With the strengthening U.S. economy, tax planning and reporting is on the rise for companies who have employees working outside the U.S. for an extended period of time. The typical scenario is a U.S. citizen-employee of a U.S. parent corporation who is transferred to work for a foreign subsidiary.
The tax ramifications are complex, largely because the U.S. citizen-employee generally becomes subject to taxation in the foreign country while still being subject to U.S. taxation at the same time. Such employees who work outside the U.S. for more than one year are usually referred to as “expatriates” (though the term in this context is entirely different than the “covered expatriate” who relinquishes citizenship and may become subject to the IRC §877A “mark-to-market” rules and related provisions).
The expatriate employee is still subject to the U.S. tax requirement to report worldwide income but will typically become subject to the foreign jurisdiction’s tax regime because of attaining resident status under the foreign jurisdiction’s tax laws or having income sourced from that jurisdiction.
Many employers with experience in sending employees to foreign work destinations have an expatriate plan or program in place that provides a package of additional benefits to the employee, such as allowances, reimbursements, other special payments, counseling, moving and relocation services and other such benefits. These payments are generally considered taxable compensation, but there may be some excludible amounts, such as business expense reimbursements or certain moving costs borne by the employer. It is necessary to thoroughly analyze these other sources of income from a corporate plan or program to ascertain whether these payments are taxable or excludible from income.
From employer to employer and plan to plan, these types of expenses are administered very differently, and tax practitioners should not depend upon how these amounts appear on the expatriate’s Form W-2. Note that the W-2 may also not include amounts that actually need to be reported for U.S. tax purposes.
Frequently, as part of this package, the employer will provide a guarantee to the employee that his or her acceptance of the foreign work assignment will be “tax neutral,” and that employee will pay the same amount of tax liability for the year working in the foreign location as he or she would if he or she remained in the U.S.
Such plans vary widely among employers but generally take the form of either a tax equalization plan or a tax protection plan.
Tax Equalization Policies
Expatriate employees are subject to U.S. worldwide income reporting requirements during their foreign work assignment. Most frequently, employees’ tax liabilities will be either higher or lower than i if they had remained in the U.S.
The underlying theory behind a tax equalization policy is to ensure the employee experiences neither a tax benefit nor detriment from accepting the foreign work assignment.
Under a typical tax equalization policy, the employee pays the employer the U.S. amount of income tax liability through hypothetical withholding tax on his or her compensation, just as if the employee remained in the U.S. Arriving at an accurate amount of hypothetical withholding means reviewing all of the relevant aspects of the employee’s tax changes (many of which have been mentioned earlier), including some nonrecurring items that will exist in the year of transfer. How any foreign tax payments will be made to cover the employee’s foreign tax liability and the required timing of those payments, are key focal points of the equalization policy. From the employee’s perspective, payment of the foreign tax liability by the employer may constitute additional income under U.S. and perhaps foreign tax rules. Accordingly, the mechanics of the tax payment process and amounts involved are important focal points.
Moreover, equalization policy terms vary widely among employers and industries. Employers generally like to standardize tax assumptions or formulas because it streamlines these equalization procedures for all employees sent to foreign work locations. More appropriate amounts are often negotiated if these standard amounts or formulas are substantially different than what those amounts would actually be for a particular employee if the employee had stayed in the U.S..
There are several other factors to be considered in determining an accurate hypothetical withholding amount, subject to any mandatory formulas or amounts in the equalization policy, including the following:
- The relevant tax laws and rates of the foreign jurisdiction to which the employee will be subject and whether this liability will be higher or lower than the employee’s “pure” U.S. tax liability had the employee remained in the U.S.;
- The amount of any Foreign Earned Income Exclusion, Foreign Housing Exclusion, and Foreign Tax Credit that the employee will qualify for under the U.S. tax rules for these items; and
- Applicability of any special provisions found in a tax treaty that may exist between the U.S. and the country to which the employee is relocating.
