Tax planning for expatriates.

Additional services can be provided to corporate clients who send employees overseas to work. A tax adviser can offer planning for expatriates to minimize the additional taxes to be incurred by an international work assignment. This article describes some of the planning and compliance issues for employers and employees.

Practitioners have many opportunities to provide a full spectrum of individual international tax services to their corporate clients with international operations. These services can include planning, compliance and assistance in mitigating the additional tax costs that employees generally incur during offshore assignments. Such work is tailor-made for an outside qualified practitioner. Companies generally do not have the internal expertise to handle the myriad complex issues. In addition, the tax adviser can serve as a third-party referee or arbitrator between the employer and employee.

Tax Equalization 

Companies that send employees overseas ("expatriates") typically pay them certain benefits to assist with the additional costs that they may incur, such as housing, cost-of-living differentials, English-language school tuition, etc. Such benefits generally constitute taxable income and, thus, increase an expatriate's tax burden.

Expatriates can also incur additional tax burdens if a work assignment is in a country with higher tax rates than in the U.S. Many European countries, for example, impose tax rates substantially higher than U.S. tax rates.

Which party--the employee or employer--is responsible for paying these additional costs? Tax "equalization" is a voluntary system that can provide the solution. It provides a framework for the employee and employer to pay their respective shares of the employee's global tax burden.

In its simplest incarnation, a tax equalization program is a zero-based system that can provide that the expatriate will pay neither less nor more tax while on assignment than he would incur if he remained in his home state.

Advantages

A clear advantage of a zero-based equalization program is simplicity. An employee will have little trouble understanding such an easy concept, and is generally reassured that there will be no tax "penalty" as a result of the international assignment.

Another advantage is fairness. If an employer sends different employees to high-tax and low-tax jurisdictions, a zero-based program ensures that both employees receive equal tax treatment. An employee neither benefits nor is burdened by the offshore assignment.

Finally, a zero-based program actually presents an opportunity for an expatriate to help pay for the overseas assignment. Many states allow expatriates to terminate their residence for tax purposes while on assignment. Accordingly, the non-state-resident expatriate will not be subject to state tax on worldwide income. The state tax burden will be limited to state-source income only, such as wages associated with work performed in the state. Accordingly, an expatriate equalized under a zero-based plan will pay state tax (to the company) as if he remained in his home state, but the actual liability reported on his state tax returns while on assignment will be limited or zero. The excess of the state tax paid by the expatriate over the actual state tax liability can be used by the company to help pay for the assignment's costs.

Disadvantages

A potential disadvantage of a zero-based program is the cost to the employer, particularly when the expatriate is sent to a high-tax-rate country. However, if a potential expatriate is fully informed before accepting an assignment, he is unlikely to accept it if he will have to shoulder the higher tax rate burden alone.

Another potential disadvantage of a zero-based equalization program is that the company's cost exposure is likely to be high if the employee incurs a high level of "personal" taxable income while on assignment.

For example, if an expatriate earns substantial stock option income while on assignment in a high-tax country (e.g., Italy or Japan), the employer would be responsible for a significant tax liability under a zero-based program. This exposure can be limited by imposing a fixed annual amount of "personal" income covered by the tax equalization program.

Some employers do limit this exposure by imposing a fixed annual limit on "personal" income (including stock option income) covered by the tax equalization program. Such a limit, of course, could be deleterious to a company's ability to attract employees with substantial personal income to overseas assignments.

Mechanics

Once an employer decides on the general provisions of a tax equalization program, they must be implemented. The following steps are usually required:

Computation of estimated hypothetical tax liability: Before leaving for the overseas assignment, the employee's stay-at-home "hypothetical" tax liability should be computed; this will hinge on the provisions of the equalization policy. If the equalization program is zero-based, the hypothetical tax will equal the Federal and state tax liabilities computed on the employee's wage and personal income and itemized deductions. No assignment-related compensation (such as housing or cost-of-living allowances) should be included in the computation. The per-period hypothetical withholding should be determined by dividing the remaining hypothetical tax liability by the year's remaining pay periods.

Replacement of income tax withholding: Once the assignment begins, the expatriate's Federal and state income tax withholding is generally suspended and replaced by per-period hypothetical withholding. Hypothetical withholding is retained by the company for later use for the payment of the expatriate's worldwide tax liabilities. The hypothetical tax withheld by the company is not transmitted to tax agencies.

Return preparation: After year-end, the expatriate's actual U.S., state and foreign (host) country tax returns should be prepared. It is vital that the host country tax return be prepared by a qualified practitioner in the host country. The foreign practitioner should be familiar with the host country laws applicable to expatriates. The host country tax liabilities should be paid by the employer with the hypothetical tax funds withheld from the expatriate. In many cases, the tax withheld will not be adequate to cover the foreign tax liabilities.

One way of locating qualified foreign tax advisers is by joining worldwide accounting firm organizations. Referrals from other practitioners or from attorneys is an additional way.

Tax equalization computation: The final Federal and state hypothetical tax liability should be computed using final year-end figures. Like the estimated hypothetical tax liability computation discussed above, the final hypothetical computation is based on the employee's income subject to tax equalization. Generally, the hypothetical tax liability computation does not include assignment-related compensation (e.g., housing, cost-of-living allowances, etc.).

The final hypothetical tax liability should be compared to the total tax paid by the expatriate during the year. If the expatriate has paid, through withholding, more hypothetical tax than the final computed hypothetical tax, the employer should refund the employee the difference. Conversely, if the employee has paid too little hypothetical tax through withholding, he will owe additional tax to the employer.

