Taxation Law (TA)

With more employers sending employees offshore to work, and with an increasing number of self-employed taxpayers crossing international borders for work, several international tax issues that were once only rarely encountered are becoming commonplace. One such area involves the application of key provisions in various totalization agreements that exist between the U.S. and several other countries.

Dual Taxation

U.S. Social Security typically applies to U.S. citizens and resident aliens employed abroad by U.S. employers as well as those engaged in self-employment activities abroad.  In addition, U.S. citizens or residents working for foreign affiliates of U.S. employers continue to be subject to U.S. social security taxes along with their employer where the U.S. employer agrees to cover those affiliate employees under Social Security through an IRC §3121(l) agreement.  Such agreements are quite common. Self-employed U.S. citizens and residents doing business offshore are generally subject to U.S. social security even if they have do not maintain business operations within the U.S. These extraterritorial applications of U.S. Social Security tax will frequently subject the employer and employee to dual tax liability for U.S. social security taxes and the similar tax in the foreign jurisdiction in which the employee works. 

Employers that send employees to work offshore can find that such dual tax liability can be very costly where the offshore employee (frequently referred to as an “expatriate” employee) is covered by their employer by a tax equalization agreement.  Under such an agreement, the employer guarantees to the employee that the offshore assignment will not result in a reduction of income on an after-tax basis.  This can result in the employer covering all of the expenses of dual tax liability for U.S. Social Security and similar foreign taxes for expatriate employees, which can be extremely costly. This problem is exacerbated by the fact that in many foreign countries, when a U.S. employer pays the employee’s share of U.S. Social Security in accordance with the tax equalization agreement, those payments constitute additional taxable income to that employee under the foreign jurisdiction’s income tax laws.

U.S. rules also typically make Social Security coverage mandatory for employee services provided in the U.S., regardless of the citizenship or residency of the employee or their employer. This will also frequently trigger dual tax liability issues for foreign employers and employees alike.

Moreover, expatriate workers may also find that while they are subject to contributions to a foreign system, they won’t ever contribute enough to that foreign system to qualify for any benefits from it, even over the course of a longer, multi-year work assignment.  Lost contributions and credits are therefore also a concern for expatriate work situations.

Dual tax liability for U.S. Social Security and similar taxes in foreign jurisdictions poses substantial compliance and cost issues for employers and employees alike absent some effort to coordinate and mitigate these issues. 

Generally, when a citizen or national of one country works in another, a totalization agreement prevents dual tax liability for U.S. social security taxes and the equivalent form of tax in the foreign country of employment. 

Common Provisions

Currently, the U.S. has the following totalization agreements in place with the following countries (according to www. ssa.gov as of January 10, 2017). Several other agreements with other nations are pending.

While a totalization agreement prevents dual tax liability for social security, such an agreement also generally prevents dual coverage under two systems.  The overarching premise of a typical totalization agreement is to ensure workers between countries will be taxed for social security by and obtain covered benefits from the county to which they have a greater attachment.  What constitutes the “greater attachment” is one item defined within the totalization agreement. 

Such agreements generally cover not only retirement benefits, but also disability and survivor benefits, too. The particular benefits covered from a foreign nation’s system will be specified in the totalization agreement with that nation (not all countries have benefits that perfectly mirror those available under U.S. rules).

Moreover, each totalization agreement has its own specific terms, definitions, and rules that the U.S. and the particular foreign country counterparty have agreed to.  While this article will discuss some common provisions, it is absolutely essential to consult the actual, applicable totalization agreement that applies to a client’s situation (because there are several provisions that differ across agreements with different countries).

One common misconception with social security and offshore work is that the employee (or self-employed person) has the ability to elect or choose which country’s system to use for the years of offshore work. To the contrary, specific terms within a typical totalization agreement will determine the country of coverage for the expatriate worker.

Territoriality and the “Detached Worker” Rule

In many of these agreements between the U.S. and other countries, one basic premise is that in order to determine which country’s system covers the worker, the worker’s location of employment is looked to. Accordingly, under this premise of territoriality, an employee who would otherwise be dually covered is deemed to be covered by the country in which they work for the period of time working in that country.

One common exception to this basic territoriality rule is the “detached worker” rule, which prevents interruption in coverage for expatriate employees (“detached workers”) covered by their home country’s system, but who are sent offshore to the other country.  Under the detached worker rule, a worker that is temporarily transferred to a foreign country to work for the same employer will continue to be covered by their home country’s social security system. While this is a common exception, not all agreements, (such as the U.S.-Italy agreement), has such an exception.

 In addition, a typical totalization agreement will place a time limit on the application of a detached worker exception, and this time limit may not be the same for each country who are counterparties to the same agreement.