Generally, after expatriate employees file their U.S. tax returns, the tax equalization calculation is prepared. In essence, this is the notional “U.S.-tax-only” return prepared for the employees to calculate what the employees’ tax liability would have been had they remained in the U.S. for the tax year. It should take into account only those income and expense items that would have occurred had the employees stayed in the U.S. for the year and been subject only to U.S. tax law. This equalization amount is compared to the employees’ actual overall tax liability in both the U.S. and foreign jurisdiction plus the hypothetical withholding amounts paid to the employer during the year. This comparison results in a settlement for the year with either an amount owing to or from the expatriate employees under the terms of the equalization policy. The intended result is an employee who finishes the year with a total combined foreign and U.S. tax liability that is no greater than the “pure” U.S.-only tax liability that would have been incurred had those employees remained in the U.S.
When advising employees in connection with their participation in an employer’s tax equalization policy, several complex tax and timing questions are relevant. Some of these are as follows:
- How are the various expatriate-specific payments (such as housing allowances, hardship payments, reimbursements, or additional compensation) treated for tax purposes and does the employer equalize tax on these additional benefits?
- Does the equalization policy provide for equalization of state income taxes?
- How will a formula in the equalization policy, such as that for itemized deductions, affect the tax picture of the employee if a home is sold or rented?
- What terms of the equalization policy may be negotiated with the employer to arrive at a more “tax neutral” picture for the employee?
- How will the employee pay for the tax liability in the foreign jurisdiction? Will the employer remit tax payments, or will the employee calculate and remit appropriate tax installments to foreign tax authorities? What are the tax installment rules of the foreign jurisdiction, and when must payments be made in order to avoid interest, penalties or other additional tax costs? How will this impact the employee’s disposable income during the work assignment?
- Who will take responsibility for items such as the acquisition of a tax identification number in the foreign jurisdiction, the preparation of the foreign return(s) required and other U.S. tax compliance requirements (including foreign asset disclosure compliance) that may arise for the employee?
Once the expatriate completes the foreign work assignment and returns home to the U.S., it is typical for the employer to continue to pay various expenses under the expatriate plan, such as any remaining tax payments to the foreign jurisdiction (if the employer is making those payments), tax equalization settlement payments and other payments as agreed in the expatriate plan. Generally, these payments will be considered taxable income.
However, at some point, the employer will cease addressing these payments under the equalization policy and instead, will simply gross up these amounts to compensate the employee for the amount of U.S. tax liability on these items. It is important to determine when the employer begins the gross up process (and terminates use of the tax equalization policy) under the terms of the equalization policy and how the employer arrives at the amount of gross up on these final amounts attributable to the completion of the foreign work assignment.
Tax Protection Policy
An employer may instead offer a tax protection policy, which addresses the employee’s tax situation in a different manner. Typically, in this arrangement, there is no hypothetical tax withholding by the employer. Employees pay required U.S. and foreign taxes during their foreign work assignment. After the employee files foreign and U.S. returns, a tax protection calculation is made and if the actual taxes paid by the employee are greater than what the employee would have paid, the employer will pay the employee the difference. This ensures that the employee is not “out of pocket” with respect to increased tax liability for taking on the foreign work assignment. In addition, if an overall reduction in worldwide tax liability exists from the foreign assignment, the employee retains that benefit.
While this type of policy is typically easier for the employer to administer, it requires substantial planning and forecasting for the employee, who will not have the benefits of provisions in a typical tax equalization policy while offshore. A tax protection policy can result in significant unanticipated tax liabilities without proper planning and relevant negotiation with the employer.
Conclusion
It is essential for employees receiving longer-term foreign work assignments to obtain tax advice from a tax practitioner knowledgeable with the intricate and highly unique tax and related issues in this area. This includes familiarity with relevant foreign tax systems, tax treaties and various aspects of U.S. tax law, including foreign tax credit limits, income and housing exclusions and the interaction of foreign and U.S. tax laws. If you have any questions, please contact us here.
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Marc Lovell, JD, LLM, is a Director in the Tax Group. He can be reached at 617.761.0520 or MLovell@cbiztofias.com.