An employee who works abroad is always concerned about the possibility of increased income taxation and social taxation resulting from a foreign assignment. For example, will the employee be taxable in both the home country and the host country, resulting in double taxation of the employee’s compensation? Whether such increased taxation is likely, and whether it can be avoided, depends on a number of factors, such as the length of time the employee will be working in the foreign jurisdiction, the type of work the employee will do while working abroad, the employee’s citizenship, nationality or residency, and other similar factors. This determination will also need to take into account:
- The income tax, social insurance and other relevant laws of the home and host jurisdictions
- Special rules, if any, governing the cross-border transfer of employees in the home and host jurisdictions
- The provisions of an income tax treaty, social security totalization agreement or other international agreement between the home and host jurisdictions
The employer will be equally concerned with the issue of increased taxation, since many expatriates are covered by a tax reimbursement policy whereby the employer will be responsible for paying the employee’s taxes which are greater than the employee’s “home country” tax liability. For further details, see “Tax Equalization and Tax Protection Programs” below.
The employer will also be concerned with avoiding a permanent establishment (PE) issue resulting from the activities of the employee working abroad — as the employer would be taxable in the host jurisdiction for the activities of the employee working there. For further details, see “Permanent Establishment Risk” below. In addition, the employer will also be interested in the availability of a corporate income tax deduction for the employee’s compensation and assignment-related costs. Finally, to the extent the employee is taxable by the host jurisdiction, the employer will want to confirm that the applicable withholding and reporting rules are followed, both in the home and host jurisdictions. For further details, see “Compliance: Withholding and Reporting” below.
As an example of how jurisdictions often approach these issues, this chapter focuses on some of the key US federal income tax and social security provisions that apply to expatriates, whether outbound or inbound. Space does not permit a discussion of all jurisdictions and their income tax and social tax rules, so it is recommended to consult with international tax counsel to understand the rules for any other jurisdictions. It is also recommended to work closely with tax counsel to understand the potential application of these or similar provisions to the facts of any particular assignment.
US Federal Income Tax: Short-term Assignments
Where an employee lives and works abroad, it is natural to assume that the country where they are assigned will seek to tax their compensation. Notwithstanding, many jurisdictions have provided income tax relief for short-term assignments. Understanding how these rules work in a particular country is key to effective tax planning.
If there is no relief under the host country’s domestic tax law for employees who are short-term business visitors in that jurisdiction, often there may be relief under an applicable income tax treaty entered into between the host jurisdiction and the home jurisdiction.
As of the date of publication, the United States has income tax treaties in force with more than 67 countries. Several income tax treaty provisions may be relevant to mobile employees such as provisions addressing “dependent personal services” or “income from employment,” as these provisions are primarily directed at employees who are sent to work on short-term assignments in the host jurisdiction by their employers.
For example, Article 14 of the US-UK Income Tax Treaty provides a general rule and two exceptions regarding income from employment. The general rule is that salaries, wages and other similar remuneration derived by a resident of the home country in respect of employment is only taxable in that country, unless the employment takes place in the host country. If the employment takes place in the host country, the host country may tax it.
However, remuneration derived by a resident of the home country with respect to employment in the host country will only be taxable in the home country if:
- The individual is present in the host country for a period or periods not exceeding 183 days in any 12-month period commencing or ending in the taxable year
- The remuneration is paid by or on behalf of an employer who is not a resident of the host country
- The remuneration is not borne by a permanent establishment that the employer has in the host country
Therefore, if an employee is treated as a US resident under this treaty, the employee may avoid UK income tax on remuneration resulting from employment in the UK if: (i) they are not present in the UK for more than 183 days during any 12-month period (ii) they are paid by or on behalf of an employer outside of the UK and (iii) the remuneration is not deducted by a permanent establishment that the employer has in the UK.
Many US tax treaties have similar, but not always identical, language. Some treaties look at whether the employee has spent more than 183 days in a calendar year in the host country (in addition to the other requirements). In other cases, the time limit may be less than 183 days or there may be a maximum compensation limit imposed.
