Scholarships, Fellowships, and Grants Paid to Nonresident Aliens

Overview

Generally, a scholarship or fellowship grant is any amount paid or allowed to, or for the benefit of, an individual to aid in the pursuit of study or research. A scholarship or fellowship grant may be in the form of a reduction in the amount owed by the recipient to an educational organization for tuition, room and board, or any other fee.

Only "qualified scholarships" may be excluded from income. Qualified scholarship amounts include tuition and fees required for the enrollment or attendance of a student at an educational institution, and required books, supplies, and equipment. Amounts received for room, board, travel, and incidental living expenses are not related expenses and not excluded from gross income under Internal Revenue Code section 117. For non-degree candidates and post-doctoral fellows, the entire grant is includible in the gross income of the recipient.

A scholarship or fellowship grant represents payment for services when the grantor requires the recipient to perform services in return for receiving the grant, or pursue studies, research, or other activities primarily for the benefit of the grantor. A scholarship or fellowship grant received on the condition of past, present, or future services by the recipient, or services that are subject to the direction or supervision of the grantor, also represents payment for services.

Section 117 of the Internal Revenue Code broadly defines scholarship as "an amount paid or allowed to, or for the benefit of, a student, whether an undergraduate or graduate, to aid such individual in pursuing his studies" and fellowship as "an amount paid or allowed to, or for the benefit of, an individual to aid him in the pursuit of study or research."

Information on the following topics is provided as an aid when paying scholarship and fellowship grants to nonresident aliens.

• Source of the Payment - U.S. or Foreign Source
• Qualified vs. Nonqualified Payments
• Scholarship/Fellowship vs. Prize/Award vs. Gift vs. Compensation
• Nonresident Alien vs. Resident Alien
• Tax Withholding, Tax Treaty Benefits, & IRS Reporting Requirements
• How Scholarship/Fellowship Grants are Paid at the University

Source of the Payment - U.S. or Foreign Source

The first step in determining whether a scholarship, fellowship, or grant payment made to a nonresident alien should be subject to tax withholding and reporting, is to determine the source of the grant.

In General, scholarship, fellowships, and grants that originate from sources outside the United States are not taxable to nonresident aliens who receive such grants. Nor are they reportable to Internal Revenue Service. Revenue ruling 89-67 points out that the source of the grant payment is determined by the "residence or the payor" not the location of the educational activity. Thus a nonresident alien studying in the U.S. but receiving grant funds from a foreign source is not subject to tax withholding or IRS reporting on those funds, even if paid through an "intermediary agency". The Revenue Ruling does state that there must be a "genuine agency relationship" between the intermediary and the payor of the grant.

Example: The scholarship grant payment is considered foreign source if the foreign student's government contracts with a U.S. agency to administer the grant funds paid to their students in the U.S.

Final regulations under section 861 were issued by IRS in 1995 that retains the "residence of the payor" rule from Revenue Ruling 89-67, but also states that scholarship, fellowship, and grant payments made by a U.S. payor to a nonresident alien studying outside the U.S. is also considered "foreign source".

Qualified vs. Non-Qualified Scholarship Payments

Under section 117 of the Internal Revenue Code a "qualified scholarship" is one that is used to pay "tuition and fees paid to enroll in , or to attend, an educational institution" or "fees, book, supplies, and equipment required for the courses at the educational institution". Only qualified scholarship payments made to nonresident aliens are neither subject to withholding or IRS reportable.

Any portion of the scholarship, fellowship, or grant that does not directly pay for those items mentioned above is considered non-qualified, thus includible in the gross income of the recipient and subject to withholding. For non-degree candidates and post-doctoral research scholars, the entire grant is subject to withholding and reporting to IRS if paid to a nonresident alien.

Scholarship/Fellowship vs. Prize/Award vs. Gift vs. Compensation

Prize/Award

For nonresident aliens there is an important distinction between a scholarship or fellowship and a prize or award - tax withholding rate. A prize or award is subject to 30% federal tax withholding, whereas a scholarship or fellowship is generally subject to 14% withholding. The difference between the two depends upon the nature of the payment. If the payment is based on past accomplishment or activity it's considered a prize or award. If, on the other hand, the payment is made for future or continuing education activity (that doesn't required services), it should be considered a scholarship or fellowship.

Gift

For federal tax purposes, a gift is characterized as "detached and disinterested generosity, motivated by affection, respect, admiration, or charity". In other words, under section 102 of the Internal Revenue code a gift can be excluded from taxable scholarship/fellowship payment reporting. If however the payment qualifies as both a gift under section 102, and a scholarship or fellowship grant under section 117, per IRS section 117 will override and the payment will be subject to all the rules applying to scholarship and fellowship grants. In the "eyes" of IRS, it is virtually impossible to argue that a payment made to an individual to pursue educational activity should be treated as a gift for tax purposes. The only exception is under section 117 the scholarship/fellowship rules don't apply if the payment was "provided by an individual to aid a relation, friend, or other individual in the pursuit of study or research if the grantor is motivated by family or philanthropic considerations". This exception applies only to grants made by individuals - not organizations.

Compensation

The distinction between a scholarship or fellowship grant and compensation is quite important from a tax compliance perspective. Compensation paid to a nonresident alien is subject to either 30% withholding rate, if paid for independent services, or at the graduated tax rates if paid to an employee. A scholarship or fellowship grant represents payment for services when the grantor requires the recipient to perform services in return for receiving the grant, or pursue studies, research, or other activities primarily for the benefit of the grantor. A scholarship or fellowship grant received on the condition of past, present, or future services by the recipient, or services that are subject to the direction or supervision of the grantor, also represents payment for services.

