Relocating employees overseas.

Tax Planning Strategies Can Result in Significant Savings for Employers and Their Employees

Employers that are relocating, or contemplating relocating, U.S. employees to foreign locations for temporary or indefinite assignments can save tax dollars for both themselves and their employees by evaluating and carrying out the available Federal state and international tax planning strategies.

The starting point for an analysis of both domestic and foreign tax issues is the type of tax reimbursement policy that will be implemented - tax protection or tax equalization. This article will compare these policies, and discuss the Federal, state and foreign tax issues and strategies to consider when structuring a relocation package.

Tax Reimbursement Policies

* Tax protection policy

Under a tax protection policy, the employer reimburses the expatriate for actual taxes paid in excess of an estimated hypothetical tax liability. The hypothetical tax is generally calculated on the employee's base salary using U.S. Federal income tax rates, allowing for individual personal exemptions and assumed itemized deductions. If actual liability is less than the hypothetical tax liability, the employee pays only the actual tax incurred in both the United States and the foreign country.

As Example 1 on page 208 shows, tax protection can constitute an incentive to the employee if the foreign location is in a low or no tax jurisdiction.

Example 1: Potential Tax Savings Under a Tax Protection Plan
Employee E, married with one dependent, is relocated to Korea
in connection
with a U.S.-Korean joint venture that is engaged in introducing
new technology. The activities of the joint venture qualify for
a five-year
tax holiday under the Korean tax and foreign investment laws.
Consequently,
E is not subject to Korean income tax on compensation earned
in Korea.
                                       U.S. tax on
                        U.S. tax per   "stay at home
                         tax return        basis"
Wages                    $ 65,000         $ 65,000
Foreign premium             6,500
Employer-provided
 housing                   40,000
Interest income             2,000            2,000
Foreign earned
 income exclusion(*)      (70,000)
Housing exclusion(*)      (31,615)
Adjusted gross
 income (AGI)              11,885           67,000
Standard deduction         (6,200)          (6,200)
Exemptions                 (7,050)          (7,050)
Taxable income             (1,365)          53,750
Tax                             0           10,253
Foreign tax                     0                0
Total tax               $       0      $    10,253
(*) Sec. 911 provides that qualifying individuals who work
abroad and receive compensation
from foreign sources may elect to exclude up to $70,000 of
foreign
income earned during their foreign residency. In addition,
qualified foreign housing
expenses over a base amount (which is adjusted annually) that
are attributable
to the period of foreign residency may qualify for exclusion.
  Under tax protection, E is obligated to pay only the tax due
with the
actual returns, in this case zero. If, on the other hand, E had
not qualified
for tax-exempt treatment, and had to pay Korean tax at the
approximate
rate of 36% on total compensation of $71,500 ($65,000 + $6,500),
the
host country (Korea) tax obligation could have reached $25,740,
considerably
higher amount than the tax that would have been incurred on
a stay at home basis.

* Tax equalization policy

Tax equalization policies are generally more popular with employers, as they are aimed at keeping employees at the same tax responsibility as if they continued to work in the United States, thus preventing one foreign assignment location from being favored over another.

Under a tax equalization policy, the employer guarantees that the employee will pay the same tax that would have been paid had the employee remained in the United States. Consequently, any tax, U.S. or foreign, that exceeds the employee's tax liability, must be borne by the employer. In Example 1, under a tax equalization policy, E's tax obligation would be fixed at $10,253, to be paid to his employer regardless of the fact that no foreign or U.S. tax was actually incurred. However, E would also be liable for only the $10,253 if the Korean tax holiday was not available. His employer would be responsible for paying the additional $15,487 of foreign tax incurred.

Federal Tax Issues

The U.S. Federal tax law issues that need to be addressed range from those that may have an impact on the employee individually to those that will ultimately affect the employer's tax burden.

* Principal residence sales

This issue encompasses two situations: (1) an employee contemplating selling his principal residence while on or before a foreign assignment, with the possibility of violating the two-year roll-over allowance (up to four years for taxpayers who have a tax home outside the United States after the date the residence is sold) or (2) a returning employee being reassigned to a new U.S. location, who is thus prevented from reoccupying a principal residence that was maintained while on assignment.

It is not uncommon for an employee's original assignment to be extended, and consequently exceed the time frame allowed in the principal residence gain rollover provisions of Sec. 1034(a) and (k). Under Sec. 1034(k), an individual who sells his principal residence in connection with an assignment outside the United States has four years to purchase or build and reoccupy a new principal residence in order to defer the gains on the sale of the first residence. If this replacement period is exceeded, the taxpayer must file an amended return reporting the gain, and pay the tax and interest on the tax owed. As interest is compounded over the four-year period, it can easily be 40%-50% of the capital gains tax.

A number of court cases have addressed the issue of reoccupancy of a principal residence. The pattern that has emerged focuses on the intent of the taxpayer to return to the first home, and whether "exceptional or unusual circumstances" prevented reoccupancy.(1) Accordingly, each case under Sec. 1034 necessitates a determination based on the particular facts and circumstances. Employers need to establish policies defining under what circumstances the employee or employer will bear the potential tax and interest costs if a replacement residence is not purchased, or relocation prevents reoccupancy of the original principal residence, within the rollover period.

