Employment Tax Liabilities of Foreign Entities

Editor: Annette B. Smith, CPA

Employment Taxes

Foreign companies often send employees to the United States to conduct business. If an employee is in the United States on a temporary or transient basis, the foreign company may be reluctant to apply for an employer identification number (EIN), establish an employment tax account with the IRS, and undertake the mechanics of withholding, depositing, and reporting employment taxes.

Whether a foreign entity constitutes an employer for U.S. employment tax purposes is an important question, because the Code imposes tax liabilities and certain other obligations on an employer. Also, the determination of employee status can affect whether a foreign entity has a permanent establishment in the United States that would cause the foreign entity to be subject to U.S. tax on U.S. effectively connected income. A number of technical questions are involved in determining status as an employer for federal employment tax purposes when a foreign business sends individuals to work in the United States.

Employer Obligations

A U.S. employer generally must withhold income taxes, plus Social Security and Medicare (i.e., FICA) taxes from wages paid to an employee. Also, the employer must pay FICA and unemployment (FUTA) taxes on wages. The employer must deposit these taxes timely and, in most cases, file quarterly employment tax returns reporting the wages, income tax, and FICA taxes paid and file an annual FUTA return. The employer also must provide to the employee and file with the Social Security Administration a Form W-2, Wage and Tax Statement, showing the wages paid and taxes withheld from the employee. As a prerequisite to remitting and reporting, the employer must obtain an EIN.

Foreign Employers With Employees in the United States

These rules also apply to a foreign entity that has employees performing services in the United States, unless a statutory exception applies or these obligations have shifted to another entity. The foreign employer generally must withhold income taxes unless the employee is a nonresident alien and is present in the United States only for a short time (90 days or less) during the tax year and earns only a small amount ($3,000 or less), or unless the employee provides certain documents establishing that he or she is exempt from income taxes under a treaty.

Similarly, FICA taxes are imposed on wages paid by a foreign employer to employees working in the United States, unless the employee is a nonresident alien and working as a “detached worker” under a bilateral agreement—a “totalization agreement”—designed to prevent the application of two social tax regimes. Generally, services performed in the United States are subject to FUTA.

Common Law Employers

The touchstone for analyzing whether an entity is an employer is the common law test. The test determines whether there is an employer-employee relationship and which entity is the common law employer.

Generally, an employer-employee relationship exists when the person for which services are performed has the right to direct and control the individual who performs the services concerning the result of the work and the details and means by which that result is accomplished. The question of direction and control is key. A contract or service agreement (e.g., a secondment agreement that states the parties’ intentions about who is the employer) may provide some evidence under the common law test, but it is not determinative on that question. If the relationship of employer and employee exists, the designation or description of the relationship by the parties as anything other than that of employer and employee is immaterial.

Accordingly, the general rule is that the entity that has an employer-employee relationship with an individual (determined under common law) is the employer and thus is obligated to withhold, remit, and report employment taxes with respect to wages paid to the employee. There are, however, important exceptions to this general rule.

Statutory Employers

A broad exception exists for what commonly is called a “statutory employer.” Sec. 3401(d)(1) provides that when the common law employer is not in control of the payment of wages, the entity that does control the payment (the statutory employer) must withhold federal income taxes. Although Sec. 3401(d)(1) on its face applies only to federal income tax withholding liability, it was interpreted broadly by the U.S. Supreme Court in Otte, 419 U.S. 43 (1974), to include FICA and later by the IRS and the courts to include FUTA. Thus, if a common law employer is not in control of the payment of wages, the statutory employer, in its own name and EIN, is liable to withhold, remit, and report employment taxes with respect to wages paid to an employee.

If a U.S. entity controls the payment of wages for an employee performing services in the United States for a foreign common law employer, Sec. 3401(d)(1) and related case law allow the IRS to impose liability on the domestic entity. At the same time, that provision creates a potential basis for the foreign common law employer to assert that it is not liable for employment taxes because it is not in control of the payment of wages. This approach can work without consequence if the U.S. entity complies with withholding and reporting requirements. Otherwise, the IRS may take the position that the common law employer is liable if the domestic statutory employer fails to comply.

As a practical matter, a domestic statutory employer often pays wages, while the foreign common law employer provides some imputed income items, benefits, or payments directly to the employee. One example is a compensatory transfer of stock from a foreign common law employer directly to the employee performing services in the United States. Generally, the foreign common law employer having “control” of the transfer or payment is obligated, in its own name and EIN, to withhold, remit, and report employment taxes with respect to the noncash payment.

Designated Agents

Another broad exception to the general rule that the common law employer must withhold, remit, and report employment taxes with respect to wages paid to an employee applies when an employer appoints another entity to be its agent. Sec. 3504 allows an employer to designate an agent for purposes of withholding, remitting, and reporting federal income taxes and FICA taxes—but not FUTA taxes. For example, a foreign common law employer with employees performing services in the United States can appoint a U.S. entity as its agent.

To appoint an agent, the foreign employer provides its EIN on Form 2678, Employer/Payer Appointment of Agent, and requests the IRS to designate the domestic entity as its agent. After the IRS approves the request, the IRS will look to the domestic agent to meet the employer’s obligations for federal income taxes and FICA. However, if the agent fails to meet its obligations, the common law employer remains liable for the taxes and penalties.

One of the shortcomings of using an agent is that the designation does not apply to FUTA taxes. Thus, the foreign employer remains directly responsible for employer requirements related to FUTA taxes. In many cases, because of international agreements or other exceptions, a foreign employee performing services for a foreign employer in the United States may not be subject to income taxes and FICA taxes. However, as stated earlier, wages for services performed in the United States generally are subject to FUTA taxes.

Compliance

If a foreign entity is the common law employer, it may be able to shift some or all of its employment tax liabilities to another entity. The foreign entity, however, remains the common law employer. This distinction is important in part because whether a payment to an individual is a wage payment or is excluded from the definition of wages is determined with respect to the relationship between the individual and the common law employer, not between the individual and the statutory employer or the agent. The distinction also is important because the common law employer remains liable for employment taxes unless there is a basis for shifting liability, and, in some cases, if the taxes have not been paid, even if there is a basis for shifting liability.

Finally, the fact that a foreign employer has employees performing services in the United States affects the determination of whether the foreign entity has a permanent establishment in the United States. The appointment of an agent or the existence of a statutory employer does not alter the determination of whether the foreign entity is the common law employer for purposes of the permanent establishment determination.

EditorNotes

Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@us.pwc.com.

Unless otherwise noted, contributors are members of or associated with PwC.