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How do we handle income taxes for expatriates?

Employers should be aware that almost every country has some type of income tax that applies to all workers. In addition to the tax requirements of the host country, U.S. citizens are also responsible for U.S. tax on income regardless of where the income is earned.

Additionally, Social Security and Medicare taxes are deducted from wages of employees working outside the U.S. if one of the following applies:

  • The employee is working for an American employer.
  • The employee performs the services on or in connection with an American vessel or aircraft, and either the employee entered into the employment contract within the United States, or the vessel or aircraft touches at a U.S. port while the employee is working on it.
  • The employee is working in one of the countries with which the United States has entered into a totalization agreement (also called a binational or bilateral Social Security agreement).
  • The employee is working for a foreign affiliate of an American employer under a voluntary agreement entered into between the American employer and the U.S. Treasury Department.

State income taxes can further complicate the situation. Each state has requirements on residency as it relates to income tax liability. The employee will need to contact the specific state to determine the tax requirements.

Employer Options

Companies generally take one of four approaches to handling income taxes for their expatriate workers:

• Laissez-faire. In this approach, the company is not actively involved in managing U.S. and foreign taxes. Essentially, the employee is responsible for any taxes incurred. However, often the employer increases the expatriate's compensation to cover the additional tax expense.

• Ad hoc. In an ad hoc approach, the employer determines tax reimbursement on a case-by-case basis. Essentially, each expatriate employee negotiates his or her own deal with the company. This approach may work when a company's international workforce is small, but as the international program grows, the negotiation process can become cumbersome.

• Tax protection. In the tax protection approach, the company figures the expatriate's hypothetical U.S. income tax and compares it with actual taxes paid. At the end of a year, the company reimburses any disparity. If the expatriate pays less in taxes than he or she would have paid in the United States, the expatriate keeps the difference. A disadvantage of this program is that it can create inequities between expatriates in low-tax-cost countries and those in high-tax-cost countries.

• Tax equalization. In a tax equalization program, the expatriate's tax situation is neither better nor worse than it would have been in the United States. A hypothetical U.S. income tax is withheld from each paycheck. Foreign taxes are either paid by the employer or reimbursed. Although this program ensures equity among expatriates, it requires more administrative resources than the other methods.

Government Relief

The Internal Revenue Service (IRS) has two provisions to help ease the tax burden for employees on international assignment.

The first provision is Internal Revenue Code (IRC) Section 901, which provides that if the U.S. tax is higher than the host country tax, the employee pays the U.S. tax. If the host county tax is higher, the employee is able to take a credit, or the host country tax can be claimed as an itemized deduction.

The second provision is IRC Section 911. This section allows for the exclusion of a portion of the employee's foreign income from taxation. The IRS sets the maximum amount of foreign earned income that an employee working abroad can exclude from gross income under this section, which adjusts annually.

If the employee is planning on claiming this exclusion, he or she will be required to meet either the bona fide residence test or the physical presence test. US citizens may complete IRS form 673 to give to their employer to show they meet the qualifications. IRS form 2555 or 2555-EZ must be filed by the employee to claim the exclusion.

Employers should encourage employees to discuss tax issues with their financial advisors before beginning international assignments.


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