Tax Strategies for International Assignments: Minimizing Worldwide Costs for U.S. Expatriates by Ann Truett

Ann Truett serves as Of Counsel in the Greenberg Traurig Boston Office. She frequently works with the Business Immigration Group. She works with companies and individuals to limit the global tax impact of international assignments. In this first of two articles, Ann focuses on minimizing worldwide costs for U.S. citizens working outside the United States. In the second article, she will address key pre-immigration tax strategies for foreign nationals entering the United States.

International assignments bring a whole new level of complexity to human resource decisions. Strategic goals must be weighed against financial considerations prior to sending an employee abroad. On average, the employer’s cost of sending an employee on an international assignment is three to five times his or her U.S. compensation. Therefore, tax planning is an important factor when structuring the assignee’s compensation package.

The reason for high tax costs is twofold. First, the foreign tax rates are often higher than they are in the U.S. (the income and social tax rates combined can exceed 70%). Second, as both an enticement to employees and to keep them "whole", compensation packages are expanded. Incentive allowances can include a foreign service premium or bonus, a mobility premium, and hardship or danger pay. Balance sheet allowances to keep employees "whole" can include a housing differential, a cost of living allowance (also known as either "COLA" or a goods and services allowance), relocation costs, tax reimbursements, education expenses, a spouse allowance, home leave, automobile expenses, and fitness/recreation expenses. These may be taxable both in the U.S. and in the foreign country. Both the added incentives and the taxes paid by the company are included in taxable income, often in the home and host countries. This has a pyramiding effect: the taxes increase the taxable income which increase the taxes. As a result, tax reimbursement can become the most costly element of a relocation package.

Tax planning cannot be done in a vacuum. The tax techniques to follow cannot be considered without also evaluating their effects for the corporation. For example, in determining the most tax effective duration of a foreign assignment, one must consider the purpose of the assignment. Although it can be most tax effective to limit a foreign assignment to six months in a treaty country, the additional costs of a longer assignment may be dwarfed by the long-term financial gains to the corporation.

This article addresses the U.S. expatriate assignment, although the strategies listed here can be applied to most international assignments.

Most tax reimbursement policies are designed to ensure that the assignee will not have to pay combined U.S. and foreign country taxes in excess of the tax that would have been owed had the assignee remained in the U.S. ("hypothetical tax").

Under a tax protection plan, the company reimburses the assignee for any taxes in excess of the hypothetical tax. In practice, the assignee pays both the U.S. and foreign taxes and requests a refund. If the assignment is in a foreign country where there are no taxes, such as Saudi Arabia, the assignee may get a windfall.

Under tax equalization, the company generally pays the assignees’ actual U.S. and foreign taxes and withholds the hypothetical tax from salary. The purpose of tax equalization is to keep the assignee "whole". The company, not the assignee, realizes any tax savings. The majority of companies that adopt tax reimbursement use this method.

Tax Strategies

Tax planning for foreign assignments requires a careful analysis of each transfer to determine which techniques work best in each country. The strategies outlined below should be reviewed in every situation to determine whether savings opportunities might result.

In conjunction with the evaluation of each of the following techniques, cost projections should be prepared so that management can evaluate the impact of alternative salary packages on local tax liabilities and restructure the terms to reflect the most effective tax planning alternative. It is essential to consider the relevant tax issues prior to finalizing the compensation package.

Determining the Assignment Period

Strategic planning of the arrival and departure dates can result in significant tax savings. This can be achieved in a number of complimentary ways. First, most industrialized countries such as the U.S., have progressive tax rates, and by effectively splitting income between two countries, one can take advantage of the lower tier tax rates in both. Savings can be maximized if the assignee spends half of each tax year in each country. In addition, a short delay in the transfer date may be the difference in qualifying for the generally lower non-resident tax rate. Another reason to avoid tax residency is that residents are generally taxed on worldwide income, while non-residents are taxed only on income generated in that country. However, being non-resident is not always an advantage. Tax residents in Venezuela, for example, are taxed at progressive rates between 6 and 34%. Credits and deductions are allowed. Non-residents are taxed at a flat 34%. No credits and deductions are allowed.

Second, the internal tax rules of the home and host countries should be reviewed for potential tax benefits. For example, in the United States, a foreign earned income exclusion ($80,000 in 2002) and certain exclusions for foreign housing costs are available for all expatriates who meet either the physical presence test or the bona fide residence test. To satisfy the physical presence test, the employee must be outside of the United States for 330 days during a consecutive twelve-month period. The bona fide residence test requires that the employee be a bone fide resident of a foreign country for a period which includes one entire calendar year.

Several countries include tax provisions that exempt income earned by expatriates during certain time periods. For example, Hong Kong does not tax income earned by an employee, if they are present in Hong Kong for less than 60 days during the tax year. In Japan, an inhabitant’s tax of up to 15% is levied on all individuals who are a resident of Japan on January 1 of the following year. This would be avoided if an employee leaves Japan prior to January 1. It is important to revisit the special treatment provisions for expatriates to keep pace with the ever-changing tax laws worldwide.

