Indian students face tax residency challenges in US amid H-1B applications

Many Indian students studying in the U.S. on F-1 visas are facing confusion and stress regarding tax residency rules as they apply for H-1B work visas.

As Indian students transition from F-1 student visas to H-1B work visas in the United States, many are encountering unexpected complications related to US tax residency rules. This situation arises primarily after the five-year exemption period granted to F-1 visa holders expires, leading to confusion and compliance issues.

Here’s a breakdown of the complexities regarding U.S. tax residency for Indian students transitioning from F-1 to H-1B visas:

U.S. Tax Residency and the Substantial Presence Test

In US tax law, an individual’s residency status is determined primarily through the Substantial Presence Test (SPT). This test assesses the number of days a person has been physically present in the U.S. over the past three years. Generally, if someone spends 183 days or more in the U.S. within this timeframe, they are classified as a tax resident, subjecting them to the requirement of reporting and paying taxes on their worldwide income.

F-1 Visa Exemption

However, students on F-1 visas benefit from a unique exemption that allows them to avoid this classification for up to five years. During this period, they maintain non-resident status, which means they do not have to disclose global income and face fewer tax obligations. This exemption is crucial for many international students who wish to manage their financial responsibilities while studying in the U.S.

F-1 Visa Benefits:

What it Means: Students on an F-1 visa can study in the U.S. for up to five years without being considered tax residents. This means they don’t have to report income earned outside the U.S. or pay taxes on it.
 

Example: If an Indian student is studying for a master's degree and works part-time on campus, she only pays taxes on her U.S. earnings, not on any money she might earn from a summer job back in India.

The "Nomad Tax Trap"

As these students approach the end of their five-year exemption period, the situation becomes more complex. "The 'nomad tax trap' refers to a tax predicament faced by foreign nationals, particularly those on student (F1) and work (H-1B) visas in the U.S., where their tax residency status becomes unclear, potentially resulting in higher taxes and double taxation," said Ankit Rajgarhia, Principal Associate, Karanjawala & Co.

The "nomad tax trap" emerges when students apply for an H-1B visa—a visa that signals their intent to remain in the U.S. for employment. This application can unintentionally jeopardize their non-resident status. Tax professionals may view the H-1B application as evidence of an intent to stay, which could trigger the SPT and result in a change in their tax classification.

Transition to H-1B Visa:

What Happens: When students apply for an H-1B visa, which allows them to work full-time in the U.S. after graduation, tax experts may interpret this application as a sign that they intend to stay in the U.S. long-term. This can lead to a change in their tax status.
 

Example: If Nikhil applies for an H-1B visa, tax authorities might now consider her a tax resident, meaning he must report all his income, including any money earned abroad.

However, by just applying for the H-1B visa lottery (a process with no guarantee of approval) does not affect your tax residency status. : Only if your H-1B application is approved and you begin working in the U.S. do you need to follow the "substantial presence test." This test determines if you've spent enough time in the country to be considered a tax resident.

Compliance Paranoia

Tax advisors may begin to scrutinize the legitimacy of students' claims to non-resident status, particularly when an H-1B application is involved. As a result, students may be caught in a web of heightened tax obligations, requiring them to disclose global assets and possibly face penalties for non-compliance.

"Students pursuing further studies by obtaining another F-1 visa may be able to maintain their non-resident tax status beyond five years, provided they meet certain conditions that demonstrate they do not intend to permanently reside in the US. This raises the question of whether applying for an H-1B visa, a type of work visa in which applicants who can move forward with the visa process are selected randomly through a lottery, constitutes an active step toward permanent residency even before the lottery results or final visa status confirmation. Compliance paranoia arises when US Certified Public Accountants argue that participation in the lottery or a pending status adjustment application represents intent to become a permanent resident, thereby refusing to endorse tax returns where individuals claim non-resident status. In such cases, a student on a second F-1 visa, unable to claim the same tax relief, may face higher taxes and be required to disclose global assets, resulting in extensive paperwork or the need to sever ties with assets in India to retain US tax benefits and avoid non-disclosure penalties," said Kunal Savani, Partner, Cyril Amarchand Mangaldas.

To navigate this increasingly intricate landscape, many students find themselves compelled to divest from foreign financial holdings. This step is often taken to ensure compliance with U.S. tax regulations and to mitigate the risks associated with being classified as tax residents.

""Foreign students or workers fear running afoul of complex tax regulations, which can result in penalties or double taxation. For instance, an F1 visa holder transitioning to an H-1B visa may face confusion regarding when their tax residency begins. Misinterpreting their residency status or not filing taxes correctly may lead to compliance issues.," said Rajgarhia.