Volume 5, Number 11, Page 4

U.S. Employees in Latin America : Tax Consequences

by David K. Armstrong, Esq

As many U.S. companies expand into Latin America, they send U.S. employees to represent the company. The U.S. employee working abroad is typically referred to as an "expatriate." When a U.S. employee receives an expatriate assignment, it complicates life for the employee and his or her family. Less obvious, but also challenging, are the taxation issues which overseas assignments generate. Set forth below is a brief summary of some of the U.S. tax issues that must be considered when contemplating an expatriate assignment.

Tax Benefits

For U.S. citizens working overseas, there are a variety of tax benefits. Two of the most prominent advantages are the ability to take: (1) a "foreign-earned income exclusion" and (2) a "foreign tax credit." The "foreign-earned income exclusion" gives a U.S. expatriate the opportunity to exclude up to $80,000 of foreign earnings from taxable income. The 1997 Taxpayer Relief Act raised the exclusion from $70,000 to $80,000. The increase will be phased in in $2,000 increments. The exclusion for 1998 is therefore $72,000. To qualify for this exclusion, the expatriate must meet one of two foreign residency tests.

The first test is the bona fide residence test. Under this test, the expatriate must be an actual resident of the foreign country (under its local definition) for an entire tax year, that is, from January 1 to December 31. Temporary absences from the country during the year will not interrupt the residency period for tax purposes. The second test under which the expatriate may qualify for the exclusion is the physical presence test. Under this test, the expatriate must be in the foreign country for at least 330 full days within any 12 consecutive month period.

If either test is met, the expatriate is allowed to exclude two types of income. The first type is the flat exclusion on foreign source income. In addition to this exclusion, the expatriate may also exclude income related to excess housing costs. This exclusion is applicable when the employer provides housing for the expatriate, and the fair market value of that housing is included in the expatriate's income. The housing cost exclusion is determined on the basis of the total housing expenses. These include rent, utilities, real and personal property insurance, occupancy taxes, non-refundable fees paid for securing a leasehold, rental of furniture and accessories, residential parking, and repairs. The total housing expenses are then reduced by a base housing amount. The base housing amount is equal to 16% of the GS-14 pay grade for a government employee. If the employer does not cover housing costs, the expatriate may take a deduction for those costs.

Expatriates may take either a tax credit or a deduction for income taxes imposed by foreign countries. An individual who elects to take the earned income exclusion is not allowed a deduction or a credit for foreign income taxes paid or accrued on any portion of the excluded earned income. Because the election of the earned income exclusion may mandate a loss of part or all of the foreign tax credit, an analysis should be done to determine whether the exclusion should be elected. Typically, in a high-tax country, the expatriate will benefit more by utilizing the full foreign tax credit and not electing to take the earned income exclusion. Conversely, when an expatriate is in a low-tax country, the earned income exclusion is typically more beneficial than taking the foreign tax credit. Neither the earned income nor the foreign tax credit will be jeopardized if the expatriate maintains a personal residence in the United States.

Payroll Tax Issues

For payroll purposes, the employer's federal income tax withholding obligation stops with the pro-rated amount earned by the expatriate overseas, or in amounts eligible for the housing exclusion. However, Social Security and Medicare payments must continue to be withheld even if income taxes are not.

Most Latin American countries also require tax payment or withholding in the event the expatriate is working in such country in excess of 183 days. A special rule provides that wages paid by an American employer to a U.S. citizen working abroad are exempt from federal income tax withholding to the extent that the wages are subject to income tax withholding of the foreign jurisdiction.

Compensation Package

A number of financial hardships are associated with moving to and working in Latin America. To offset these hardships, companies typically add certain benefits to the expatriate's compensation package, such as:

(a) An overseas hardship premium that is usually based on a percentage of the expatriate's salary;

(b) A cost of living allowance to allow the expatriate to maintain the standard of living he or she established in the United States;

(c) A housing allowance to cover the cost of foreign housing;

(d) An education allowance if the expatriate has children who will be attending private schools in the foreign country;

(e) A home leave allowance which covers the cost of round-trip tickets to the United States for vacation purposes;

(f) A storage cost reimbursement to cover any expenses incurred in storing furniture and other items in the United States; and

(g) An equalization package, explained in greater detail in the next paragraph, to reimburse the expatriate for any additional tax burden incurred because of overseas residency.

Tax Reimbursement Packages

When an individual works overseas, he or she often bears an additional burden because of the increase in salary and tax liability. Normally, a company will reimburse the individual for the additional required taxes. The objective of this tax reimbursement plan is to have the expatriate pay approximately the same amount of taxes as the individual would have paid had he or she remained in the United States.

An analysis should be done to determine the most cost effective way for the company to reimburse the expatriate for the additional taxes paid. The type of plan used may depend on the specific tax laws of the Latin American country where the individual will be located. With the proper planning, the timing of the reimbursement can generate substantial tax savings.

Currently there are three general methods for timing tax reimbursement payments: the current gross-up method; the one-year roll-over method; and the deferred compensation or loan bonus method. These three methods result in different total tax reimbursement costs. They also vary in complexity of administration and in their acceptance by foreign tax authorities. Under the current gross-up method, the reimbursement for excess taxes is computed and given to the expatriate in a lump sum payment. Since this reimbursement will generate additional tax liability, it is "grossed up," or increased sufficiently to offset this tax-on-tax. This method generally results in the highest tax cost, because reimbursements are commonly subject to foreign taxation at the highest marginal rates.

Under the one-year roll-over method, a calculation is made after the tax year is over and the tax returns have been filed. The calculation determines the excess taxes, and the reimbursement is made in the subsequent year. No gross-up need be done until the final year of foreign residency. The one-year roll-over method is accepted by many foreign countries as a proper method of reimbursing expatriates. In medium-to-high tax foreign countries (such as Mexico and Ecuador), it generally results in lower costs than the current gross-up method for two reasons: (1) it mitigates the pyramiding of tax-on-tax; and (2) the grossed-up reimbursement made at or after the end of the foreign assignment typically falls into a lower tax bracket. In certain circumstances it may escape foreign tax altogether.

Under the deferred compensation method, generally referred to as the "loan bonus method," the employee borrows the funds needed to pay all foreign tax liabilities from a third-party bank. After completing the overseas assignment, the employee receives a bonus or deferred compensation payment equal to the borrowed funds, plus any interest charges. The lump-sum payment, if it is taxable at all in the foreign country, is taxable in the year it is received. This lowers the foreign tax cost by eliminating the tax-on-tax effect.

Whether the loan bonus method should be used depends on the law of the particular foreign country.

For additional information, please contact David K. Armstrong via telephone at 801.237.1981, via fax at 801.237.1950, or via e-mail/Internet at armstrd@swlaw.com.