In today's global economy, U.S. employers are sending workers abroad in increasing numbers. These workers commonly are referred to as expatriates or assignees. It is a trend that helps spread technical expertise throughout an organization, while simultaneously inspiring creativity and innovation. With proper planning, the transition abroad can be beneficial to both the employer and the assignee. Without proper planning, it can be a disaster. Though not a complete road map, the following is a basic overview of what one would want to know when advising clients prior to foreign work assignments.
The Basics
An understanding of how expatriates, or expats, are taxed is necessary before one can properly plan for an assignment abroad. In short, U.S. citizens are taxed on their worldwide income by the United States, regardless of their residency or the income's source. This means that a U.S. employee's income could potentially be subject to double taxation, in both foreign and U.S. jurisdictions. It seems a bit unfair, right? Well, fortunately, the U.S. government is not completely heartless. Relief is available in many cases. For foreign earned income, an expat can claim either a Sec. 901 foreign tax credit, an itemized deduction for foreign taxes paid, or a Sec. 911 exclusion.
Foreign Earned Income Exclusion
A U.S. taxpayer may exclude up to $100,800 of foreign earned income in 2015 (adjusted for inflation annually) as well as a housing allowance if he or she maintains a tax home in a foreign country and qualifies via either (1) a bona fide residencetest or (2) a foreign physical presencetest (Secs. 911(a) and (b)(2)).
- Bona fide residence test: A taxpayer who is a citizen of the United States satisfies this test if the taxpayer establishes to the IRS's satisfaction that he or she was a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year. Temporary visits to the United States or elsewhere for vacation or business do not necessarily prevent a taxpayer from establishing a bona fide foreign residence for a continuous period. The expat cannot qualify under this test if he or she submits a statement to the foreign country stating that he or she is not a resident of that country and is held by that country to not be subject to income tax in that country (Secs. 911(d)(5)(A) and (B)).
- Foreign physical presence test: A taxpayer that is a citizen or resident of the United States meets this test if he or she is present in one or more foreign countries (not the United States) during at least 330 "full" days in any given 12-month period (Sec. 911(d)(1)). These days need not be consecutive, which allows for potential partial exclusions when assignments begin in the middle of the calendar year. Also, notice that not all time needs to be spent in the country in which the taxpayer is claiming to have a tax home and not all time needs to be spent doing business. Personal and vacation time count. This test does not require that the taxpayer's income be subject to foreign income tax. Good records substantiating time spent outside the United States are a necessity, however.
If claiming the exclusion, the taxpayer will need to file Form 2555, Foreign Earned Income. U.S. citizens living abroad are allowed an automatic two-month extension until June 15 to file their individual tax returns. This extra time may be needed to properly substantiate certain claims for relief mentioned above. If needed, a U.S. citizen living abroad may apply for an additional extension.
Foreign Tax Credit
U.S. citizens are entitled to a foreign tax credit for income taxes paid or accrued to a foreign country. Though it sounds simple enough, this calculation can be complex in certain situations. Sec. 904 limits the credit by the amount of U.S. tax that is levied on the same amount of income. Sec. 901(j) can cause the credit to be denied entirely if the income earned is from a country whose government the United States (1) does not formally recognize; (2) has severed diplomatic relations with; (3) has not severed diplomatic relations with but with which it does not conduct relations; or (4) has designated as repeatedly supporting acts of international terrorism. Any excess foreign taxes not credited in the current year can be carried back one year and forward 10 years (or just forward 10, if elected) per Sec. 904(c).
Previously, if these tax credit amounts were unused, they could be converted into a deduction in the 10th year. The IRS recently changed its position regarding the 10th-year deduction, so CPAs can no longer rely on the safety net of converting a credit to a deduction in the final year (see Ward, "Foreign Tax Credit: When Is It Too Late to Change Your Mind?" 46 The Tax Adviser 662 (September 2015), where the author writes, "As evidenced by the recent reliance on this position in CCA 201330031 and CCA 201517005, it appears the IRS is holding firm in denying the 10-year period of limitation to taxpayers amending to change elections to claim credits for foreign taxes to elections to claim deductions."). Basically, if a taxpayer can reasonably predict that the expat will be in an excess credit position, the deduction might be the better way to go from the beginning. Foreign tax deductions can still be turned into foreign tax credits, but not the other way around.
It is also worth mentioning that U.S. individuals cannot claim a foreign tax credit for otherwise creditable foreign taxes attributable to income that they elect to exclude from gross income as foreign earned income (Sec. 911(d)(6)). In other words, a taxpayer can get either the exclusion or the credit, but not both. In practice, both are often calculated to see which provides the higher tax benefit for the particular situation.
It sounds simple enough, but it is hardly ever that simple.
A number of things might occur. One aspect that often is not considered is how the taxpayer's home state treats his or her assignment abroad. Practitioners should determine to what extent the relevant state law considers a taxpayer stationed abroad to still be a state resident and subject to state income tax. Most states do not follow federal law in terms of double-taxation relief, i.e., foreign tax credit or exclusion. The state might offer some sort of relief, however, but sometimes it is not much. For example, an Oregon resident is allowed to take a foreign tax deduction up to $3,000, but it phases out at higher income levels. On the other hand, Oregon nonresidents may exclude the foreign earned income.