Totalization agreements also typically address self-employed persons. While most of the agreements will use the worker’s country of residence as the basis for coverage, many agreements use criteria other than that of residence to determine what country’s system covers the self-employed worker.

Common Key Rules for U.S. Workers

First, a totalization agreement is typically inapplicable to the U.S citizen (agreements usually use the broader definition of “national” instead of “citizen”) when the U.S. citizen fully qualifies for U.S. social security without regard to any credits under the foreign system in which they worked. However, it is still typically worthwhile to furnish the relevant information regarding the foreign work time and credits, because if the regular (non-totalized) benefit turns out to be less than the totalized benefit (by taking into account foreign credits), the U.S. will usually pay the higher totalized amount to the taxpayer. Moreover, if the U.S. worker fully qualifies for a foreign benefit, any U.S. credit is likewise ignored.

In addition, in order for U.S. and foreign credits to be combined, the U.S. worker must have at least six quarters of coverage based on work covered by U.S. social security. Only when this minimum has been met will foreign credit be considered. A similar rule will exist for eligibility for foreign coverage (so a minimum number of foreign credits will typically be required in order for any U.S. credits to be considered if the U.S. worker applies for coverage in the foreign system under which they worked.

In addition, no quarter may receive both U.S. and foreign credit (so one or the other applies to each quarter).  Moreover, for a U.S worker that has foreign credits in more than one foreign country, their U.S. credits may only be combined with credits from only one foreign system at a time to determine eligibility for a U.S. totalized benefit.  For example, if a U.S. worker has credits under both the French and German systems, U.S. benefits will be calculated under the agreement with the country that results in the highest benefit amount. Once such eligibility has been established, no other credits from other foreign countries are considered.

In addition, each country determines eligibility for benefits under its own rules and will independently pay benefits independently.  Contrary to popular belief, there is no “pooled” totalization benefit plan among countries with totalization agreements in place.

Exemption from Coverage

The totalization agreement will specify which country’s system under which the worker will be covered. Typically, the country of coverage will be the country in which the worker is working, however, some agreements may use different rules.  For example, in the U.S. – Italy Totalization Agreement, a U.S. national working in Italy continues to be covered by U.S. social security, while an Italian national working in the U.S. continues to be covered under the Italian system.  Some agreements may even provide the worker with the ability to make certain voluntary contributions to a system, or elect which country under which they wish to receive coverage. This underscores the need to consult the specific agreement(s) that apply to the worker’s circumstances for both planning and benefit application purposes before the worker departs for the offshore work assignment.

Certificates of Coverage

However, a U.S. national who is employed or self-employed in a foreign country who is covered by both systems under the applicable agreement and who wishes to become exempt from paying into the foreign system must complete an Application for a Certificate of Coverage. (In the U.S. this is a Social Security Administration form, and a form often overlooked). Other countries have equivalent forms that are used).  This form certifies that the worker is covered by the social security system of the country that issues the certificate for the time period specified in the form itself.  For example, a U.S. worker sent to work in Germany on a temporary work assignment, who will continue to be covered by U.S. social security will require a Certificate of Coverage issued by the U.S. Social Security Administration to establish their exemption from tax under the German system. 

The Foreign workers temporarily working in the U.S. generally require a Certificate of Coverage from the social security system in their home country to establish the exemption from payment into the U.S. Social Security system as provided for in the applicable totalization agreement.

These certificates are honored by other countries as evidence of the worker’s periods of coverage and the system under which they were covered during their working careers. These forms should be retained as evidence of an exemption in case a country’s taxing authority (such as the IRS) inquires why taxes were not withheld. Each country has a “competent authority” from which such certificates are obtained.

Generally, in cases in which the worker works in either country and their work is covered by only one social security system, no certificate is necessary and the worker is obligated to pay taxes only to the system under which they are covered.

Applying for U.S. Social Security with Foreign Credits

Generally, a worker applying for totalized benefits from the U.S. Social Security Administration must file a regular application for social security benefits as well as a special application for totalized benefits. Such special applications are unique to each totalization agreement with each foreign country.  It is essential that the proper forms be filed with the Social Security Administration, because this will be the basis for eligibility determination.  Navigating through the various forms can be challenging to someone not familiar with this process.

In addition, differences may exist in conclusions reached by the two or more countries relevant to the taxpayer’s circumstances. For example, it is possible for a disability applicant to be deemed not disabled under U.S. Social Security rules, but found disabled under French law. This would likely result in the French system paying a proportionate benefit based on the disabled worker’s earnings in France, with the U.S. making no payment to the disabled worker.  Unfortunately, however, navigating the numerous U.S. Social Security forms for benefit application can prove difficult.