The total worldwide actual tax liabilities reflected on the tax returns should be compared to the final hypothetical tax. Any excess of actual Federal, state and host country tax liabilities over the final hypothetical tax represents income to the expatriate (because the expatriate has paid the final hypothetical tax, and the employer has paid the excess for him).

The income represented by the excess of actual-over-hypothetical tax liabilities in year X should be included in the payroll of the expatriate in year X + 1. This is because the income amount cannot accurately be determined in year X, as the tax returns have not been prepared during that year.

The host country will likely impose tax on this income. Additionally, the employer will be responsible for this tax in a zero-based program.

Computation of tax gross-up: In the year following the year the expatriate returns to the U.S. from the assignment, it is generally necessary to compute a "gross-up." A gross-up will be needed if the expatriate's actual tax liabilities in the repatriation year exceeded hypothetical tax liabilities and, thus, resulted in the inclusion of equalization income in payroll for the year after repatriation.

The gross-up computation determines the Federal, state and payroll taxes on the equalization income included in the employee's payroll. Generally, the employer is responsible for paying these liabilities.

Every dollar of tax paid by the employer in this context also represents income to the employee; thus, the employer has to pay tax on this tax. Accordingly, the gross-up computation should be made algebraically.

If an employee has a foreign tax credit (FTC) carryforward as a result of the assignment, the Federal tax gross-up should be reduced accordingly. The equalization income is foreign-source for FTC purposes.

Payroll

As the above discussion indicates, control over the expatriate's payroll matters is vital. Accordingly, in general, a U.S. expatriate should not be placed on the payroll of the foreign affiliate at which he is working. Additionally, by remaining on the U.S. payroll, the expatriate continues to be eligible to participate in the U.S. company's benefit plans (e.g., Sec. 401(k) plans). A U.S. expatriate who remains on a U.S. payroll continues to accrue benefits under the Social Security system.

A potential disadvantage of keeping an expatriate on the U.S. operating/ parent entity's payroll system is that the company could be exposed to corporate income tax in the host country if it is deemed to have a "permanent establishment" (PE) there. This issue is most important when an expatriate is sent to a country that does not have a tax treaty with the U.S. and/or in which the company does not already have a taxable presence (e.g., through a subsidiary). This PE exposure can generally be mitigated--if necessary--by paying the expatriate from an intermediate (U.S.) entity that insulates the U.S. operating/parent entity from the host country.

Planning and Compliance

Residence and Year of U.S. Entry

Practitioners may have the opportunity to provide tax compliance services to individuals who move to the U.S. ("foreign nationals"). There are at least nine different ways to prepare a return in the year of entry into the U.S. In many cases, there is a significant difference in the computed tax liabilities between the various alternatives, which include the optional use of elections and treaty provisions. Practitioners should be versed in these alternatives so as to minimize foreign nationals' tax liabilities.

Filing responsibilities: Although most countries tax based on residence and/or source of income, U.S. citizens and "green card" holders remain subject to U.S. tax even when outside of the U.S. for extended periods. The U.S. is unique among most countries in this respect. Accordingly, annual U.S. tax filings are required, even if they reflect no liability.

In addition, it is vital to explain to expatriates that "where the salary comes from" generally has no bearing on which country has the right to tax the income. This rule applies to U.S. citizens abroad and to foreign nationals in the U.S. A very common mistake is the assumption that there are no return filing responsibilities in the country in which services are rendered, because the associated remuneration is paid from an entity in a different country.

Foreign home sales: Individuals who sell residences in foreign countries while working in the U.S. present practitioners with unusual challenges. The computation of gain and loss differs depending on whether the foreign residence has been used as a rental property; currency-related gains or losses are possible.

In addition, when a foreign residence has a mortgage, under U.S. law, it is common to experience a "foreign currency mortgage gain" on the dwelling's sale. An inequitable net result can be a nondeductible loss on the sale of the physical dwelling and a taxable "gain" on the foreign mortgage repayment.

Pre-immigration planning for foreign nationals: Because the U.S. treats income differently from some other countries, pre-immigration planning can be crucial.

* Asset transits (gifting): Once domiciled in the U.S., a foreign national will be subject to U.S. transfer tax rules and the associated limits on transferring wealth to children and grandchildren. Accordingly, alien clients with plans to immigrate to the U.S. should be advised to transfer assets before the move, especially given the punitively high U.S. transfer (estate) tax rates.

* Income recognition: Many countries do not tax certain categories of income, such as capital gain. Additionally, the tax rates in many (especially Asian) countries are significantly lower than combined U.S. and state tax rates. Accordingly, foreign nationals should, when beneficial, recognize appropriate categories of income before establishing residence in the U.S.

Conclusion

The globalization of the operations of multinational entities (which is likely to accelerate, rather than recede) represents a unique opportunity for tax practitioners to provide interesting, value-added services to clients (and potential clients). Practitioners who avoid international tax issues entirely risk suffering an erosion in their practices, as more and more of their clients go offshore.

EXECUTIVE SUMMARY

* A zero-based program presents an opportunity for an expatriate to help pay for his overseas assignment.

* Some employers impose an annual limit on personal income eligible for tax equalization.

* Hypothetical tax withheld by an employer is not transmitted to tax agencies.

For more information about this article, contact Andrew M. Mattson, a member of the AICPA International Taxation Technical Resource Panel, at [phone] or [e-mail]