US employers and foreign employees tax problem

IRS rules that withholding exceptions for employees in foreign country don’t apply – Chief Counsel Advice 200814010

Mike Habib, EA

In Chief Counsel Advice (CCA), IRS has held that a U.S. employer had to withhold on wages it paid to employees working in a foreign country. The withholding exception under Code Sec. 3401(a)(8)(A)(ii) (dealing with foreign countries that require wage withholding) didn’t apply. This conclusion wasn’t altered by the employer’s proposed arrangement that attempted to comply with both the U.S. and foreign country’s withholding laws. The CCA also held that neither this nor another exception applicable to the Code Sec. 911 foreign earned income and housing cost exclusions applied to the foreign employees who were aliens. The CCA was issued even though the taxpayer withdrew its ruling request after being notified of IRS’s intent to rule adversely.

Background. For income tax withholding purposes, “wages” doesn’t include remuneration paid for services performed for an employer (other than the U.S. or a U.S. agency) by a U.S. citizen if, at the time of payment, it’s reasonable to believe that the remuneration will be excluded from gross income under the Code Sec. 911 foreign earned income and foreign housing exclusions. Such payments are subject to withholding only to the extent that they are expected to exceed these exclusions. (Code Sec. 3401(a)(8)(A)(i)) Under another exception, “wages” don’t include remuneration paid for services performed for an employer by a U.S. citizen if, at the time of payment, the employer is required by the law of the foreign country or U.S. possession to withhold income tax on the remuneration. (Code Sec. 3401(a)(8)(A)(ii))

In Rev Rul 79-392, 1979-2 CB 360, IRS ruled that a U.S. company wasn’t required to withhold federal income tax on remuneration paid to its U.S. employees who serve as consultants to a foreign company and perform all services within the foreign country, where, under an agreement with the company, the foreign country assesses the income tax imposed by its law on the consultants on a direct collection basis.

Facts. X, a U.S. limited liability corporation, employed a number of U.S. citizens and U.S. resident aliens in a foreign country (foreign employees). Under the foreign country’s tax procedures, its income tax (salaries tax) was remitted to its tax authority using a program of provisional tax payments submitted by individual employees.

X had been advised by counsel that payroll deductions that were not specifically permitted under the foreign country law were prohibited, except where a government official gave his express approval. X wasn’t aware of any occasion where a government official gave such approval. This withholding prohibition didn’t apply to amounts paid at the employer’s discretion, and so the deduction of U.S. income tax withholding from discretionary bonuses paid to the foreign employees wasn’t prohibited.

To comply with both the U.S. and foreign country’s laws on withholding, X plans to adopt a proposed approach in which X would enter into an agreement with the foreign country tax authority to obtain an acknowledgment that X was the foreign employee’s agent in connection with the purchase of tax reserve certificates (TRCs) on behalf of the foreign employee. The TRCs would be automatically redeemed by the foreign country tax authority on a first-in-first-out basis to settle any outstanding foreign country tax liabilities for each foreign employee. The foreign country tax authority would automatically redeem the TRCs (purchased on behalf of the specific foreign employee) to pay that foreign employee’s foreign country tax liability on the tax due date. X believed that it would be replicating a tax withholding system by deducting approximately 16% of the foreign employee’s gross compensation to purchase TRCs in the same amount for the foreign employee’s foreign country TRC account to satisfy applicable foreign country tax.

Conclusions. The CCA ruled that because the foreign country didn’t require income tax withholding on the wages of X’s foreign employees, remuneration paid to them didn’t qualify for the exception under Code Sec. 3401(a)(8)(A)(ii), regardless of whether X entered into its proposed approach. IRS rejected X’s comparison of its approach to that in Rev Rul 79-392. Under the facts in Rev Rul 79-392, the company was required under the law of the foreign country to withhold income tax on the remuneration paid to the consultants. However, in X’s case, the foreign country law doesn’t require withholding from the remuneration paid to X’s employees. Rather, the foreign country prohibits withholding on wages (as wages is defined for this purpose under foreign country law) unless there is an agreement between the employer and employee approved by the foreign country tax authority. Thus, the two situations deal with different facts, and Rev Rul 79-392 doesn’t support X’s proposed approach.

X’s funding of the TRCs through the proposed approach wouldn’t require X to withhold foreign country income tax from the wages of the foreign employees for purposes of the Code Sec. 3401(a)(8)(A)(ii) exception. Furthermore, IRS was unaware of any amendment to X’s proposed approach that would require X to withhold the foreign country income tax from X’s foreign employees’ wages under Code Sec. 3401(a)(8)(A)(ii), in light of X’s representation that the foreign country law provided that no withholding of foreign country income tax was required from employees’ wages.

The CCA also ruled that neither the exception in Code Sec. 3401(a)(8)(A)(i) or the one in Code Sec. 3401(a)(8)(A)(ii) applied to remuneration for services performed by individuals who were aliens (whether a resident alien or a nonresident alien). Thus, these exceptions couldn’t apply to an X employee who is an alien individual.

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