It should be noted that the Organization of Economic Community and Development (OECD) has indicated that the “employer,” for the purposes of treaty analysis, is not necessarily the legal employer. The OECD recommends that the “economic employer” concept be used in applying this type of income tax treaty provision. An “economic employer” is deemed to be the one who actually directs and controls the activities of the individual. The “legal employer” is the one who is denominated as the employer on paper.
Consequently, when structuring short-term assignments in countries that have adopted the “economic employer” concept, the activities and actions of the employee need to be reviewed. The treaty exemption will only apply if the home country entity meets the “economic employer” test and if other tests are met (i.e., 183 days and no chargeback of compensation costs to the host entity).
In a similar fashion, if the employee intends to rely on this treaty exemption, compensation costs related to the employee should not be charged against and reimbursed by a host country entity or permanent establishment in the host country. Note that in some cases the existence of a treaty exemption, such as this one, may not necessarily exempt the employee from making an individual income tax filing in the host country.
Treaty provisions providing relief from the potential double taxation of retirement plan participation or pension plan distributions, or with respect to stock option-related income, may also be available depending on which treaty is involved. These provisions should be reviewed and considered, especially in cases of longer-term assignments. However, these provisions are currently only present in a small number of US income tax treaties.
Traveling and Temporary Living Expenses
Under US income tax rules, an employee may be able to exclude traveling and temporary living expenses while “away from home” in the pursuit of a trade or business (including amounts expended for meals and lodging that are not lavish) from gross income amounts paid by the employer. Internal Revenue Code (Code) Section 162(a)(2) allows an exemption for living expenses that are ordinary and necessary while the employee is temporarily away from home.
Whether an employee is “away from home” is a facts and circumstance based determination. However, in no event can an international assignment be considered “temporary” if it is expected to, or does, last for more than one year.
US Federal Income Tax: Long-term Assignments
In addition to the income tax relief the United States provides to its taxpayers who are on short-term assignments, it also provides some relief for US taxpayers who are on long-term assignments (which last one year or more).
Foreign-Earned Income and Housing Exclusion
One of the most valuable tax planning devices for a US employee who is working outside of the United States is the ability to elect to exclude “foreign earned income” and a “housing cost amount” from gross income under Code Section 911.
The maximum amount of foreign-earned income that can be excluded is indexed and is USD 108,700 for 2021. It can be only elected by a “qualified individual,” meaning a person whose “tax home” is in a foreign country and who is either:
- A US citizen who is a bona fide resident of a foreign country for an entire taxable year; or
- A US citizen or resident who is present in a foreign country or countries for at least 330 full days of such period during any period of 12 consecutive months
A qualified individual must elect to exclude foreign-earned income on IRS Form 2555, or a comparable form, which must be filed with the individual’s US federal income tax return for the first taxable year for which the election is to be effective. Individuals who expect to be eligible for the exclusion may adjust their federal income tax withholding by completing an IRS Form 673 and filing it with their payroll department.
In addition to the foreign-earned income exclusion, a qualified individual may elect to exclude a “housing cost amount” from gross income, which relates to certain housing expenses attributable to “employer-provided amounts.”
The term “employer-provided amounts” means any amount paid or incurred on behalf of the individual by the individual’s employer that is foreign-earned income for the taxable year without regard to Code Section 911. Thus, salary payments, reimbursement for housing expenses or amounts paid to a third party are included. Furthermore, an individual will only have earnings that are not “employer-provided amounts” if the individual has earnings from self-employment.
If the individual’s qualified housing expenses exceed USD 17,392 (for 2021) (i.e., 16% of the maximum foreign-earned income exclusion for a full taxable year), the individual may elect to exclude the excess up to a maximum of USD 32,610 (for 2021) (i.e., 30% of the maximum foreign-earned income exclusion for a full taxable year). However, the IRS has issued guidance providing upward adjustments to this maximum in a number of high housing cost locations.
A qualified individual may make a separate election to exclude the housing cost amount on the same form and in the same manner as the foreign-earned income exclusion. An individual does not have to make a special election to claim the housing cost amount deduction.