Nonresident Alien vs. Resident Alien

For IRS purposes the definitions of nonresident alien and resident alien are as follows:

• NONRESIDENT - A non-U.S. citizen who does not meet either the "green card" test or the "substantial presence" test described in IRS Publication 519, U.S. Tax Guide for Aliens.
• RESIDENT - Meets either the "green card" or "substantial presence" test described in IRS Publication 519.

To determine residency for tax purposes the international visitor or student should complete the substantial presence test. The substantial presence test helps determine if nonresident aliens should be treated as U.S. residents for income tax purposes.

Nonresident aliens are subject to federal tax withholding at either 30% or 14% on all non-qualified or taxable scholarship/fellowship payments made from a U.S. source. Under IRC 871(c), F-1 and J-1 visa classifications are subject to 14% withholding; all other visa classifications (e.g. H-1b) are subject to 30% withholding on their scholarship or fellowship payments under section 1441. If the nonresident qualifies for a tax treaty exclusion and files the correct forms with Payroll Services, then the payment will be exempted from tax withholding. Scholarship/Fellowship payments to nonresident aliens are reported to IRS on Form 1042-S.

Resident aliens for tax purposes are treated the same as U.S. citizens in respect to scholarship or fellowship payments - nonqualified payments, though taxable and reportable to IRS by the payee, are not subject to withholding and reporting by the payor (University). However, if the resident qualifies for tax treaty benefits and files the correct forms with Payroll Services, the scholarship or fellowship payment can be treated as exempt from taxation in the U.S. and reported to IRS on Form 1042-S.

Following is a brief description of both the "green card" test and the substantial presence test.

• GREEN CARD TEST - Under the green card test the alien is treated as a U.S. resident for tax purposes if INS issues him/her lawful permanent residency ("green card") at any time during the calendar year. The permanent residence status remains in effect until it is either rescinded or judicially determined to be abandoned (Treas. Reg. 301.7701(b)-1(b)(1)).

• SUBSTANTIAL PRESENCE TEST - The substantial presence test is comprised for two parts - the 31-day test, and the 183 day test. The alien must be present in the U.S. for at least 31 days during the calendar year, and 183 days during the three-year period that includes the current year and the two years preceding the current year. The alien counts all days present in the current year, one-third of the days present in the previous year, and one-sixth of the days present in the second previous year. However, there are exceptions to the way the days are counted.

  F-1 and J-1 student visa holders are exempt from counting their first 5-calendar years in the U.S. towards substantial presence.

  J-1 scholars (or non-students) are exempt from counting days for two years of the last 6-calendar years in the country.

For more information concerning resident aliens, see Substantial Presence Test.

Tax Withholding, Tax Treaty Benefits, & IRS Reporting Requirements

All U.S. source non-qualified scholarship or fellowship payments made to a nonresident alien are subject to tax withholding and reporting to IRS. Under section 1441, taxes must generally be withheld at the 30% tax rate on all "fixed and determinable" U.S source income payments made to nonresident aliens, unless exempted under the Internal Revenue code or a tax treaty. However, under IRC 871(c) nonresident aliens present in the U.S. on F-1, J-1, M-1, or Q visa statuses are subject to only 14% withholding on the taxable portion of the scholarship or fellowship payments.

Many countries have entered into reciprocal agreements with the U.S. whereas the foreign resident can claim an exclusion from tax withholding under a tax treaty benefit. If the nonresident alien qualifies for the treaty exclusion, then IRS Form W-8BEN must be filed with Payroll Services to exempt the scholarship/fellowship payment from tax withholding.

Form W-8 BEN is valid until December 31st of the third calendar year following the year in which the form was submitted. It is valid indefinitely as long as payments are made at least once a year. However, Form W-8BEN is INVALID on the day any of the information contained on it ceases to be valid (e.g. when the individual's treaty benefits expire). For more information concerning tax treaty benefits, see Claiming Tax Treaty Benefits or see Tax Treaty Countries for a list of the countries that have entered into tax treaty agreements with the U.S.

All taxable scholarship or fellowship payments made to nonresident aliens are required to be reported to the payee and to IRS on Form 1042-S.

How Scholarship/Fellowship Grants are Paid at the University

At the University of Minnesota, scholarship and Fellowship payments are made in three ways:

• Non-service graduate fellowships paid in classes 9560, 9561, 9562, 9564, 9565, 9566, 9567, 9568, 9569, 9582, and 9583. These are paid to support the fellows in their course of study or research. These payments are made on a biweekly pay cycle through the normal HR/Payroll process. Contact your Departmental HR/Payroll Administrator for more details.
• Fellowship payments made to short-term visiting research scholars to defray their living expenses while at the University to perform independent research. These are paid through the PVC payment process. See Paying Nonresident Alien Contractors/Payees for more information concerning the PVC payment process.
• The process looks at the taxable credits posted to the student's accounts, and totals the offset charges on the student's account.  Based on the student's tax data in PeopleSoft, the process will determine if the student has a tax treaty, or if the student has met any substantial presence qualifications.  It then determines the applicable tax rate, totals taxes already posted to the student's account, and does a calculation to determine if there is additional tax due or if the amount of tax charged should be reduced.  the data will automatically  route to Payroll Services for IRS reporting purposes.  If the Nonresident alien student is eligible for treaty benefits, the tax treaty forms must be submitted to Payroll Services before the payment is processed.

References

The above information was compiled from the following sources:

• Nonresident Alien Tax Compliance by Donna E. Kepley
• U.S. Taxation of International Student and Scholars by NAFSA Association of International Educators
• Nonresident Alien Tax Issues - Update from IRS Presented by International Issues Specialist, Internal Revenue Service to NACUBO
• IRS Publication 519, U.S. Tax Guide for Aliens
• IRS Publication 970, Tax Benefits for Education