Foreign Tax Credit
Another mechanism for the prevention of double taxation is the foreign tax credit, provided for in IRC Sec. 901. Calculation of this credit may be very complex, but, in basic terms, it allows a credit against the U.S. tax allocable to a particular category of foreign source income.
There is a limitation calculation designed to ensure that the credit will never offset any U.S. tax allocable to U.S. source income. IRC.Sec. 904.
When the Foreign Earned Income Exclusion has been elected, the foreign taxes potentially available for foreign tax credit are disallowed in direct proportion to the percentage of Foreign Earned Income that is excluded. That is, if 85% of the total Foreign Earned Income is excluded, then 85% of the foreign taxes paid on that income for that year would be disallowed and unavailable for credit against U.S. tax.
Equalization, Tax Protection, And Gross-Ups
Companies that assign employees abroad may take a variety of positions with respect to assignment-related expense reimbursements and tax reimbursements.
A company may be willing to reimburse only moving expenses, leaving any further expense/tax burden to the employee, i.e., treating the employee as a “local hire.” Of course, very few employees would be willing to relocate on such terms. Such cases usually involve an employee’s independent desire to relocate abroad, perhaps due to a pre-existing marriage to a national of the particular country.
A step toward further involvement in assisting the relocated employee is “tax protection.” This entails an agreement to reimburse expenses for the employee, coupled with a guarantee to protect the employee from any resulting additional taxes.
Under such an arrangement, effectively administered, the employee is protected from any additional tax cost, and indeed could end up significantly better off from a tax standpoint than if he had remained working in his home country. In certain cases, where tax windfalls could depend upon the country of assignment, the selection of country assignments could create dissension within the company’s International Assignee population.
A more comprehensive approach to limiting the tax impact of International Assignments is “Tax Equalization.” This type of program not only protects employees from additional tax, but also prevents instances of tax windfall. It is designed to ensure a situation where foreign assignments become “tax neutral,” thus making no country more tax desirable than the next.
A well designed Tax Equalization Policy tends to promote greater consistency of treatment, and thereby greater fairness amongst all the transferred employees. Under such a program a hypothetical tax is calculated for the employee, which is designed to represent what that employee’s tax obligation would have been had the employee remained and worked in his home country.
An amount designed to meet this obligation is hypothetically withheld from the employee and retained by the company. At the time the actual tax return is completed in the following year, the hypothetical tax calculation is prepared, and either the employee must pay a further amount to the company to discharge his hypothetical tax obligation, or he receives a refund of overpaid hypothetical tax.
The company is responsible for payment of all actual taxes, U.S. and foreign, and in return, retains the benefit of exclusions, deductions, and credits directly related to the foreign assignment. Thus, they do not show up on the hypothetical tax calculation.
Tax Gross Ups
Under any of the aforementioned approaches, where the company has provided a benefit, or reimbursed an expense of the employee (except where specifically excepted by the Code, as with certain moving expenses), taxable compensation income is created. When the Company is responsible for the corresponding tax generated, payment of that obligation will in turn produce a taxable reimbursement with its own tax obligation, (i.e., “tax on tax”).
Ultimately, such tax escalation is finalized through a “pyramid gross-up”, which is a calculation that determines the amount of tax necessary to fully cover all the additional taxes to be incurred due to reimbursements in that year.
Tax reimbursement costs can be enormous, accelerating further costs to the Company, and in many cases pushing the total reimbursement into a higher tax bracket. Consequently, the tax gross-up should be done in the final year, and not on an ongoing basis. In many cases, tax that might be incurred on expense reimbursements can be avoided, by taking advantage of the Foreign Earned Income Exclusion or offsetting foreign tax credit.
Where such tax cannot be currently offset, it can at least be deferred until the following year, to the time of return preparation, and when the equalization is prepared, the tax obligations settled, and the transaction closed.