However, the individual must provide the following information:
- Social security number
- Name of employer
- Foreign country where tax home is established
- Tax status
- Qualifying period of bona fide residence or presence
- Foreign-earned income for the taxable year
- Housing expenses
Foreign Tax Credit
Another valuable tax planning device for a US employee who works outside of the United States is the ability to receive a tax credit for foreign or US possession income tax paid or accrued during the taxable year. The credit also applies against taxes paid in lieu of income taxes (a category that includes withholding taxes).
Note that an individual may not take a credit for taxes paid on foreign income that is excluded from gross income under Code Section 911. The credit is available to any employee who is a US citizen, resident alien of the United States or a resident alien who is a bona fide resident of Puerto Rico for the entire taxable year.
The foreign tax credit is subject to a specific limitation. It is generally limited to the same proportion of the employee’s total US tax that the employee’s foreign-source taxable income — but not in excess of the entire taxable income — bears to the entire taxable income for the taxable year.
Whether an employee has foreign-source taxable income for the purposes of this limitation depends on the type of income involved and, in some cases, the residency status of the employee.
For example, with respect to wages, the employee has foreign-source income if the services are performed in a foreign country. With respect to interest, the employee has foreign-source income if the interest is credited to a bank account in a foreign country or if the employee invests in foreign bonds that pay interest in a foreign currency. Income from the sale of personal property by a US resident is US-source income regardless of the place of sale. Similarly, income from the sale of personal property by a non-resident is generally sourced outside the United States.
In the event that an employee cannot use all of the foreign tax credit, they are permitted to carry the unused credit back for one year and to carry forward the unused credit for 10 years. This means that the employee can treat the unused foreign tax of a tax year as though the tax were paid or accrued in the employee’s first preceding and 10 succeeding tax years up to the amount of any excess limitation in those years.
Participation in Non-US Compensation Programs
Where an employee on foreign assignment becomes a participant in a compensation or benefit plan sponsored by an employer in the host country, such participation may have US income tax consequences — especially in connection with the rules under Code Section 409A and 457A regarding deferred compensation.
A complete review of Code Section 409A and 457A rules is beyond the scope of this discussion. In general, if a person has a legally binding right in one taxable year to receive an amount (either as compensation or as reimbursement or otherwise) that will be paid in a subsequent taxable year, that amount is considered deferred compensation for the purposes of Code Section 409A unless it meets one of the exemptions.
Assuming that no exemption to Section 409A applies, amounts that are considered deferred compensation must comply with various requirements regarding the time and form of the payment, timing of deferral elections and a six-month delay of separation payments made to certain “key employees” of a public company to mitigate adverse income tax consequences. In addition, there are prohibitions under Section 409A on offshore funding and funding tied to the employer’s financial condition. If the requirements are not met, the deferred compensation amounts will be taxable to the employee at the time of vesting and an additional 20% tax will be imposed.
Since Code Section 409A rules apply to all plans globally that have US taxpayer participants, the issue should be carefully considered for any non-US compensation plans (e.g., retirement plans, equity incentive plans and cash bonus plans) in which the expatriate will participate. It is highly unlikely that such plans will be designed to avoid or comply with the Code Section 409A requirements.
As a first step of the analysis, it is critical to identify all of the potential compensation plans that will be offered to the employee, including, for example, equity compensation plans. The Code Section 409A rules do provide a few specific exemptions for foreign plans, although they are limited in scope.
For example, a foreign retirement plan may qualify for an exemption from Code Section 409A as a “broad-based retirement plan.” US citizens and green card holders will be able to qualify for this exemption if:
- They are not eligible to participate in a US-qualified plan
- The deferral is non-elective and relates to foreign-earned income
- The accrual does not exceed the amount permitted under Code Section 415 (i.e., the US-qualified plan limits)
The broad-based plan must also meet the following requirements:
- The foreign plan must be in writing.
- The foreign plan must be non-discriminatory in terms of coverage and amount of benefit (either alone or in combination with other comparable plans).
- The foreign plan must provide significant benefits for a substantial majority of the covered employees and contain provisions, or be subject to tax law provisions or other restrictions, which generally discourage employees from using plan benefits for purposes other than retirement and restrict access to plan benefits before separation from service.