* Principal residence rentals

The passive loss rules provide an exception for losses incurred on rental real estate if the taxpayer actively participates. The rental of a principal residence will usually qualify as active participation rental real estate eligible for the $25,000 passive loss allowance to the extent that rental losses are incurred.(2) As many, if not most, expatriate compensation packages will result in an AGI level that precludes the use of the $25,000 allowance, current losses will be suspended and carried forward unless the taxpayer has gains from other passive activities. This treatment may result in the full allowance of the $25,000 rental loss in the employee's tax equalization, with a lesser amount (or possibly none) of loss in the tax return.

Note that the mortgage interest incurred on a principal residence that is rented temporarily should be exempt from the passive loss limitations.(3) This will increase the rental loss that is allowed currently, and reduce that portion that must be carried forward.

Also note that the temporary rental of an individual's principal residence while on an overseas assignment should not, in most cases, change the character of the residence from a principal residence, as long as at the conclusion of the assignment the employee reoccupies or demonstrates extenuating circumstances preventing reoccupancy.(4)

* Phaseout of exemptions and deductions

Due to the added costs of an assignment, an employee's AGI may be three to five times greater than normal, triggering limitations on itemized deductions and exemptions. It is important to consider these limitations when projecting the tax liability the company may end up bearing.(5) See Example 2 on page 210.

Example 2: The Effect of Phasing Out Exemptions and Deductions
Executive E is being assigned overseas by her employer, Y. Her
filing status
is married, filing a joint return, with one dependent. She
incurred
$30,000 of itemized deductions in 1993. Her tax situation looks
as follows:
                                     U.S. tax on
                    U.S. tax per   "stay at home
                     tax return         basis"
Wages               $130,000          $130,000
Foreign premium       19,500
Foreign tax
  reimbursement       45,000
Club membership       25,000
Child's tuition       24,000
Employer-provided
 housing              80,000
Interest income        5,000             5,000
Foreign income
 exclusion           (70,000)
Housing exclusion    (71,615)
AGI                  186,885           135,000
Deductions           (27,647)          (29,203)
Exemptions            (5,640)           (7,050)
Taxable income       153,598            98,747
Tax                 $ 40,144          $ 23,140
  Y lost the benefit of $2,353 in itemized deductions and
$1,410 in
exemption deductions (for an approximate tax cost of $1,200)
due to the
limitations on these items. Because of the restrictions on
using foreign
tax credits (FTCs) associated with income that is excluded, Y
and E lose
the FTC benefit associated with the payment of the host country
taxes.
(sec, 904(a).)

* Estimated tax payments

If an employee is on a tax equalization program, the taxes withheld from the employee's paycheck are not paid directly to the IRS. The reason for this, as shown in Example 1, is that in many cases only a nominal amount of Federal tax is actually due with the U.S. tax return, due to the availability of foreign earned income and housing exclusions.

Circumstances may create a situation, however, in which the exclusions are not sufficient to absorb an employee's compensation package. This is particularly true in years when the employer adds back to the employee's income the gross-up for moving costs and foreign taxes paid. Although the employee's "stay at home" tax does not change, because taxes on these items are not borne by the employee personally, the Federal return will now show a significant balance due, with no offsetting payments through withholding or otherwise. For example, in Example 2, an underpayment penalty would have been imposed under Sec. 6654 on the tax obligation due with the Federal return. Most employers pay for penalties and interest incurred on these balances, which could have been avoided if a projection had been prepared and withholding or estimated payments made.

State Tax Issues

* State taxes

State tax implications are often overlooked by employers and employees when negotiating a compensation package, and can represent a significant cost to both employers and employees. Thought needs to be given to incorporating a state tax reimbursement system in the company's tax reimbursement plan. One of the administrative difficulties in instituting a state tax reimbursement plan is tailoring each employee's tax situation for the appropriate state. Suddenly, the human resource manager or expatriate administrator must be proficient in the tax laws of all 50 states. Including all employees under a single state tax equalization program, such as imposing a hypothetical state tax based on where the company is headquartered, negatively affects those employees from low or no income tax states. Compounding the matter also are states that incorporate a city tax into the calculation of the state tax, such as New York or Michigan.

A majority of companies opt out of a state tax reimbursement policy entirely, and leave all state tax matters including filing and payment requirements, to the individual employee. This can be costly for the employee, who must then try to take care of it personally while overseas, hire a tax accountant to handle the issue or find himself owing back taxes and penalties associated with the years he was out of the state and opted not to file or pay state tax, if it is later determined that he did not break state residency while overseas.

There are two primary distinctions in most state statutes applicable to expatriate situations: resident versus nonresident status, and residence versus domicile distinctions. Resident status usually implies that an individual has a dwelling in a particular state; domicile, on the other hand, is usually defined as the place to which the individual intends to return. An individual may have multiple residences, but only one domicile.

* Conformity with Federal tax laws

The 50 states may or may not adopt the provisions of the Federal tax laws. items that should be looked out for include:

* Conformity with Sec. 911, allowing the foreign earned income and housing exclusions. If the state does not allow these exclusions, both must be added back as adjustments in determining state AGI.

