Tax considerations for expats
When employees are selected to work outside their home country (referred to as expatriates or expats), they may face many concerns. These can include settling into their new home, helping their children get adjusted to a new school and learning the local language, all while focusing on performing well in their new job position. The last thing the expat needs added to the list is concern around their compensation and the global tax rules that may impact them. Although well-intentioned, most manufacturing CFOs and human resources personnel are not aware of all the compensation and tax issues that might impact an expat, and therefore, cannot address these issues when working out the details of the expat's proposed assignment overseas. Experience shows that good assignment planning before the assignment begins is important and will help minimize issues down the line.
So, how do you start? Well, once you've identified the right person for the assignment, you then need to understand their needs. Many companies attempt to provide the expat with a standard package. This may be a good solution for a company with hundreds of expats. However, when you have a few key personnel going overseas, or personnel in high-level positions, it is important to understand their individual needs. These can include cost of living adjustments, housing differentials, family education, language services, travel, home leave, and tax consulting and compliance assistance. The biggest concern for most expats relates to compensation and taxes. The expat needs assurance that his or her financial position will not be detrimentally affected by the assignment, and providing this assurance up front will enable your expat to concentrate on the assignment at hand.
Since the above-mentioned items such as cost of living adjustments, housing, education, etc. are all taxable items to the employee in the United States and potentially in the host country, the employee could see his or her income taxed at much higher rates, providing him or her with a lower after-tax income than expected–i.e., an indirect pay cut. This can stop expats in their tracks, and their attention may shift away from their assignments to their tax situations. This can easily be rectified by putting together a tax equalization policy in the planning stages that enables the individuals to pay no more or no less tax than they would had they not gone on the assignments. It is important to have a written policy around this process to ensure clarity and consistent application. A detailed but brief written policy is ideal. Under full tax equalization, the expat will bear the economic burden for the tax liability as if he or she had never gone on assignment (hypothetical tax), and this amount will be withheld from the regular paycheck. The hypothetical tax will then be used by the company to contribute to the host country taxes and any residual U.S. taxes. The company will bear the cost of any taxes over and above the hypothetical taxes.
There can also be many payroll implications, including those associated with:
- 401(k) plans
- Differences in social tax systems in the United States and host countries
- Whether to pay in local currency or U.S. dollars (or both)
- Split payroll to enable payments in the United States and the host country
- Shadow payroll to report the income in the United States and host country
- Determination of which country gets to tax what income and at what levels
At tax time, the employee could also run into difficulties if these payroll issues are not addressed in advance. U.S. citizens living outside the United States will have many additional tax filings and tax implications. Ensuring they have the proper guidance and advice in the host and home countries will alleviate the stress of the tax and allow them to focus on their assignment. U.S. citizens are required to file and pay U.S. federal and sometimes state taxes, no matter where they live and work in the world. The United States has enacted a number of specific tax provisions designed to reduce the possibility of double taxation. These provisions include the foreign tax credit, the foreign earned income exclusion and the foreign housing exclusion. The foreign tax credit is a simple credit for taxes paid (with some limitations), and no complex tests need to be satisfied in order to claim the credit. However, to claim the foreign earned income exclusion, certain tests must be satisfied. In particular, the expat must meet a physical presence test (330 days outside the United States in a 12-month period) or a bona fide residence test (full calendar year outside the United States). The foreign housing exclusion may also allow expats to reduce their U.S. taxable income by an additional amount. In addition, benefits may be available under a variety of U.S. income tax treaties.
Bottom line, you do not have to be a Fortune 500 company to be impacted by these issues. Ensure your company and your expats are protected by engaging in these conversations with your trusted advisor prior to the structuring of the assignment details.