Timing of Payments

Payments can be shifted from a resident period and possibly higher tax rates to a lower, non-resident tax rate period, or even shifted outside of the host tax jurisdiction entirely. Typically, this requires the company to accelerate or defer income (such as bonuses) to a pre- or post-assignment year. If a payment is made prior to or subsequent to the assignment, it should relate to services performed outside the host country, so that it may possibly avoid foreign taxation. It is important to note that, in general, income earned in a country will be taxed by that country, regardless of where it is paid.

Special attention should be paid to timing for assignments to certain countries such as the United Kingdom, Australia and Hong Kong (where the tax years end on April 5, June 30 and March 31, respectively).

An important timing issue relates to stock options. Countries may impose tax at grant, vesting or exercise of the option and/or upon sale of the underlying stock. A U.S. expatriate may be taxed on the same options in the Netherlands at vesting and in the U.S. upon exercise. If the company is obligated to pay all additional taxes under tax reimbursement, the results can be catastrophic. The highest German tax court recently issued a ruling making it clear that expatriates will be subject to German tax upon exercise of a stock option based on the time between grant and exercise that the individual was a German resident, regardless of resident status at grant or exercise. As such, expatriates are now required to report stock option income on a German return in the year of exercise, which may be years after departing Germany.

Payroll Delivery

The company has a number of options in determining how compensation will be delivered. Significant savings can be achieved in some countries by shifting payments offshore. If pay is remitted outside the United Kingdom (U.K.), for example, it is possible to reduce taxable income allocable to non-U.K. workdays. Split payroll arrangements can also be advantageous. Employees working throughout Europe are often able to take advantage of the treaty network through multiple payrolls.

Tax liabilities can be minimized through the use of dual contracts in countries, such as India, where generally, during the first nine years of residency, residents are taxed only on compensation relating to services performed in India.

Character of Payments

As stated earlier, expatriates can receive favored tax treatment in many countries for various allowances and benefits, such as autos, housing, moving expenses and children’s education. By recharacterizing the payment of these amounts, the employee might not be subject to tax in the host country, thereby saving the company money without sacrificing any benefits to the employee. For example, instead of increasing an employee’s salary for a housing allowance, the company might directly provide housing for that employee (the company signs the lease) or specifically designate a portion of the cash payment as a housing allowance. In Singapore, a cash housing allowance is fully taxed, but a company-provided apartment is taxed on a portion of the actual rent. To minimize U.S. taxes, regular compensation may be substituted with tax-effective items such as stock options or retirement benefits.

A number of countries, such as the Netherlands and Belgium, offer tax concessions to foreign nationals. In the Netherlands, upon approval of the tax authorities, up to 35 % of salary can be paid tax free. In Belgium, certain expatriates are considered as 'non-resident' and come under a special taxation regime. They are liable to pay Belgium tax only on income connected with professional duties carried out in Belgium.

Income Tax Treaties and Totalization Agreements

The United States has entered into bilateral income tax treaties with approximately 55 countries. The income tax treaties govern the taxation of compensation earned in a non-resident country. Typically, the treaties provide a tax exemption where the employee is in the host country for 183 days or less and compensation is not paid or borne by an entity in that country. In addition to this tax exemption, the expense reimbursements for such items as housing, automobile, and meals received by the employee would not be taxable in the U.S., provided that they qualify as regular business traveling expenses for assignments less than one year. It is important to note that any reimbursed expenses incurred by the spouse would be taxable to the employee in the U.S. Relief is also often provided from taxation of investment income, pensions, and annuities. Bilateral tax treaties should be reviewed carefully prior to any short-term assignment.

The United States has entered into social security totalization agreements with 18 countries which are designed to prevent expatriates from being subject to social security tax in both countries. Where the employee is transferred to a foreign country for a "temporary period" (usually up to 5 years), he or she can remain on the home country system and qualify for exemption from the host country system by remaining on the home country payroll and by obtaining a Certificate of Coverage.

Some Corporate Considerations

When sending employees overseas, a corporation can unwittingly create a "permanent establishment" for itself and thereby expose itself to taxation in the host country. In general, if an employee paid by the company goes to a foreign country and performs services for, and acts on behalf of his or her employer, a permanent establishment can be created. This can occur even when the company has an affiliate in the host country.

Normally deductible corporate expenses may not be deductible when an employee is sent abroad. For example, a local company would not be entitled to a deduction for the expatriate employee’s salary if the local company is not directly benefiting from his services. The local company must charge its foreign affiliate for the compensation and then the foreign affiliate would be entitled to the deduction. Also, it is important to remember that in any cross-border transactions with foreign affiliates, one must treat the transaction as if it were an arms-length transaction so as to avoid transfer pricing exposure.

Conclusion

This article provides a framework for considering a number of key tax planning strategies available to reduce international assignment costs. Because tax laws are always subject to change, these techniques must be reviewed and analyzed in light of home and host country rules and treaties, as updated. Both, individual and corporate tax ramifications must be considered together when designing the most tax efficient foreign assignment.

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