In recent years, many organizations have restructured their international businesses to operate through entities disregarded for U.S. federal income tax purposes (DEs). Although these organizational structures may provide benefits from a corporate income tax perspective, this item shows how restructuring into foreign DEs may also affect the employment tax treatment of the organization’s individual employees.
In the United States, the Federal Insurance Contributions Act tax (FICA, consisting of Social Security and Medicare tax) is imposed on wages from employment. For this purpose, employment includes services performed by an employee inside the United States, regardless of the citizenship or residence of either the employee or the employer. If services are performed outside the United States, employment subject to FICA is generally limited to services by U.S. citizens or residents as employees of an American employer.
The term “American employer” includes U.S. corporations as well as partnerships if two-thirds or more of the partners are U.S. residents. Hence, U.S. citizens and residents who work abroad for foreign corporations (including foreign subsidiaries of U.S. corporations) are generally not subject to FICA. Some employees might prefer this treatment—perhaps because the increase in retirement benefits would be minimal compared to the tax they would have to pay while working outside the United States—and others might prefer the FICA tax coverage. The focus of this item is on how a foreign DE might obtain FICA tax coverage for its employees.
Before 2009, Notice 99-6 allowed DEs to satisfy employment taxes (FICA and income tax) in one of two ways: (1) calculation, reporting, and payment by the DE’s owner, as though the employees of the DE were employed directly by the owner (branch treatment); or (2) separate calculation, reporting, and payment by each state law entity under its own name and taxpayer identification number (separate employer treatment). By choosing the branch treatment, a foreign DE of an American employer would be considered a branch of the American employer, with U.S. citizens and residents employed by the foreign DE treated as employees of the American employer, subject to FICA tax.
However, this branch treatment is no longer available. Regulations issued under Regs. Sec. 301.7701-2 (T.D. 9356), effective January 1, 2009, made Notice 99-6 obsolete. Under these regulations, a foreign DE of an American employer is required to use the separate employer approach. Treasury took this stance in the regulation because most states recognize DEs for state employment tax purposes, so recognizing DEs for federal employment tax purposes would more closely align federal and state employment tax reporting.
In the international context, the regulations cause foreign DEs to be considered separate employers. Although this does not significantly affect income tax withholding (except to shift the withholding obligation to the foreign entity), it does significantly affect the FICA tax withholding obligation, because a foreign DE does not qualify as an American employer.
The only mechanism available for extending FICA tax coverage to U.S. citizens and residents employed by foreign DEs is through a Sec. 3121(l) agreement. Sec. 3121(l) allows an American employer with a 10% or more ownership interest in a foreign affiliate to enter into an agreement with the IRS and extend FICA tax coverage to all U.S. citizens and residents employed by the foreign affiliate. For purposes of the 10% or more ownership threshold, an American employer must own directly or indirectly at least 10% of a corporation’s voting stock or, for other entities, at least a 10% profits interest. The Sec. 3121(l) agreement, which is made on Form 2032, Contract Coverage Under Title II of the Social Security Act, remains binding for subsequent years and cannot be revoked.
With these rules in mind, consider the potential consequences for employees who are U.S. citizens or residents employed outside the United States in the following three scenarios:
Scenario 1: The employees work overseas for a foreign branch operation of a U.S. subsidiary. For employment tax purposes, the U.S. subsidiary’s foreign branch is not recognized as an employer. Thus, the U.S. subsidiary should be considered the employer. As a result, the employees of the foreign branch that are U.S. citizens or residents are subject to FICA.
Scenario 2: Two of a U.S. corporation’s U.S. subsidiaries are the sole partners in a foreign partnership that employs the workers overseas. With two-thirds or more of the partners of the foreign partnership being U.S. resident corporations, the foreign partnership should meet the definition of an American employer. Thus, the employees should be covered by FICA, and a Sec. 3121(l) agreement is not necessary. Note that if the partnership were owned equally by a U.S. and a foreign corporation, the partnership would not qualify as an American employer, and the foreign partnership could enter into a Sec. 3121(l) agreement in order to provide FICA coverage to its U.S. employees.
Scenario 3: A U.S. corporation’s U.S. subsidiary owns a foreign entity that is treated as a DE that employs the workers overseas. Treatment of the foreign entity as a DE causes the entity to be disregarded for U.S. income tax purposes but not for employment tax purposes. Therefore, the foreign entity’s status as a DE causes it to be a regarded entity for U.S. employment tax purposes. The foreign entity would therefore be considered the employer with the obligation to withhold U.S. income tax for the U.S. employees. However, it would not be considered an American employer; as a result, the U.S. employees would not be subject to FICA. The U.S. parent could enter into a Sec. 3121(l) agreement to enable the U.S. employees to receive FICA tax coverage.
The foreign jurisdictions in which the employees are working may also impose social taxes without regard to U.S. taxes being imposed. If these foreign jurisdictions have entered into Social Security totalization agreements with the United States, liability for social taxes would be governed by the agreement. This would result in only U.S. or foreign social security coverage, depending upon the specific situation. In jurisdictions where a local social tax is imposed but a totalization agreement is not in effect, entering into a Sec. 3121(l) agreement with the IRS for employees of a foreign affiliate working in that jurisdiction could impose a duplicate social tax cost on both the employer and the employee, where only a single social tax cost previously existed.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.