Donald C. Dowling, Jr., Partner, White & Case LLP, New York
Employer income tax withholding mandates usually amount to a straightforward issue of the local law at the place of employment. An employee working in Italy is subject to Italian tax withholding mandates. Someone based in Chile is subject to corresponding Chilean rules. Staff in Korea is subject to Korea’s requirements.
This means that an inbound expatriate whose place of employment shifts to a new host country generally gets caught under host-country tax withholding requirements. This is certainly how it works stateside: A foreign entity—one not organized under U.S. law—that employs an alien who immigrates to the U.S. and works a job in, say, Seattle or St. Louis is almost always subject to U.S. tax withholding requirements. Cf. IRS Rev.Rul. 92-106 (12/7/92). The U.S. does not want foreign employers to use their offshore payrolls to pay employees who are not legal U.S. residents but who work on U.S. soil and who benefit from U.S. government services in a way that avoids American tax withholding. Not surprisingly, it tends to work the same way abroad. When a U.S. employer sends an American to work as an expatriate at some overseas place of employment, local host-country tax withholding requirements usually apply. (Even if a “social security totalization agreement” comes into play, it does not affect tax withholding.).
A big complication is that the U.S. tax withholding mandates do not switch off just because an American sets out to work abroad. These U.S. obligation can be “sticky,” following certain Americans overseas. The U.S. is one of very few countries in the world that taxes its “tax subjects” on their worldwide (including foreign-sourced) income (subject to some exclusions, such as a credit for foreign taxes paid). This, though, does not necessarily mean that all employers must make withholdings to the U.S. IRS on all foreign-sourced income that U.S. taxpayers earn abroad. When, if ever, must an employer withhold income tax to the U.S. IRS for an American taxpayer working overseas? To answer that, we first clarify three concepts:
1) A “U.S. taxpayer” includes both U.S. citizens and U.S. “tax residents” (for example, U.S. “permanent residents”/green card holders), even if working abroad.
2) “Working abroad” means having a principal place of employment outside the U.S., regardless of whether the employee works overseas as a company-designated expatriate, as someone living abroad for personal reasons, or as a “trailing spouse.”
3) A “U.S. employer” is an employer who is a U.S. “person.” This includes an employer entity incorporated in a U.S. state even if it is registered overseas as a branch or representative office. But this excludes American companies’ wholly- or majority-owned foreign-incorporated subsidiaries and affiliates not transacting business stateside.
U.S. citizen. Under U.S. Treasury regulations and IRS rulings (chiefly Treasury Reg. 31.3401(a)(8)(A-1b), (d-1) and IRS Rev.Rul. 92-106 (12/7/92)), employers must withhold and remit to the U.S. IRS income tax of U.S. citizens working abroad. But this mandate is subject to two vital exclusions: (1) the employer need withhold against a U.S. employee working abroad only on income above the “foreign earned income exclusion,” which in 2011 was $92,900, and (2) the employer need withhold on income earned outside the U.S. only if that income is not subject to withholdings under local withholding mandates imposed by the host country. That is, the employer need not withhold on income that the employee is required, under local law, to have withheld locally. So an employer need to impose U.S. withholding tax payments made to a U.S. citizen working abroad only on income remaining after excluding both the foreign earned income exclusion and income subject to actual host-country-mandated income tax withholdings.
Non-U.S.-citizen U.S. taxpayer. This same U.S. withholding mandate also reaches U.S. “tax subjects” working abroad who are not U.S. citizens—but in that case, the two exceptions do not apply. That can mean double withholding: A non-U.S.-citizen U.S. taxpayer working abroad can easily be simultaneously subject to both local and U.S. tax withholding. That said, though, employers can reduce U.S. withholdings of non-citizen U.S. taxpayers working abroad by the anticipated foreign tax credit they will be entitled to take on U.S. tax returns.
Non-U.S. employer. Surprisingly, the U.S. IRS takes the position that this same analysis applies not only to U.S. employers, but also even to non-U.S. employers. See IRS Rev.Rul. 92-106 (12/7/92). That means a non-U.S. employer of a U.S. taxpayer working abroad is actually supposed to make U.S. tax withholdings to the U.S. IRS―even if the non-U.S. employer transacts no business stateside. This is an aggressive position that raises problems. Few non-U.S. employers operating outside the U.S. have U.S. taxpayer identification numbers with which they can make U.S. IRS withholdings. And non-U.S. employers operating abroad may not be in a position to know which of their employees may happen to be U.S. taxpayers. For most non-U.S. employers, compliance with this IRS withholding mandate may prove all but impossible. Indeed, IRS enforcement against non-U.S. employers that transact no business in the U.S. may be all but impossible, as well.