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By Thomas St.G. Bissell, Esq.
In a recent commentary, this author explored some of the planning opportunities for cross-border employees (and their employers) under the IRS regulations that now treat a foreign "disregarded entity" (DE) as a "regarded" entity for U.S. federal employment tax purposes.1 An unusual aspect of the new regulations, however, is that individuals who are employees of a foreign DE apparently may continue to be classified for U.S. income tax purposes as employees of the DE's parent company. This rule has some unusual results where the parent is a U.S. company, particularly if an income tax treaty applies.
The DE regulations provide that – except for purposes of U.S. employment taxes and certain excise taxes – a business entity with a single owner that is not a "corporation" for U.S. tax purposes is "disregarded" as an entity separate from its owner "for federal tax purposes."2 Where an individual works as an employee of a DE, the obligation to withhold and pay U.S. employment taxes on the employee's compensation is imposed on the DE itself. In determining the individual's substantive federal income tax liability under §1 or §871(b), however, the employee's income tax liability may depend (in part) on the location of his employer. In that situation, it appears that the employer is not the DE itself, but the DE's parent company.
Under the Code itself, this distinction will rarely matter. For example, under §861(a)(3), a nonresident alien employee who visits the United States on business will be effectively exempt from federal income tax on his allocable compensation if he satisfies three tests: (1) he is in the United States for not more than 90 days during the taxable year; (2) the allocable compensation does not exceed $3,000; and (3) he is an employee of a foreign employer (as specially defined3 ) that is not engaged in a U.S. trade or business, or he is the employee of an "office or fixed place of business maintained in a foreign country" by a U.S. employer (as specially defined4). Thus, if he is an employee of a DE that is owned by a U.S. parent company, he would normally satisfy the third test – not because his employer is a foreign corporation, but because it is the foreign "office" of a U.S. employer. The only exception might be the unusual situation in which the DE itself did not have an "office or fixed place of business" in a foreign country, with the result that the third test in the statute would not be met.
The distinction, i.e., between the employee's employer for income tax purposes and for employment tax purposes, is much more significant if the nonresident alien employee of a U.S.-owned DE is resident in a country having an income tax treaty with the United States. In that situation, there is generally no dollar limitation (such as $3,000) on the amount of U.S.-source employment income that may be exempt from U.S. taxation,5 and at the same time there is a risk that the United States and the country where the employee is resident could disagree on how the treaty affects the employee of a DE. For example, assume that a nonresident alien resident in the United Kingdom is an employee of a U.S.-owned DE, and makes business trips to the United States for which his allocable U.S.-source compensation is much greater than the $3,000 in §861(a)(3)(B). In order to be exempt from U.S. federal income tax under Article 14(2) of the U.K.-U.S. Income Tax Treaty, his U.S.-source compensation must satisfy all three of the following tests:
(a) he may not be physically present in the United States for more than 183 days in any 12-month period beginning or ending in the taxable year;
(b) his "remuneration" for services performed in the United States must be paid by, or on behalf of, an employer "who is not a resident of" the United States; and
(c) the remuneration for services performed in the United States may not be "borne" by (i.e., deducted for corporate income tax purposes by) a "permanent establishment" that the employer has in the United States.