Depending on the company policy (discussed later), sometimes the employer or the foreign company "gross-up" payments and pay the foreign tax on the expat's behalf. These gross-ups are income to the employee, which can increase the amount of taxes owed in the United States and the home state, making any withholding on the U.S. side insufficient, ultimately causing the employee to fork over some extra cash unexpectedly at the filing deadline. Remember that the entire tax liability is due at the original filing deadline for the return, April 15, not the extended date of June 15. In addition to taxes paid on the assignee's behalf, other items must be considered as well. Compensation packages for foreign assignments often have many additional allowances or income items.
The tax rate in the foreign country compared with the U.S. tax rate also makes a difference. For instance, a higher foreign tax rate means that it costs the employee more to work in the foreign jurisdiction, which is a benefit to the employer. Conversely, if the foreign tax rates are lower, the employee receives a benefit. Basically, the arrangement is not always considered fair.
Structure of the Foreign Assignment
Because of all the possibilities that can occur as a result of an expat's foreign assignment, it is imperative that planning occur well before the assignment begins. A few things should happen.
First, the employer should work with a service provider to develop an expatriate employee policy, often referred to as a global policy. This policy may touch on a variety of items, including, but not limited to, automobile policies, cultural orientation programs, pet policies, emergency and security planning, and, of course, the payment for and preparation of foreign, federal, and state taxes.
As mentioned previously, there is often a disparity between an assignee's U.S. tax liability and foreign tax liability. Employers can choose to handle this disparity in one of three ways:
1. Equalization,
2. Protection, or
3. Laissez-faire.
Equalization: If a company decides to enact an equalization policy, both the employer and the employee are no better or no worse for having participated in the overseas assignment. In other words, the policy is tax-neutral.
If a "hypothetical tax" exceeds the actual tax as filed on the assignee's U.S. tax returns, the assignee would owe the employer the difference. If the actual tax exceeds the hypothetical tax, the employer would reimburse the assignee for the difference.
The mechanics work as follows: After the tax return is filed, the hypothetical tax is figured considering only income and deduction items that the assignee would have incurred had he or she stayed in the United States. The hypothetical tax is then compared with the actual tax liability per the tax return plus any hypothetical withholding. Hypothetical withholding is withholding in addition to regular withholding that the employer holds on to so that in the event that the hypothetical liability exceeds the actual liability, the assignee does not have to settle the entire liability.
Some common questions should be kept in mind when reviewing an equalization policy. How are state taxes handled? If an assignee decides to sell his or her home as a result of the foreign assignment, is this factored in? Is all of the income equalized? Or is it just the employment income?
Protection: If a company enacts a tax-protection policy, the employer makes certain the employee bears no adverse effects from the foreign tax assignment.
When the hypothetical tax exceeds the actual tax, the employee retains the benefit and is not required to reimburse the employer the difference; when the actual tax exceeds the hypothetical tax, the employer will reimburse the assignee.
The actual calculation of tax under a tax-protection policy is a bit simpler in that there generally is no hypothetical withholding. All taxes are paid directly by the assignee. The employer will square up later.
Laissez-faire: This policy is just as it sounds—let the cards lie where they fall. A lot of smaller companies will typically go this route. Implementation of both equalization and protection policies can be time-consuming and expensive.
Structuring a Compensation Package
After the employer settles on a global policy, both the employer and the prospective assignee should sit down with the service provider to structure a compensation package that is both tax-efficient and fair. At this time, the employer and the service provider should explain to the assignee how he or she will be taxed and what to expect as far as services are concerned. These packages are generally much more complex than regular domestic compensation and usually cost employers two to three times more. They usually consist of a base salary and various other allowances, depending on the location of the foreign assignment.
The more common allowances are cost-of-living adjustments (COLAs), housing allowances, and moving allowances.
The COLA allows an expat to live off the same level of income that he or she would have had in the United States. The adjustment is calculated based on the employee's spendable income multiplied by a cost-of-living index. This income is taxable to the assignee.
Housing can be tricky. If the employee receives a cash allowance, it is generally taxable. Generally, the allowance is calculated by subtracting the amount of home country housing costs from the amount it would cost the expat in the foreign country. Sometimes expats are required to live on the employer's property as an unavoidable working condition. When this is the case, the housing is considered a tax-free fringe benefit.
Most of the time, employers will cover an assignee's moving expenses. This either comes in the form of an allowance or reimbursement upon submittal of expenses. This benefit is also taxable.
The benefits received vary by country. Special attention should be paid to the following countries: Iraq, Kuwait, Lebanon, Libya, Qatar, Saudi Arabia, Syria, United Arab Emirates, and the Republic of Yemen. These countries are specifically listed as boycott countries by Treasury under Sec. 999(a)(3). If an expat takes an assignment in one of these countries, he or she will have to file a Form 5713, International Boycott Report.
Lastly, although this topic probably deserves its own article, prior to the assignment, the company should make sure that it has a solid payroll strategy in place. For less-sophisticated organizations with limited personnel, hiring an outside payroll professional is recommended. Larger companies with a strong internal foreign tax department may be able to handle the payroll function internally. Consultation with a professional is needed in either case.
Planning for foreign work assignments can be time-consuming and requires expert knowledge, but it is necessary to ensure all the relevant tax issues are considered in advance. Only then can both the employer and the expat benefit fully from the experience.
EditorNotes
Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300781-407-0300 or mkoppel@gggcpas.com.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