There are also Code Section 409A exemptions for plans exempt under a tax treaty, foreign social security plans and plans that are considered funded by a trust under the rules, among others.
In addition, Code Section 457A can also apply to deferred compensation earned by US taxpayer employees working abroad. It limits the ability to offer deferred compensation in cases where employees (who are subject to US taxation) perform services for employers who are considered “non-qualified entities.” In general, employers based in jurisdictions that do not have a corporate income tax will be “non-qualified entities.”
Furthermore, an employer based in a jurisdiction that has a corporate income tax and an income tax treaty with the United States may be considered a “non-qualified entity” (depending on the extent to which the jurisdiction taxes non-resident income differently from resident income and the extent to which the employer’s income for the year includes non-resident income). Given the complexities of Code Section 457A, employers are encouraged to consult with tax counsel regarding the potential impact of this section on their expatriate population.
US Federal Income Tax — US Inbound Assignments
Employees who are sent to work in other countries, even for relatively short assignments, may nonetheless be subject to local income tax on the compensation they earn for working abroad unless there is a local tax exemption for such limited work or an income tax treaty provision provides an exemption. In the United States, for example, the Code provides a limited exemption for foreign employees working in the United States on a short-term basis, but it is practically of no use since the compensation earned during the period of assignment cannot exceed USD 3,000. Other jurisdictions may have similar statutory exemptions for short-term assignments but, generally speaking, they are rare.
Taxation as a “Resident”
The principal concern for an employee who comes to work in the United States (and who is not a US citizen or does not want to become a US citizen) is whether they will be taxed as a resident alien or a non-resident alien.
As a resident alien, they will be taxed in the same manner as a US citizen, namely, all worldwide income, including any compensation paid or earned outside of the United States, will be subject to US federal income tax. A resident alien is permitted to offset this US tax liability by a tax credit or a tax deduction for foreign income taxes paid on compensation income, if any, subject to certain limitations.
As a non-resident alien, they will only be taxed on income “effectively connected” with the conduct of a US trade or business at the same rate and in the same manner as US citizens and residents, but with some limitations (e.g., generally not able to file a return jointly with a spouse). In addition, absent a tax treaty exemption or reduced rate of tax, there will be a flat 30% tax rate on certain investments and other fixed or determinable annual or periodic income from sources within the United States that is not “effectively connected” with the conduct of a US trade or business.
The employee’s performance of services in the United States will be deemed to be the conduct of a US trade or business. Therefore, the compensation received will be “effectively connected” with a US trade or business and taxable at the same rate as that for US citizens and residents.
In general, an employee will be treated as a “resident alien” for tax purposes if the employee:
- Is lawfully permitted to reside permanently in the United States (i.e., the “green card” test)
- Is in the United States for a substantial amount of time (i.e., the “substantial presence” test)
The “green card” test is as its name suggests. This covers foreign nationals granted alien registration cards called “green cards” (even though the cards are not green).
The “substantial presence” test is satisfied if, in general:
- The employee is present in the United States for at least 31 days during the current calendar year.
- The sum of the days they are present in the United States during the current calendar year, plus one-third of the days they were present in the preceding year, and one-sixth of the days they were present in the second preceding year, is equal to or exceeds 183 days.
There is an exception to the “substantial presence” test if a foreign national is present in the United States for fewer than 183 days during the year and has a tax home in, and closer connection to, a foreign country.
If the employee does not satisfy either of the two tests described above, it is possible to elect to be treated as a resident under certain circumstances.
A non-resident alien who is temporarily present in the United States as a non-immigrant under the foreign student F visa or exchange visitor J visa, may exclude from gross income compensation received from a foreign employer or an office maintained outside of the United States by a US person.
In addition, wages, fees or the salary of an employee of a foreign government or an international organization are not included in gross income for US tax purposes if:
- The employee is a non-resident alien or a citizen of the Philippines
- The services as an employee of a foreign government are similar to those performed by employees of the US government in foreign countries
- The foreign government grants an equivalent exemption to US government employees performing services in that country
Finally, non-resident aliens may be entitled to reduced rates of, or exemption from, US federal income taxation under an applicable income tax treaty between the country of which they are residents and the United States.
