Foreign nationals who are nonresident aliens for U.S. income tax purposes are subject to the following tax rules and procedures:
1. Taxation of U.S.-Source Income. Nonresident aliens are subject U.S. federal income tax on their U.S.-source fixed or determinable annual or periodic (FDAP) gross income and on income that is effectively connected to the conduct of a U.S. trade or business (called Effectively Connected Income or ECI). FDAP income is passive income, such as dividends, interest, royalties and rents. ECI includes compensation for services (employment or self-employment) performed in the U.S. and certain taxable scholarship/fellowship grants to recipients in F, J, M or Q immigration status from U.S. grantors for study, training or research in the U.S.
2. Taxation of Nonresidents Aliens Abroad. Because nonresident aliens are only taxed on U.S.-source FDAP income and ECI, they are not subject to U.S. income tax on their foreign-source income. The nature and source of income are defined by U.S. tax rules. For example, a payment in return for services (regardless of the name given to the payment) is sourced where the services are performed regardless of the location and currency of the payment unless an exception applies. But, most passive income is sourced based on the tax residence of the payer or, in the case of royalties, where the intangible personal property resulting in the payment is used. As a result, a nonresident alien does not have to be physically in the U.S. to have U.S.-source income and be subject to U.S. income tax.
3. Withholding on Wages of Nonresident Employees. There are special payroll wage-withholding rules that apply to wage payments to nonresident employees described in IRS Publication 15, Circular E, Employers’ Tax Guide. They include a special gross-up of wages for application of the wage-withholding table in order to eliminate the effect of the standard deduction (this rule does not apply to residents from India who entered the U.S. as students or business apprentices). There are also special Form W-4 rules for nonresident employees. They may not claim “exempt.” If married, they must indicate single status (because they may not file their tax return jointly with a nonresident alien spouse). They may claim zero or one personal exemption with exceptions for nonresident employees who are U.S. nationals; qualifying residents of Canada, Mexico or South Korea; or residents from India who entered as students or business apprentices. Nonresident alien and resident alien employees are subject to state wage withholding under the same rules that apply to U.S. citizens who are state residents or nonresidents under the applicable state rules.
4. FICA Rules for Nonresident Employees. As with citizens and resident alien employees, employment compensation of nonresident aliens is subject U.S. Social Security and Medicare (FICA) taxes. However, there is a FICA exception under section 3121(b)(19) of the Code for nonresident employees in F-1, J-1, M-1 or Q-1/Q-2 immigration status. (This exception is not available to employees in any of these categories who are resident aliens.) Foreign national students, whether resident alien or nonresident alien, are eligible for the Student FICA Exception under section 3121(b)(10) under the same rules that apply to U.S. citizens.
5. Withholding on U.S.-Source Income of Nonresident Alien Payees. All non-wage U.S.-source income payments to nonresident aliens are subject to withholding at a 30% rate unless an exception applies. Taxable scholarship and fellowship grants paid to or on behalf of nonresident aliens who are candidates for a degree at a qualifying educational institution and who are in F, J, M or Q immigration status are subject to 14% withholding. This lower rate also applies to nondegree candidates in such status provided the payer is in one of the categories specified by the Code, such as a U.S. tax-exempt organization. Other exceptions, such as an exemption from withholding under an applicable income tax treaty, require the income recipient to submit a valid withholding certificate – a Form W-8BEN or a Form 8233 if the income is compensation for personal services. A U.S. taxpayer identification number – a Social Security Number (SSN) or Individual Taxpayer Identification Number (ITIN) – is required for an exemption from withholding under a tax treaty with a regulatory exception for income on publicly traded investments. Tax treaty exemptions for non-compensatory payments other than scholarship and fellowship grants are generally not available to foreign nationals who are resident aliens.
6. Reporting Income and Taxes of Nonresident Aliens. All U.S.-source income payments to nonresident aliens are subject to reporting on a Form 1042-S information return with the exception of wages subject to wage withholding, which must be reported on Form W-2. Foreign-source income may be reported on a Form 1042-S (Exemption Code 03) but such reporting is not required. Wages that are exempt from wage withholding under an applicable income tax treaty provision must be reported on a Form 1042-S, not a Form W-2. Treaty-exempt income of resident aliens may also be reported on a Form 1042-S (making tax return administration easier for both the income recipient and the IRS) but it is not required. Special procedures may be necessary to avoid double reporting, depending on the sophistication of an employer’s payroll system.