* Acceptance of Sec. 1034 two- (or four-) year rollover treatment for capital gains associated with the sale of a principal residence. If a state does not adopt Sec. 1034, capital gain tax may be incurred at the state level.

* Recognition of the Sec. 6081 automatic extension of time to file a tax return, to June 15 of the year following the tax year, for individuals residing overseas on April 15. A number of states do not allow the automatic extension, and a formal extension request must be filed to extend the due date of the state return past April 15.

* Taxability of reimbursements after the employee returns to the state.

International Tax Issues

Foreign tax considerations are an inherent aspect in planning and structuring an employee's relocation package. The following issues warrant particular attention.

* Basis of taxation

How the host country differentiates between resident and nonresident status can influence the timing of bonus payments and relocation benefits. For example, if the foreign country defines residence as domiciled and residing in the country, the prepayment of certain assignment-related compensation items before the employee physically moves to the foreign location, such as a lump-sum goods and services allowance, may help the employee escape foreign taxation in some jurisdictions. Similarly, bonus payments for performance paid after the employee has moved permanently back to the United States may also help to avoid foreign taxation.

Is worldwide income subject to foreign tax, or only income derived from sources within the foreign country? If the host country does not endorse a worldwide reporting system, a split payroll mechanism may be advantageous, as only the compensation earned in the foreign location will be subject to foreign tax. This may also have an impact on the timing of receipt or payment of the employee's other income or deduction items, e.g., a sale of rental or business property.

* Tax withholding system

The major types of income typically subject to withholding include wages, interest and dividends. Treaty provisions, if applicable, should be reviewed for possible application, to obtain a lower withholding rate or possibly an exemption from withholding.

* Filing requirements and deadlines

Foreign tax return filing due dates may have an impact on obtaining the necessary information to complete the U.S. return, particularly FTC information. Foreign countries with tax years different from the United States (e.g., the United Kingdom) may necessitate making accrual adjustments in calculating a calendar-year income for U.S. purposes. As not all foreign countries permit filing extensions for taxpayers who cannot complete their return by the original due date, it is imperative to maintain a log of foreign country filing due dates and procedures.

* Treatment of profit and pension plans

In many foreign countries, contributions to employer-sponsored qualified pension or profit-sharing plans are not considered deferred income and are subject to foreign tax currently.

* Types of income other than compensation subject to tax

Projections for purposes of forecasting an employee's potential foreign tax liability may have to incorporate significant detail about the employee's outside sources of income, such as interest, dividends, capital gains, rental income or loss.

* Calculation of taxable income

In formulating a foreign tax projection, it is important to consider what types of standard or special exemptions and deductions are allowed in calculating foreign taxable income, and to find out whether joint returns can be filed in the foreign jurisdiction, or if separate returns are required.

* Preferential treatment for assignment-related costs and reimbursements

Most countries have exclusions or exceptions for certain elements of an overseas compensation package, in order to encourage investment by offshore companies. The expatriate compensation package should be structured to maximize the benefits available in the specific foreign location - such as employer-supplied housing, cars and drivers, moving and relocation reimbursements, home leave, cost of living adjustments and hardship premiums, club dues, and maid or guard wages - rather than using a general company policy for all expatriates, wherever situated.

* Social security benefits

A totalization agreement (or international social security agreement) between the host country and the United States is designed to eliminate double social security taxation for the same employment in each country and provide coverage for individuals who will receive social security benefits from the United States or the foreign country of employment.

When a U.S. employee is transferred to work for a foreign affiliate of a U.S. company, and the foreign affiliate bears the employee's compensation costs, the employee and the company are not required to pay U.S. social security taxes. Continuation of the employee's U.S. social security contributions and benefits should be analyzed. U.S. employers may elect to extend social security benefits to expatriates who are employed by their foreign affiliates. An election under Sec. 3121 (1) is made on Form 2032, Contract Coverage Under Title II of the Social Security Act, and filed with the IRS and the Social Security Administration. Once it is made, a U.S. corporation is entitled to a tax deduction for both the employee and employer portions of the social security tax paid under the Sec. 3121(1) agreement.(6) The corporation electing a Sec. 3121(1) agreement can select which entities to include and exclude as appropriate. Note that a Sec. 3121(1) election should be carefully planned, as the election cannot be terminated.(7)

Conclusion

An analysis of the various Federal, state and international issues and related tax provisions clearly indicate; that careful planning in expatriate program design and administration can result in significant tax savings for both employers and their employees.

(1) Arthur R. Barry, TC Memo 1971-179; Richard T. Houlette, 48 TC 350 (1967); Ralph L. Trisko, 29 TC 515 (1957). See also Rev. Rul. 78-146, 1978-1 CB 260. (2) Sec. 469(i). (3) Sec. 469(j)(7). (4) Regs. Sec. 1.1034-1(c)(3)(i); Rev. Rul. 78-146, note 1. (5) Secs. 68(a); 151(d)(3). (6) SEC. 176/ (7) Sec. 3121(1)(3).