A non-resident alien who claims an exemption from US federal income tax under a provision of the Code or an applicable treaty must file a statement with the employer giving their name, address, taxpayer identification number, and the reason for exemption certifying that the individual is not a citizen or resident of the United States and the compensation to be paid during the tax year is, or will be, exempt from income tax. If exemption from tax is claimed under a treaty, the statement must also indicate the under which provision and treaty the exemption is claimed, the country of which the non-resident alien is a resident and sufficient facts to justify the claim for exemption.
Participation in Non-US Compensation Programs
As previously discussed, Code Section 409A has a very broad application. In the case of employees who come to work in the United States, there is also a concern that certain non-US plan benefits they receive while working in the US could be subject to the adverse consequences of Code Section 409A. Accordingly, the employee’s participation in non-US compensation programs must be reviewed for Section 409A compliance, the same as for US programs.
For example, some non-US stock option plans may not meet the requirements of the fair market value grant exemption from Code Section 409A. Stock option plans that provide for an exercise price that is less than the fair market value on the date of grant may have this problem. If a foreign national was granted stock options outside of the United States, arrives to work in the United States and becomes a “resident alien” of the United States, then unexercised stock option grants under such plans may be particularly problematic under Code Section 409A.
Notwithstanding, there are some exemptions under Code Section 409A for deferred compensation that vests before the employee becomes a US tax resident. Again, as in the case of all US employees who go to work abroad, it is critical to identify all of the plans and arrangements that could potentially be subject to taxation under Code Section 409A in advance of an employee’s assignment to the United States.
US Social Security
One of the major concerns for an employee working outside of his home jurisdiction is whether compensation will be subject to local social insurance taxes (Social Security) in the United States. The concern arises from the employer’s standpoint as well, as in many jurisdictions social insurance taxes on compensation are imposed on the employer as well.
Social Security taxes in the United States (commonly referred to as “FICA” taxes) are relatively low in comparison with those of other jurisdictions. Therefore, it is a common desire to remain covered by US Social Security and avoid the imposition of local social insurance taxes wherever possible for a US employee who is working abroad. Continuing to be covered by US Social Security also allows the employee to build up his eligibility for a maximum Social Security benefit upon retirement.
In general, Social Security contributions must be paid on the earnings of a US citizen or resident alien working for an American employer anywhere in the world. An “American Employer” is defined as:
- The United States or any instrumentality thereof
- An individual who is a resident of the United States
- A partnership, if two-thirds or more of the partners are residents of the United States
- A trust, if all of the trustees are residents of the United States
- A corporation organized under the laws of the United States or any state
Special rules apply to companies that contract with the US federal government so that certain foreign entities may also be considered American Employers for the purposes of this rule.
Thus, a US employee who is seconded to work abroad and continues to be employed by an American Employer will remain covered by US Social Security and FICA taxes will be withheld from their compensation as a result.
Similarly, a US employee who works outside the United States for a foreign branch or division of an American Employer will remain covered by US Social Security as a branch or division is technically a mere extension of the home company.
On the other hand, a US citizen or resident who is employed outside of the United States by an employer who is not an American Employer will not remain covered by the US Social Security system and, therefore, FICA taxes will not be required to be withheld from his compensation.
Notwithstanding, there is a special election available for certain employees to remain covered by US Social Security while working abroad. If a US citizen or resident is working for an American Employer and if the US employee is sent by that American employer to work for a “foreign affiliate,” as defined below, then the American employer may enter into a voluntary agreement under Section 3121(l) of the Code to continue the US Social Security coverage of that individual. A “foreign affiliate” is defined as a foreign entity in which an American employer owns at least a 10% interest. This voluntary, but irrevocable, agreement extends US Social Security coverage to services performed outside of the United States by all employees who are citizens or residents of the United States.