Because the U.K. employee's employer is a DE that is classified as a branch of its U.S. parent for all federal tax purposes (except U.S. employment tax purposes), it seems likely that the IRS would treat the individual as an employee of the U.S. parent company, i.e., of an employer that is "resident" in the United States under Article 4 of the treaty. As such, the employee would fail the second test of Article 14(2), and would be subject to U.S. federal income tax on his remuneration that is allocable to U.S. workdays (subject possibly to the $3,000 Code exemption). However, because his employer is not a DE for U.S. employment tax purposes, the liability to withhold U.S. wage withholding tax under §§3401 ff. would be imposed on the DE and not on its U.S. parent.6
Because the employee in this example is classified as a U.K. resident, he would also be subject to U.K. income tax on remuneration allocable to U.S. workdays, but under both U.K. law and Article 24 of the treaty, he should be entitled to claim a foreign tax credit for the resulting U.S. federal income tax (and possibly also for U.S. state and local income tax) against his U.K. personal income tax on the same income. However, because the DE would not be disregarded for U.K. tax purposes, there is a possibility that the U.K. taxing authorities could take the position that the individual did in fact satisfy Article 14(2)(b) of the treaty and thus that the United States had no right to tax him on his U.S.-source remuneration (provided that he also satisfied the tests of Article 14(2)(a) and (c)).7 The result could be that the individual would suffer unrelieved double taxation, i.e., payment of both U.S. and U.K. tax on the same U.S.-source income without a foreign tax credit. Presumably the issue could be resolved under the "Competent Authority" provisions of Article 26, although the two governments are not necessarily required by the treaty to come to an agreement that avoids double taxation.8
To the extent that the U.K. tax authorities did challenge the creditability of the U.S. tax in this situation, the employee might argue that the United States had a right to tax his U.S.-source remuneration under Article 14(2)(c), i.e., that regardless of whether his employer was a U.K. or a U.S. company, his U.S.-source remuneration was "borne by" (i.e., deducted for corporate income tax purposes by) a U.S. permanent establishment of his employer. Thus, the employee could point to the fact that because the DE's expenses are "consolidated" with those of its U.S. parent for U.S. corporate income tax purposes, his U.S.-source compensation was deducted on the U.S. parent's Form 1120. The counter-argument might be that the rule in Article 14(2)(c) does not apply on its face to a U.S. parent company, but only to a U.K. "regarded" company that has its own branch office (permanent establishment) in the United States and that deducts that particular employee's U.S.-source compensation on its own Form 1120F. The individual's argument might be further weakened if it were shown that his U.S.-source compensation was "allocated" to foreign sources under Regs. §1.861-8 in calculating the U.S. parent's foreign tax credit limitation, because the employee's U.S. workdays benefited the DE's non-U.S. operations rather than the U.S. parent's U.S. operations. Intercompany cross-charges of compensation and the group's transfer pricing methodology should, however, be carefully reviewed before any final determination is made.
Although most U.S. income tax treaties require the foreign treaty country to allow a foreign tax credit (subject to limitations) against the treaty country's income tax for U.S. income tax imposed (properly) on U.S.-source compensation of a treaty country resident, a few treaties provide instead for so-called "exemption with progression" (EWP) instead of a credit.9 Thus, if an individual who is resident in an EWP treaty country pays U.S. tax on his U.S.-source compensation and excludes it in calculating the home country income tax on his non-excluded income, the home country tax authorities could deny the exclusion on the grounds that the United States had no right to tax the U.S.-source compensation. The result could be the imposition of tax in both countries on the U.S.-source compensation, thus giving rise to a potential Competent Authority proceeding.
It should be noted that the issues discussed above would not necessarily arise under all of the United States' income tax treaties. A few treaties also grant an exemption from U.S. tax where the treaty country resident is an employee of a permanent establishment maintained in that country by a U.S. resident company.10 In that case the exemption from U.S. tax for U.S. business trips would be available whether the employer were considered to be a company resident in the treaty country or, under the IRS's DE rules, a branch of the U.S. parent. In addition, a few treaties grant an exemption from U.S. tax for U.S. business days if the total U.S.-source remuneration is less than a fixed dollar amount, regardless of who the employer is.11 These rules are very much the exception, however, and neither rule is contained in the 2006 U.S. Model Income Tax Treaty prepared by the Treasury Department.
If the individual is employed by a foreign DE that is owned by a foreign corporation (not a DE) in the U.S. multinational group, the issues discussed above would usually not arise. Almost all U.S. treaties provide a U.S. tax exemption where the employer is not a U.S. resident company,12 with the result that whether the employer is considered to be resident in the DE's country or in its parent's country, a U.S. tax exemption would be available to an individual resident of the treaty country who makes business trips into the United States.