Calculation of totalized benefits is also complex, because various sets of rules can apply depending on the circumstances of the applicant.  A tax practitioner with experience in this area can prove immensely beneficial in providing insight on how the benefit will be calculated and determined, and provide some key planning strategies based on terms within the applicable totalization agreement(s) and Social Security regulations that impact the worker’s benefit. An experienced practitioner in this area can also ensure the proper forms are filed in order to facilitate correct contribution and credit information (both U.S. and foreign) to ensure correct benefit calculations.  

In addition, each totalization agreement includes a provision that allows for the relevant authorities to grant an exception in unusual cases where the greater attachment rule, or strict application of other rules in the totalization agreement, would result in anomalous or unfair results to the worker.

Interpreting Totalization Agreements

Not surprisingly, agreements among countries are subject to varied interpretations, with definitions and concepts that do not always superimpose themselves neatly onto a taxpayer’s particular circumstances. This can result in the need for tax practitioners to interpret the details of totalization agreements to determine how applicable terms impact a taxpayer.

Courts, too, have had to grapple with the task of interpreting applicable definitions or law necessary to make terms of a totalization agreement applicable to the taxpayer’s circumstances.  

The recent case Eshel v. Commissioner, No. 14-1215, (D.C. Cir. 2016), is illustrative of the distinctively different level of interpretive exercise involved in interpreting totalization agreements (which are, in effect, treaties among nations) from the approach used for statutes.

The U.S. and France have had a totalization agreement in place since 1987. The agreement specifies the various taxes, U.S. and French, covered within the ambit of the agreement.   At issue in Eshel were two French taxes:  Contribution Sociale Géneralisee (General Social Contribution, or CSG) and Contribution pour le Remboursement de la Dette Sociale (Contribution for the Repayment of Social Debt, or CRDS). Both of these taxes were implemented by the French government after the inception of the U.S.-French totalization agreement in 1987, so neither the CSG nor the CRDS were specifically listed in the totalization agreement as taxes or payments covered by the agreement. 

Article 2(1)(b) of the U.S.-French Totalization Agreement, which enumerates the specific “social security-type” French laws covered by the totalization agreement,  further specifies that the totalization agreement will also apply to French legislation that “amends or supplements” any of the enumerated French laws.

The court below, (the Tax Court), used a “dictionary definition” approach for “amend or supplement” to conclude that the CSG and CRDS payments were, in fact, covered by the totalization agreement, indicating that the French legislation establishing these CSG and CRDS payments amended or supplemented those French laws specified in the agreement.

This adversely impacted Mr. & Mrs. Eshel, because on their returns, they claimed CSG and CRDS amounts as part of their foreign taxes paid in connection with the foreign tax credit (FTC). However, in order for a tax to be eligible for the FTC, the tax must be an income tax with the predominant character of an income tax from a U.S. perspective, in accordance with Treas. Reg. §1.901-2(a). Taxes covered by a totalization agreement are not considered to be income taxes, and therefore, not eligible for the FTC. (For an overview of taxes that do and do not qualify for the FTC, see Treas. Reg. §1.901-2 and https://www.irs.gov/individuals/international-taxpayers/what-foreign-taxes-qualify-for-the-foreign-tax-credit).

The Tax Court’s conclusion, therefore, precluded the Eshels from claiming their CSG and CRDS payments as part of the income tax amount eligible for their FTC. The Eshels appealed. The DC Circuit Court of Appeals indicated that the Tax Court erred in using a “dictionary meaning” approach.  According to the appellate court, while this approach may have sufficed to assist with the interpretation of a U.S. statute, it was not the approach to be used with an executive agreement between nations such as a totalization agreement. The appellate court indicated the Tax Court should have referred to the text of the totalization agreement itself, and the shared understanding of the U.S. and France regarding what French laws “amended or supplemented” the list of French laws outlined within that agreement.  The appellate court cited past cases that supported this different approach to be used with executive agreements and treaties, indicating that courts have a responsibility to read such agreements in a manner consistent with the shared expectations of the contracting parties without taking a U.S. definitional approach.  The appellate court reversed the Tax Court’s holding and remanded the case to the Tax Court to revisit the totalization agreement interpretation issue in a manner consistent with the appellate court’s stated approach.

For tax practitioners with clients who are subject to totalization agreements with circumstances that do not fall very neatly or precisely within the definitions of the agreement, Eshel is instructive. The  interpretive approach indicated in Eshel (and the precedent cited therein) most certainly impacts the risks to both employee and employer within the framework of guarantees made by employer to employee under a tax equalization or tax protection agreement. It also impacts taxpayers who may be basing a foreign tax credit claim on foreign payments made that could fall under a totalization agreement and therefore should not be used as part of their FTC claim or foreign tax deduction.