Under this voluntary agreement, the American employer pays the employer’s and employee’s portion of FICA taxes that would be imposed if such wages were subject to FICA taxes under the general rules. There is no legal requirement for the employee to reimburse the American employer for the employee’s share of the tax, although some companies do in fact require such reimbursement.
Just as the expatriate and their employer might want to avoid the problem of increased income taxation resulting from the foreign assignment, there is also a desire to avoid the problem of double social taxation.
Double social taxation occurs when an employee remains covered by the social insurance taxes of their home jurisdiction and becomes covered by the social insurance taxes of the host jurisdiction. For example, a US employee who is seconded to work abroad (and therefore remains employed by an American Employer), will remain covered by the US Social Security system. At the same time, the host jurisdiction may impose its social insurance taxes on the employee’s compensation merely because the employee works there (a fairly common standard in non-US jurisdictions). In such a case, contributions to both social tax systems may be required on behalf of the employee and also by the employer — reducing the employee’s compensation and increasing both the employee’s and employer’s social tax burden.
The employee may also encounter fragmented social security coverage. A US citizen (or resident) who has worked for less than 10 years and transfers employment to a foreign employer (that is not an American Employer) will not continue to earn “quarters of coverage” for a maximum US Social Security benefit. In addition, if the expatriate’s employment history includes a lot of temporary assignments in different foreign jurisdictions, the employee may find that they have not worked long enough in any one jurisdiction to qualify for an old age, retirement or other social benefit under any system of the country at the end of their career.
To address these problems, many jurisdictions have entered into international agreements called totalization agreements. These international agreements provide a set of rules to determine which jurisdiction will cover the individual’s employment under its social insurance tax system (Totalization Agreements). Note that a Totalization Agreement does not change the domestic rules of a country’s social tax system and does not impose social insurance tax coverage if employment would not ordinarily be covered.
In the United States there are 30 Totalization Agreements in force. In general, each Totalization Agreement follows the “territoriality” principle where employment for purposes of social insurance taxes is covered only by the laws of the country in which the work is performed.
An exception to this territoriality rule exists where the employee is sent by the home country employer to be on temporary assignment in the other jurisdiction. In that case, the employee will remain covered by the social insurance system of the home country. An assignment is temporary if it last five years or less. Note that there are some variations to these rules, so it is recommended to check the applicable Totalization Agreement to determine which provisions apply in each case.
With regard to benefits, a Totalization Agreement permits an employee to combine (or totalize) periods of coverage for the purposes of determining eligibility for coverage. For example, to qualify for a minimum US Social Security benefit under the totalization procedure, the executive must have at least six quarters of coverage in the United States system. The Totalization Agreements contain parallel provisions for each country, so that if the combined (or totalized) periods of coverage are sufficient to meet the eligibility requirements for benefits, then pro rata benefits are payable from each country’s social insurance system.
An employee must obtain a certificate of coverage from the responsible authorities in their home jurisdiction to verify continued coverage while working abroad in order to take advantage of the “temporary assignment” exemption.
In the United States, an application for such a certificate must be made by the employer to the Social Security Administration (SSA), and must contain the following information:
- Full name of the outbound mobile employee
- Date and place of birth
- Citizenship, country of permanent residency
- Social security number
- Date and place of hire
- Name and address of employer in the United States and the other country
- Dates of transfer and anticipated return
If the employee is transferring to France, the employee must also certify that there is medical coverage under a private insurance plan, as France imposes this certification requirement on anyone who seeks exemption from French social security tax. In many cases, the certificate of coverage can be obtained from the SSA by applying online.
Social Security Implications for Inbound Assignments
In the case of an employee assigned to work in the United States by a foreign employer, such employment will be subject to US Social Security coverage (e.g., FICA taxes) unless the performance of services does not come under the definition of “employment” for US Social Security purposes. For example, there is a specific exemption for non-resident aliens who are present in the United States under the F or J visa.
An inbound employee who does not qualify for those exemptions from US Social Security will be subject to FICA tax withholding on compensation, unless an exemption under a Totalization Agreement in effect with the home country can be claimed. For example, if the employee is on a temporary assignment, then the applicable Totalization Agreement can be relied upon as an exemption from the application of FICA tax withholding. In that event, the employee will need to produce a certificate of coverage from the home country authority to claim the exemption.
