Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV Co.

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