In the case of a U.S. citizen or resident alien working abroad in a treaty country who makes business trips into the United States, potential double tax issues similar to those discussed above can also arise. That fact pattern will be discussed in a future commentary.
This commentary also will appear in the May 2011 issue of BNA's Tax Management International Journal . For more information, in BNA's Tax Management Portfolios , see Streng, 700 T.M., Choice of Entity, Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, Williamson, 943 T.M., U.S. Income Tax Treaties — Provisions Relating Only to Individuals, and in BNA's Tax Practice Series , see ¶7130, Foreign Persons — Effectively Connected Income, and ¶7140, U.S. Income Tax Treaties.
2 Regs. §301.7701-2(c)(2)(i). Where the entity is a foreign company with limited liability that is not a "per se" corporation under Regs. §301.7701-2(b)(8), the entity's parent company would normally file IRS Form 8832 in order to classify the foreign entity as a DE.
3 This test is satisfied if the employer is a "nonresident alien individual, a foreign partnership, or a foreign corporation" that is not engaged in a trade or business in the United States (ETBUS). §861(a)(3)(C)(i).
5 Many U.S. income tax treaties do include a dollar limitation for U.S.-source income of "artists and athletes," a category of nonresident aliens that is beyond the scope of this commentary. In addition, a few treaties with developing countries limit the treaty exemption to a dollar amount for all employees from the treaty country who make business trips to the United States (or vice versa). See, for example, Article 19(2)(d) of the Korean treaty ($3,000 threshold).
6 Although technically the DE would also be obligated to pay and withhold U.S. social security tax (FICA) with respect to the individual's U.S. workdays, under the U.K.-U.S. social security totalization agreement it is likely that a FICA exemption would be available. Because there is no agreement between the United States and the United Kingdom with respect to the federal unemployment tax (FUTA), the DE would be required to pay FUTA with respect to the employee's U.S. workdays.
7 Compare the U.S. rule which denies a foreign tax credit to a U.S. taxpayer under §901 where it is determined that the particular foreign income tax was not a "compulsory" payment by the U.S. taxpayer. Regs. §1.901-2(e)(5). Thus, if part or all of the taxes paid by a U.S. taxpayer to a foreign country would be refunded if he applied for a refund, the portion that is eligible for a refund will not be creditable under §901 whether or not the taxpayer claims a refund. Regs. §1.901-2(e)(5)(ii), Ex. (6).
8 Article 4(5) of the treaty also provides that where "a person other than an individual is a resident of both" countries, the Competent Authorities will attempt to resolve the issue. However, the language of Article 4(5) appears to limit the two governments' discussions to consideration of how to tax the entity itself, and not how to tax its employees.
9 See, for example, Article 22(1)(a) of the Belgian treaty; Article 23(3)(a) of the German treaty; and Article 23(1)(a) of the Swiss treaty. The EWP rules provide in effect that, although the U.S.-source income is exempt from income tax in the treaty country, it is taken into account in calculating the individual's tax rate on other income that is subject to the treaty country's income tax. The effect is to impose the same average rate of income tax in the treaty country on the individual's non-excluded income that would have been imposed if the U.S.-source compensation had not been excluded. Because the U.S.-source compensation itself is usually taxed at a lower effective rate – since the average U.S. tax rate on that income is usually lower than the treaty country tax that would be imposed on it in the absence of EWP – nonresident alien employees resident in an EWP treaty country often plan affirmatively to become subject to U.S. tax on their U.S.-source compensation in order to achieve a net worldwide tax saving on that portion of their compensation.
12 See Article 14(2)(b) of the 2006 U.S. Model Income Tax Treaty, which requires only that the remuneration be "paid by, or on behalf of, an employer who is not a resident of" the treaty country into which business trips are made, i.e., not a U.S. resident company in the facts under discussion. A few old treaties still require that the employer be resident in the treaty country itself. See, for example, Article X(1)(a) of the Greek treaty, and Article XI(2)(b) of the Pakistan treaty.
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