Employee Reporting Obligations
Employees who are US tax residents should also be aware of the individual reporting requirements under the Foreign Account Tax Compliance Act (FATCA) and in connection with the Foreign Bank and Financial Account requirements. Specifically, “foreign financial assets” is defined rather broadly in the FATCA. Foreign financial assets can include shares of foreign companies, balances under foreign compensation plans and other arrangements sponsored by foreign affiliates. Certain taxpayers may also have to complete a Form 8938 (Statement of Foreign Financial Assets) and attach it to their annual US income tax return. Given the complexities of these reporting obligations, employers are encouraged to consult with tax counsel regarding the potential impact of these requirements on their expatriate population because there are significant penalties for failing to report on time.
Selected Concerns from the Employer’s Perspective
Availability of Corporate Income Tax Deduction
One of the primary issues from the employer’s standpoint is whether the costs of the expatriate’s compensation are deductible, and if so, by which entity. Under US federal income tax principles, the entity that is the common law employer, (the entity that has the right to direct and control the activities of the employee) is entitled to the income tax deduction. This principle may be similar in non-US jurisdictions, so it would be prudent to consult with a tax adviser on any tax deduction question.
Under US tax principles, if the employee is seconded to work abroad for another company, they remain a common law employee of the sending employer and that employer is entitled to deduct the costs of the employee’s compensation.
Similarly, if the employee’s employment is transferred to another company (another corporate entity, such as a subsidiary, a parent company or a brother-sister company), it is that other entity that has the right to deduct the costs of the employee’s compensation. Even if the company is in the same corporate group as the employee’s former employer, the former employer is not entitled to deduct the costs of compensation because the benefit to such employer is deemed to be only an indirect or derivative benefit. For these purposes, a division or branch is deemed to be the same as the corporate entity to which it relates, and is not considered a separate entity for income tax deduction purposes.
Permanent Establishment Risk
One key issue that always needs to be considered in structuring international assignments is whether the employment structure will inadvertently create a permanent establishment (PE) issue for the home country employer. A PE exists where the employing entity is considered to be doing business in the host country and is therefore subject to corporate income tax by the host country on an allocable amount of the entity’s net income. As discussed in the chapter on Employment, an employee remains employed by, and therefore directed and controlled by, the home country employer in a secondment structure. Accordingly, this structure creates a PE risk for the home country employer. The length of the assignment does not necessarily matter — risks still arise when an employee is on a short-term or “informal” assignment (where the employee is seconded to work in another jurisdiction for just a few weeks or months).
A company that creates a PE is often obligated to file tax returns with a foreign tax agency, to observe local accounting standards for foreign tax purposes and to pay higher taxes on a worldwide basis. The existence of a PE may also trigger registration, filing and publication obligations for the company that would not otherwise exist.
A local tax inspector may assume that a company has automatically created a PE if the expatriate is on secondment while working in the host jurisdiction. To mitigate this risk, many multinational companies include express language in the expatriate’s assignment letter specifying that the expatriate has no authority to conclude contracts on behalf of the home country employer while working in the host jurisdiction. However, this protective language does not always work. Consultation with international tax counsel is recommended.
Activities that could constitute a PE vary by jurisdiction and are based on income tax treaty provisions as well as the structure of the employment relationships. The concept of PE has undergone significant changes since OECD issued guidance. As a result of these changes, a covenant expressing that the expatriate does not have the authority to conclude contracts may not be enough to avoid a PE risk in some jurisdictions. In some jurisdictions (e.g., China), secondment attracts special scrutiny, both because it is a secondment and it creates a potential tax liability for the home country employer (unless the expatriate is directed and controlled by the local entity in China). In other jurisdictions (e.g., India and Canada), the secondment structure may run afoul of the Services PE concept — a PE may exist merely because an employee of the home jurisdiction performs services in the host jurisdiction. We recommend that companies work closely with their tax advisers to understand the nuances and potential exposures that may arise in connection with the PE risk.
