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Tax & the resident
November, 16th 2007
The US visa status determines the amount of taxes that Indian immigrants have to pay and items they are taxed on. Arnav Pandya checks out the fineprint.

IT is a truth universally established that for many Indians the US is a second home, or even just the workplace. And then, can important issues like taxes be far behind? Its given that Indians living, working and doing business in America is very common now, and that means a lot of people spending long periods of time there. One area that needs careful attention therefore, is the taxation aspect as this will determine the extent of tax liability that has to be paid by the individual.

Indians fall under the category of foreign nationals in America. The actual taxation depends on whether a person is classified as a resident or a non-resident alien in the US. The position can change year after year and calculations are thus required annually. The residency status, as far as the taxation is concerned, is a separate issue for immigration purposes.

RESIDENCY STATUS

This is a very critical part of the entire taxation process and it follows a somewhat mechanical process because one has to look at the fulfillment of various conditions. Calculations need to be made each year to determine the position for the year.

If a person has to be classified as a resident alien for a year then they have to fulfil either the lawful permanent resident test or the substantial presence test. The lawful permanent resident test is also known as the green card test. Under this condition, an individual is considered as a resident alien from the day they get a green card until the day that this status is revoked or judicially found to be abandoned. This means that once an alien has a green card then they become a tax resident alien even if they stay outside the US.

The second test is the substantial presence test where some exact calculations are required. There are two specific conditions that have to be met in this case in order for a person to be called a resident alien. The first condition is that the person has to be physically present in the US for 31 days in the current year (2006 for the last calculation and so on). The second condition is that the person has to be physically present in the US for a weighted average of 183 days over a three year period, which includes the current year and the two preceding years. The days in the US are calculated by a weighing formula that gives a weight of full 100% for the days in the current year one third of the weight for days in the preceding year and one sixth of the weight for days in the second preceding year.

Take the example of a person who was in the US for a period of 121 days during the current year while the presence in the preceding year was 66 days, and 72 days in the year preceding that. In this case, the first condition of 31 days during the current year is satisfied. After that, the second condition of a weighted average of 183 days has to be checked. The full period of 121 days during the year plus 22 days (1/3rdof 66 days) and 12 days of the second preceding year (1/6th of 72 days) would be added up. This comes to 155 days which is less than the requirement, and thus the person would not be classified as a resident alien for that particular year.

Two conditions are very important here. The first is that a stay up to 121 days in the year in the US will ensure that the person does not become a resident for tax purposes. This is because if a person stays for, say, 120 days in the current year and the two preceding years, then the calculation shows that the number of days that will be counted for the purpose of taxation is 120 days plus 40 days (1/3 rd of 120) plus 20 days (1/6th of 120) which amounts to 180 days, again less than the required 183 days.

Further, if a person is resident in the US for a period that is less than 31 days then they will not meet the first condition in the list and they will immediately drop out of the resident status requirement. In order to compute the presence of a person for a day in the US, a mere presence at any time during the day is sufficient for the purpose. There is no requirement for spending a minimum amount of time during the day for this condition.

There are also some important exceptions. For example, if a person is not able to leave the US due to a medical condition that arose while they were in the US, then the time period for this condition would not be included in the calculation for residency purposes. Further, teachers who are in the US on J visas and students on F or J visas will also be exempt and so will be employees of foreign governments.

There can be a different resident status even when these required conditions are satisfied because there is an exception present in the lawknown as the closer connection exception. If a person meets the substantial presence test but is present for less than 183 days in the current year and the person is able to show that he or she has a tax home in a foreign country and a closer connection to the country than the US, then they would be considered as a non-resident alien. The facts and circumstances of each of the cases would have to be identified in order to understand the exact situation. In the year that a foreign national becomes a resident alien his status is that of a dual status alien.

TAXATION OF ALIENS

After determining the status of the individual, the next step is to consider the items that will be taxed. As far as a resident alien is concerned, all income received by such a person or derived from any source will be liable for federal income tax unless the income is specifically excluded. The amount is taxed at the applicable rate after taking the benefit of various deductions.

A tax paid by a resident alien away from the US might be taken as a deduction or may be credited against the amount of US tax to be paid. This will result in a lower tax liability for the individual. However, there is a very complicated structure that allows for deductions and set off on this front. Further, one can also use the double tax avoidance treaty to reduce the burden of double taxation that individuals might face. 

As far as a non-resident alien is concerned, the taxation will require break-ups of sources of incomewhere income connected with a US trade or business is taxed normally at the gradual rates, while US source income that is not effectively connected with a US trade or business, and is fixed or determinable, will have a special rate for taxation. Usually, foreign source income of a non-resident alien not engaged in US business or trade is not taxed in the US.

RESIDENT ALIEN

To be thus classified for a year a person has to fulfil either the lawful permanent resident test or the substantial presence test. The lawful permanent resident test is also the green card test. Under this, an individual is considered as a resident alien from the day that they get a green card until the day that this status is revoked or judicially found to be abandoned. This means that once an alien has a green card then they become a tax resident alien even if they stay outside the US.
All income received by a resident alien or derived from any source will be liable for federal income tax in the US unless the income is specifically excluded. The amount is taxed at the applicable rate after taking the benefit of various deductions.
A tax paid by a resident alien away from the US might be taken as a deduction or may be credited against the amount of US tax to be paid. This will result in a lower tax liability for the individual.

The writer is a finance professional and an alumnus of IIMB

 
 
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