TAX TREATY BENEFITS FOR FOREIGN STUDENTS

by Paula Singer, Esq. 

The United States has income tax treaties with 63 countries. Treaties serve to:

• Avoid double taxation in situations in which a taxpayer could be taxed twice, once by the country in which the income arises (the "source" country) and once by the country where the taxpayer resides (the "residence" country)
• Reduce "excessive" withholding taxes on certain types of income such as investment income and royalties
• Establish agreed-to levels of activities in which taxpayers can engage in the treaty country before becoming subject to taxes
• Provide for the exchange of information
• Eliminate taxes in situations that treaty partners agree should have favorable tax treatment

Tax treaty benefits for foreign students vary considerably depending upon when the treaties became effective.

Pre-1987 Treaties

Prior to the 1986 Tax Reform Act, scholarship and fellowship grants for students were exempt from tax. Grants for research scholars were given favorable U.S. tax treatment as well. U.S. students were able to offset work-study income with the standard deduction and personal exemption. Nonresidents cannot use a standard deduction to offset work-study income. U.S. tax treaties from this period generally provide complete exemption from tax for scholarships and fellowships for full-time students. (The former USSR treaty, which covers nine of the Newly Independent States, is the notable exception with a $10,000 treaty maximum.) In addition, they provide for a limited exemption for earned income, typically $2,000 to $5,000, compensating for the lack of a standard deduction. Most treaties limit the student benefits to five taxable years.

To provide tax treatment similar to U.S. citizens for foreign students, a few tax treaties – Barbados, Jamaica, and Hungary – allow students to elect to be treated as residents.

Following the '86 Act, only qualified scholarship and fellowship grants - tuition and required fees, books, supplies, and equipment - are exempt from tax. All other grants are taxable but not subject to withholding or reporting for U.S. citizens and residents. Taxable grants of nonresidents are subject generally to 14 percent withholding and reporting on Form 1042-S. U.S. citizens and residents may use the standard deduction to offset taxable grants on their Form 1040; nonresident students cannot use the standard deduction on their Form 1040NR-EZ. U.S. treaty policy for student benefits does not reflect the difference (except for the treaty with India, which allows students a standard deduction and a personal exemption for a spouse).

U.S. Treaty Policy on Student Benefits

The U.S. Model Treaty states the U.S. policy regarding student benefits:

Payments received for the purpose of maintenance, education, or training by a student … for the purpose of his full-time education or training shall not be taxed …, provided that such payments arise outside that State.

This limited benefit was included in treaties with Australia, Canada, Italy, New Zealand, Pakistan, and the U.K. (The treaty with Pakistan also includes a $5,000 earned income exemption.) Nonresident students need no treaty benefit for such payments from abroad, which the Rev. Rul. 89-67 deems foreign source.

Post-1986 Treaties

The replacement treaties with Austria, Denmark, Ireland, Japan, Sweden, and Switzerland incorporate the U.S. treaty policy. The new treaties with Mexico, South Africa, Sri Lanka, and Turkey also incorporate this policy.

The Treasury Explanation for the treaty with the Netherlands notes that: “It is not standard U.S. treaty policy, particularly in treaties with developed countries, to include an earned income exemption for visiting students.” The United States preserves the benefits from prior treaties when they are important to the treaty partner.

The replacement treaties with the Netherlands, France, and Germany preserve both the limited earned income exemption and the exemption for U.S. source grants. (The treaty with Germany includes a retroactive loss provision for earned income if the stay in the United States extends beyond four years.) The replacement treaties with Kazakhstan, Luxembourg, Russia, and the Ukraine preserve exemption for grants regardless of the source.

New treaties negotiated with China, the Czech Republic, Estonia, Indonesia, Israel, Latvia, Lithuania, Portugal, the Slovak Republic, Slovenia, Spain, Thailand, Tunisia and Venezuela - include benefits for scholarship and fellowship grants, regardless of the source and a limited exemption for earned income.

Paula Singer, Esq., CEO of Windstar Technologies, Inc. and partner in the tax law firm, Vacovec, Mayotte & Singer, Newton, MA has over 25 years of experience providing advice and compliance services to individuals, their employers, and payors on cross-border employment matters.

Watch for Volume 2, Number 1 for a discussion on “How Tax Treaty Benefits are Claimed."

Q. We have a student who is a citizen of China and has been living with his parents in Singapore for the past 10 years. He wants to claim student benefits under the treaty with China. Can he?

A. Tax treaty benefits are based on tax residency not citizenship. The student article of the treaty with China (Article 20) gives benefits to a student “who is, or was, immediately before visiting [the United States], a resident of [ China].” IRS regulations allow you to deny treaty benefits when eligibility for benefits is unclear. Your student appears to be engaged in “treaty shopping” because the United States has no treaty with Singapore. You should deny the student's request.

Windstar Welcomes Aboard the Following New Clients:

House Ear Institute
Miami Dade College
Northern California Institute for Research and Education
Santa Fe Community College
The Scripps Research Institute
Tulsa Community College

Paula Singer Named Massachusetts Super Lawyer

In a survey sponsored by Boston Magazine and Law & Politics Paula Singer ranks in the top five percent of lawyers in Boston. In March 2004, Law & Politics mailed more than 37,000 ballots to attorneys across Massachusetts, asking them to vote for the best lawyers they had personally observed in action. The point totals from the survey, additional research, and a blue ribbon panel review were added to arrive at a final point total. The list of super lawyers appears in the November issue of Boston Magazine.

University of Pittsburgh, Oracle, and Windstar Team For Success

Oracle Corporation issued a press release and has posted a customer success profile on its website outlining the University of Pittsburgh's successful automation of its tax withholding and treaty analysis for foreign nationals, including a seamless integration of Windstar's International Tax Navigator® and all of the financial and human resources data under Oracle applications.

New Issue of TradeWinds Sets Sail

The fall issue of TradeWinds, Windstar's newsletter on the latest news on products, clients, and staff, has just been published. Article topics include info on the new release of FNIS™ 3, newly issued copyright on Treaty Navigator™ Screens, ERP interfaces, improvements to the Windstar Users website, and the latest news on the Windstar crew.

©Copyright 2004 by Windstar Technologies, Inc. Windstar reserves all rights to this electronic material. Information contained in this publication is based on the best information available at the time of publication.  While believing the information in this publication to be accurate, Windstar accepts no legal responsibility for its accuracy.