Tax Equalization and Tax Protection Programs
To minimize the expatriate’s potential exposure to a higher global income and social security tax burden, the employer will often implement a tax equalization or tax protection program for all of its expatriates and globally mobile employees. Such a program provides a consistent approach for handling the complex income and social security tax situation of any particular expatriate.
A tax equalization program provides that the employee’s tax burden on equalized income will be neither greater nor less than the income and social taxes (the “stay-at-home tax” or “final hypothetical tax”) they would have paid had they not gone on a foreign assignment. It requires the employee to pay a retained hypothetical tax approximating the stay-at-home taxes. In a typical tax equalization program, the hypothetical tax is computed at the beginning of the year and a pro rata amount is deducted from the employee’s wages each payroll period. At the end of the year, the employee’s hypothetical income and social taxes are recalculated based on the employee’s actual equalized income for the year. A reconciliation is then prepared to compare the employee’s final hypothetical tax liability with the employee’s hypothetical tax deducted during the year to determine whether the correct amount was withheld. If the amount of the hypothetical tax deducted during the year is greater than the final hypothetical tax liability, the difference is reimbursed to the employee. If the result is that too little hypothetical tax was deducted during the year, the employee must pay the difference to the company. The objective of the tax equalization program is to eliminate the tax windfall that an employee who moves from a high-tax jurisdiction to a low-tax jurisdiction could enjoy by virtue of lower tax rates.
A tax protection program also involves the calculation of a hypothetical tax. However, it is intended to only reimburse the employee in the event the employee incurs additional tax liability as a result of the foreign assignment (e.g., where the employee ends up working in a higher taxing jurisdiction).
Therefore, under a tax protection program, an employee is reimbursed the difference if the actual home and host country income and social taxes are more than the hypothetical tax deducted during the year .If the actual taxes are less than the hypothetical tax liability, the employee is not required to pay anything back to his employer and would benefit.
There are many variations on tax equalization and tax protection programs. Some employers cover state, local, US federal, foreign income and social taxes. What type of income is included, and excluded, depends on the company and the discussions it has with its tax advisers.
Since tax equalization and tax protection programs represent payments of compensation over a number of tax years, for US taxpayer employees there are potential Code Section 409A issues. The company providing such a program needs to ensure that the tax equalization/tax protection program complies with Code Section 409A. Consultation with tax counsel is often needed for this purpose.
As a best practice, the international assignment policy should be changed to comply with, or be exempt from, Code Section 409A.
Given the complexity of the hypothetical tax calculation, some companies will engage the services of an accounting firm to make the necessary determinations and prepare the various income tax returns for each affected employee. Employers do this both to be confident that its employees are handled consistently and that their tax returns are timely prepared and filed.
Budgeting and Cost Projections
Given the significant incremental costs generally related to an international assignment (e.g., employer-paid housing, additional allowances, tax reimbursements, home leaves, transition allowances), the company should prepare cost projections of, and accrue, for the total expected international assignment cost (including estimates of home and host country income and social tax), in cases where the employee is eligible for either tax equalization or tax protection.
Compliance: Withholding and Reporting
Global mobility has received more attention recently given that multinational companies have been focusing more on compliance-related issues. Specifically, companies often review their processes and procedures to confirm that: (i) all expatriates, extended business travelers and rotators are accounted for, (ii) the appropriate taxes (income, social taxes) are withheld from their employees’ pay and (iii) that the appropriate reporting of such pay is being conducted. More often than not, withholding and reporting problems occur when compensation is paid outside of the jurisdiction where the employee is working or there is a lack of clarity or a lack of direction to the payroll department regarding which entity is obligated to withhold on compensation and at what applicable rate. Details regarding individual participants who are working in, perhaps, dozens of jurisdictions sometimes become complex and burdensome to monitor when a large number of expatriates are on assignment or working remotely.
Notwithstanding these challenges, vigilance is paramount. Local tax authorities, based on recent audits and news accounts, have announced their intention to focus more on the activities of expatriates and their employers to ensure compliance with applicable tax withholding and reporting obligations is maintained. As local governments search for more revenue to address their fiscal budget concerns, they will look harder at this area.