Withholding Tax on Scholarships to Foreign Students

Thoughtware Alert Published: Aug 27, 2021
People hanging international flags on wall

Withholding tax and income tax treaty agreements may seem beyond the technical expertise required of U.S. academic institutions. However, when institutions make scholarships and fellowship grants to foreign students, attention to these provisions is a must to comply with IRS reporting requirements.

Typically, a foreign person is subject to tax in the U.S. on their U.S. source income. If the foreign person is not engaged in a trade or business in the U.S., they do not have to file an income tax return in the U.S. if the tax is withheld at source by a withholding agent. 

When an academic institution provides a scholarship or fellowship grant to a foreign person, the academic institution is considered a withholding agent, and the foreign student is considered a foreign person for U.S. tax purposes. The scholarship or grant may be considered U.S. source income and subject to U.S. withholding tax. The default withholding tax rate in the U.S. is 30 percent on amounts paid to a foreign person that are considered fixed, determinable, annual, or periodic (FDAP). The withholding tax rate may be reduced under an income tax treaty agreement depending on the foreign person’s facts and circumstances. 

It also is important to note that while actual cash payments are not always made in a scholarship situation, the withholding is based on the scholarship amount and, therefore, needs to be grossed up for the recipient to be eligible to take a credit for the amount of tax paid. Alternatively, the institution may pay the tax directly, but then the amount of taxes paid will become tax of the institution and ineligible for credit for the recipient.  

Candidates for Degree

If the foreign person is a candidate for degree and in the U.S. under an “F”, “J”, “M”, or “Q” visa, qualified scholarships are exempt from withholding. A qualified scholarship includes funds received for tuition and fees, books, supplies, and equipment. A nonqualified scholarship includes funds disbursed for all other expenses not listed under qualified scholarships. This includes payments made for room, board, travel, and living expenses. Payments of nonqualified scholarships are subject to withholding at a rate of 14 percent, unless reduced under an income tax treaty. If the scholarship is compensatory and requires the student to work part time as a condition of receiving the funds, the portion of the scholarship considered compensatory is not exempt from withholding tax and should be treated as wages—taxable to the recipient at U.S. ordinary income tax rates. 

Nondegree Candidates

If the foreign person is not a candidate for degree and in the U.S. under an “F”, “J”, “M”, or “Q” visa, funds received as a scholarship or fellowship grant are subject to withholding at a rate of 14 percent if the grant is for study, training, or research in the U.S. and made by a tax-exempt organization operated for charitable, religious, or educational purposes. If the grant does not meet those requirements, the grant is subject to withholding at a rate of 30 percent, unless otherwise treated under an income tax treaty. 

Payments made to nonresident alien individuals in an immigration status other than on an “F”, “J”, “M”, or “Q” visa are subject to 30 percent withholding. 

Income Tax Treaties

If a foreign person resides in a country that has an income tax treaty agreement with the U.S., they may be able to reduce or eliminate the withholding tax on the funds received regardless of whether the scholarship or grant is considered qualified under U.S. law. The income tax treaty provisions override the U.S. federal and state laws on withholding tax. 

When disbursing funds, the academic institution is required to withhold tax at the prescribed rate unless the institution receives documentation that the recipient is claiming income tax treaty benefits. To claim treaty benefits, the foreign person must complete and submit the proper documentation to the academic institution (withholding agent). This process also may apply to the portion of the scholarship treated as wages. 

Annual compliance is required by the withholding agent on all payments subject to withholding tax, even if the withholding tax rate was reduced to zero under the treaty. These amounts are reported on Form 1042, 1042-T, and 1042-S due March 15 regarding payments made in the prior calendar year.

Failure to Comply

Penalties for failure to pay federal taxes withheld may be assessed against the person(s) responsible for the funds from which payment of withheld tax could have been made in the amount of 100 percent of the amount not paid. If the withholding tax is deposited late, the withholding agent may be subject to penalties up to 10 percent of the tax paid late, plus interest. In addition, the failure to file the proper withholding tax forms in a timely manner may result in penalties up to $50 per form. State penalties may apply and may vary among each state. Intentional or willful failure to withhold taxes on scholarships or grants may result in criminal penalties. 

Takeaway

It is important for educational institutions that provide support to foreign students to make sure they have reviewed how the support is treated for U.S. federal income tax purposes and whether annual reporting is needed.

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