Taxpayer Advocate Criticizes Hardships Faced By Nonresident Aliens Trying To Obtain Refunds Of Withheld Tax

In a scathing blog published this past week, National Taxpayer Advocate Nina Olson criticized the significant roadblocks that meet nonresident aliens (“NRAs”) trying to rightfully obtain refunds of withheld tax from the IRS. The roadblocks stem from a recent general freeze by the IRS on credits claimed on Forms 1040NR, U.S. Nonresident Alien Income Tax Return, which do not match with the information provided on Forms 1042-S filed by withholding agents.

The Taxpayer Advocate is an independent office within the IRS tasked with helping people resolve tax issues with the IRS and recommending changes that will prevent future problems. It’s always interesting to hear the point of view of the office responsible for taking the IRS to task for its missteps in handling taxpayer issues.

NRA Taxation In General

While the U.S. government taxes its citizens and tax residents on worldwide income and subjects them to certain anti-deferral regimes, it taxes nonresident aliens in a more limited manner.

First, foreign persons who are considered to earn income “effectively connected” with a trade or business in the U.S. (in contrast to the passive-natured FDAP income) are subject to tax at graduated rates on a net basis (i.e., reduced by available deductions). U.S. payers generally do not need to withhold tax on such effectively connected income (“ECI”).

Second, foreign persons are generally subject to tax on U.S.-source “FDAP” (fixed, determinable, annual, or periodic) income, which includes passive-type items, such as interest, rent, royalties, and dividends. This income is taxed on a gross basis (i.e., with no offsetting deductions) at the rate of 30% by way of withholding at source by the U.S. payer, who has primary responsibility as the “withholding agent” to collect, deposit, and report the tax to the IRS. Failure to do so can expose the U.S. payer and foreign person to significant penalties and interest.

Claiming A Credit For Overwitholding

It is often that case the 30-percent withholding tax rate on FDAP income can be reduced, for instance in the case that the NRA lives in a country that has a tax treaty with the United States. An exception from withholding is also provided for portfolio income on certain US registered bonds and bank accounts.

In order for a NRA to benefit from a lower withholding tax rate, the NRA must provide the withholding agent with proper documentation to justify the lower rate (for instance, the Form W-8BEN). Sometimes, however, the documentation is not provided or is otherwise not timely received by the U.S. withholding agent, who must then withhold at the 30% rate.

Such overwithholding is not tax lost forever – the NRA can claim a credit for the overwithheld tax when he or she eventually files the Form 1040NR, U.S. Nonresident Alien Income Tax Return, for the taxable year in which the FDAP income was earned. This can lead to a refund of tax for the NRA if the Form 1040NR is timely filed.

Recent Freeze On NRA Credit Claims

According to Olson, in January of 2015, the IRS began freezing credits claimed on Forms 1040NR associated with Forms 1042-S, the forms used by U.S. withholding agents to report the amount of FDAP income paid and the amount of tax withheld by the payer / withholding agent.

The freeze was done by the IRS, apparently, amidst concerns that fraud was being perpetrated to generate tax credits that were not justified. Olson argues that the freeze amounted to an overly drastic measure that was not based on comprehensive statistical data establishing the existence of fraud on a widespread scale.

Taxpayer Advocate’s Criticism

Olson’s blog begins with this true-to-life fact pattern:

Imagine how you would feel if you were expecting your tax refund to arrive imminently, and checked the mailbox or your bank account day after day, only to be disappointed. Finally, you receive the hoped-for letter from the IRS, which you open eagerly. Disappointed to find no refund check enclosed, you read a letter that in part says, ‘We’re holding the portion of your refund that relates to the withholding credit you claimed…while we review it. Our review can take up to 6 months from the date we received your return or the due date of the return, whichever is later.

In dismay, you begin the long wait. Eventually, you receive the letter you have been looking for, again minus a refund check. This time, the accompanying letter in essence says that your refund is being withheld because the specified information provided on your return does not match the information provided to the IRS by your withholding agent. The letter goes on to explain that unless you made the error and can correct it on an amended return, you must contact the withholding agent and have them remedy it on their end.

It so happens that the error in question was made on an information report sent to the IRS by a third-party payroll processing company and it takes you a good deal of time and effort to figure out how to get in touch with the company, and then find someone to speak with about your issue. When you finally do so, you learn, to your frustration, that the company is not terribly interested in your situation, or in fixing the problem. The company gives you a number of explanations and excuses that, in the end, boil down to the message that they are simply not going to amend their information report.

In disbelief at the entire situation, you contact the IRS and ask what to do next. Again, you come up against a brick wall and no progress is made toward resolution of the issue. Eventually, you come to understand that all you can do is contact my office, the Taxpayer Advocate Service, for assistance, go to the IRS Office of Appeals to present your case, or take the matter to court. Some of these approaches will cost money for representation and all of them will involve continued delay and uncertainty regarding whether you will ever recover the money that you earned and that was withheld from your paycheck on behalf of the IRS.

In her blog, Olson expresses deep concerns that the IRS freeze has made the above anecdote a common experience for NRAs. She adds that her past efforts to highlight this issue have helped improve the situation, but unfortunately, delays continue to exist. While the IRS has done a better job of limiting the population of tax credits being frozen, she states, thousands of taxpayers are still subject to significant delays each and every year.

Taxpayer Advocate Olson states that she promises to continue to monitor issues in this area and advocate for affected NRA taxpayers. With so many areas that need the IRS’s attention this year (Tax Reform!), we hope that the IRS has the time and resources to improve the tax filing experience for nonresident aliens.

Have a question? Contact Ephraim Moss.

Your comments are always welcome!

Mr. Moss is a Tax partner in a boutique U.S. tax firm specializing in the areas of international taxation and expatriate taxation. The practice focuses on servicing U.S. individuals and small business located outside the U.S. with their U.S. and international tax matters and includes both tax planning as well as annual tax compliance (tax return preparation). He has extensive experience with filing delinquent returns under the IRS Streamlined procedure, FBARs, FATCA reporting (Form 8938), reporting interests in foreign corporations (Form 5471) and partnerships (Form 8865) as well as foreign trust reporting (Form 3520 and Form 3520/A). He works very closely with clients utilizing the various international tax treaties in order to maximize benefits through smart tax planning. Previously he held a senior position in the international tax practice of Ernst & Young. He is an attorney licensed in the State of New York.

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