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Rising to the Challenges of by Anne D'Arcy and Elizabeth Murphy, KPMG LLP, New York Setting up a suitable payroll system for international assignees, and administering it properly, can be daunting challenges for multinational employers. Assignee administrators, payroll administrators, and human resources professionals are all too familiar with global payroll challenges and the consequences of mismanaged payroll reporting. The following are some of the unfortunate consequences:
Are you compliant with payroll reporting "rules" while also applying them effectively to help reduce tax costs? Are the "tools" that you use to collect compensation both user-friendly and efficient? Do you spend more time correcting assignment-related compensation than collecting? Rest assured, you are not alone. On this latter question, fully half of the respondents to the Web-based KPMG International Assignment Payroll Survey (newly introduced) indicate that they revise and correct up to 50 percent of their W-2's! (For access to KPMG's international human resources surveys, see http://www.kpmgvirtualihr.com.) If you find yourself confronted by any of these challenges and issues, now is the time
Although such processes and practices may already be in place, there may still be some payroll misconceptions, or 'myths', that continue to create unnecessary issues or pitfalls. This article discusses a few of the 'myths' and presents some ideas designed to help prevent some of the payroll crises that can occur. What Income Is Subject to Withholding Exemption? As a quick summary, for U.S.-outbound assignees, the following compensation is subject to exemption from federal withholding:
While it would appear that this covers almost all compensation items, employers should be careful when dealing with certain other irregular items such as stock options, certain bonuses, and other one-off type payments. Stock Option Income Under current U.S. tax rules, stock option income is often sourced over the period from grant to exercise to determine the portion considered foreign source for foreign tax credit purposes. Therefore, such income, in most cases, is partially U.S. source income and partially foreign source income for most U.S. assignees (outbound or inbound). Furthermore, under the various and very diverse tax treatments of stock option income in other countries, the income may not be taxable in the other country or may be taxed at a different triggering event (e.g., grant, vest, or sale). Looking back at the list of amounts subject to withholding exemption, this income may not always qualify for exemption from withholding. To ensure correct payroll compliance, employers should examine each exercise on a case-by-case basis to determine the correct U.S. withholding treatment. Employers should also remember to consider the state withholding requirements on stock option exercises, due to the level of state audit activity for both the employer and individual. The story does not end there unfortunately. The host or home country payroll withholding requirements must also be considered. For example, consider "Ian," a U.K. assignee in the United States. He was granted stock options while resident in the United Kingdom and exercises the options while resident in the United States. (This is a very common situation.) As the stock options were granted while he was resident in the United Kingdom, the U.K. tax rules result in the full amount being subject to U.K. tax and withholding, at least at the nonresident rate of 22 percent. However, if the options were exercised while Ian was resident in the U.S., federal income tax withholding would have been deducted at the statutory rate of 25 percent. Therefore, on this one transaction, 47 percent withholding will apply before even considering state withholding requirements, which may bring the total percentage over 50 percent. If Ian is subject to tax equalization, the withholding may be payable by his employer. Ian will be able to take tax credits on his U.S. and U.K. tax returns to ensure double taxation will not apply and the company can recover any over-withholdings through the tax return and tax equalization process. If dealing with a non-tax equalized assignee, correct global withholding can cause cash-flow issues and the assignee often looks to his or her employer to assist by providing advances pending receipt of tax refunds. Payroll rules on stock option income for international assignees can be a complex area and a potential minefield. Professional advice should be sought to ensure that the company meets the necessary requirements in all relevant jurisdictions, especially for assignees considered 'career assignees', as such individuals may have been on assignment in a number of countries between the date of grant and exercise or sale of the options. Bonuses Similar to stock option income, bonuses payable to international assignees, in particular near the beginning of the assignment or shortly afterwards, can be partially U.S. source and partially foreign source and thereby create challenges for global payroll. Companies generally focus on where the assignee is at the time of payment and obey the reporting and withholding requirements in that location only. This is not always correct because some countries tax bonuses on the earnings basis rather than the receipts basis. Consider the opposite to the above situation, with "Bob", a U.S. assignee returning from the United Kingdom on June 30, 2004. In January 2005, Bob receives a bonus relating to the previous calendar year. Based on his return date, 50 percent of the bonus relates to the U.K. portion of the assignment and 50 percent is U.S. source as it relates to the period after repatriation. Consequently, withholding is, strictly speaking, required in both countries leading to a similar situation as with the stock option income. However, in this situation, the assignee is no longer on assignment; so, even if tax equalization applied, many policies will not deal with such situations. To ensure the assignee resolves the situation and avoids double taxation by claiming the appropriate tax credit on his/her tax return, the assignee should be authorized for tax services for a further year after repatriation. Other Irregular Compensation Payments It is important when considering what is exempt from payroll withholding for an employee on international assignment to identify whether a payment is U.S. source or foreign source, or both. If U.S. source and not subject to mandatory withholding in the host location, U.S. withholding may apply. Foreign source income may also be subject to U.S. withholding, if not subject to mandatory withholding or tax exempt in the host location. For example, some countries have more generous relocation exemptions than the United States. To illustrate, an assignee moving to Ireland can have stamp duty charged on the purchase of a property paid tax free. This payment, which can be substantial, is taxable in the United States and may not be covered by a tax credit, so U.S. withholding should be operated. What About Short-term Assignments? Inbound A common misconception is that assignees coming into the U.S. for various business trips or short-term projects are not a payroll concern. Companies consider such assignments "low maintenance", assuming everything will go as planned and the individual will be back at his or her desk in the home country before the ink dries on the assignment letter. If only this were the case! Many countries have domestic tax laws that exempt short-term visitors from taxation and, consequently, from payroll withholding. U.S. tax law, for example, exempts short-term business visitors to the United States from U.S. tax, if they meet certain conditions as follows:
Most international assignees in the United States for close to 90 days would probably fail the income limit and will, therefore, not qualify for this exemption. The United Kingdom has a 60-day limit, but most short-term assignments actually last more than 60 days. For employees inbound to the United States for an assignment of less than six months, there is a way, potentially, to be exempt from U.S. taxation and, therefore, U.S. withholding: they can qualify for tax treaty exemption. To use what is called the 'dependent personal services' Article of the Double Tax Agreement (DTA), the three conditions typically to be met are as follows:
DTA The first point to note on using a DTA is that it only applies where an assignee is from a country with which the United States has a DTA. This excludes, for example, short-term assignments between the U.S. and Hong Kong, Singapore, and nearly all other significant locations for multinational financial companies. Secondly, the assignee must actually remain a resident of his or her home country to use the DTA. Therefore, if an individual was brought into the U.S. for a project for five months and then moves to a third country for a second project, he or she may be away from the home country long enough to break residency, so therefore, the DTA may not be used for any of the short-term assignments. A second issue to be considered is the differentiation to be made between the last two conditions mentioned above. For example, a U.K. individual on a short-term assignment in the United States would not qualify under the second condition in the DTA, if the individual's compensation is charged to a U.S. subsidiary of the U.K. employer. In this situation, the U.K. employer serves merely as a payroll agent for the U.S. company. According to the third condition, the benefits of the DTA exemption are lost when it is shown that the U.S. activities of a U.K. corporation constitute a U.S. permanent establishment of the U.K. employer corporation in the United States. If it is confirmed at the outset that an exemption to withholding will apply due to the DTA, it is important that all relevant parties (payroll, finance, human resources, and the assignee) are aware of the conditions that must be met so that the exemption is maintained. For example, an assignee in the U.S. for a five-and-a-half-month project could easily have planned a vacation in the United States, which could bring him or her over the 183-day limit and subject his or her compensation for the U.S. project to U.S. tax. This creates a payroll exposure for the employer. Exemption from Withholding Does Not Apply In situations where an exemption from withholding does not apply, compensation may also be subject to withholding in the home country as the assignee remains employed by the home employer and is not away from the home country for a sufficient length of time to be exempt from withholding there. Consequently, the employer may need to gross up the compensation in the host location so that the employee is not footing the bill for the withholding in both countries. A tax reconciliation should then be prepared to reconcile the employer and employee at the end of the assignment. It is important that companies have policies in place to deal with such issues. When Assignment Becomes Long-term As a final warning on inbound short-term assignments, companies encounter problems, typically, when a short-term assignment suddenly becomes a long-term assignment. This may be either the employer's choice, as the project may overrun the initial period planned, or the assignee may wish to stay in the United States after the end of the project. Once the 183-day limit is exceeded, however, all compensation since the start of the assignment becomes subject to tax reporting and withholding, exposing the employer to penalty and interest charges due to payroll non-compliance. Outbound Outbound short-term assignments can also be a payroll headache from a global perspective. Companies generally continue withholding in the home location, but forget the possible withholding requirements in the host location; or they are under the misconception that because the assignment is short there may not be any requirements in the host location. As mentioned above, most countries do have an exemption for short-term business trips. A DTA may also allow for exemption. How To Correctly Deal with Negative Tax Equalization Settlements and Tax Refunds? For companies that tax equalize their assignee populations, it is common for amounts of previously-taxed income to be reimbursed to the company in a later year. This can arise due to an underpayment of hypothetical or actual tax by an assignee or the returning of a U.S. and/or foreign tax refund to the employer. As these items of compensation were taxed in a previous year, repayment of funds to the employer is considered negative income to the assignee. Most employers assume that they can just reduce total compensation by the negative income amount — maybe apply a gross-down and they are done. In some cases, if the assignee has left the company, this may reduce total compensation to zero leaving a surplus of negative income. For U.S. tax purposes, while reducing compensation in the current year may be the simplest and most practical approach from an employers' perspective, it is not altogether correct. When the income inclusion and the reimbursement do not occur in the same tax year, and the reimbursed amounts are greater than $3,000, U.S. tax law requires that the negative income be dealt with in a specific manner on the assignee's tax return for the year in which the negative income was reimbursed to the employer. In doing so, the assignee receives the tax benefit directly from the tax authorities and refunds this benefit to the employer. Where the negative income is significant, especially where the amount exceeds the assignee's compensation for the year, the employer may obtain a higher tax benefit. Does State Withholding Exemption Follow Federal Withholding Exemption? After reviewing all the various federal and host country payroll tax withholding implications of an international assignment, some companies forget to address state withholding issues. States have their own set of rules, some similar to federal, some not. One of the fundamental differences between federal law and state law is the definition of "residence." Each state determines residence differently, some differentiating between individuals domiciled in that state and individuals moving into the state. For example, New Jersey is what is called a 'domicile state', meaning that residence is determined by whether an individual is a domiciliary of New Jersey or not. Therefore, assignees leaving New Jersey to take up an international assignment generally do not break New Jersey residence. For these individuals, New Jersey withholding should continue throughout the assignment. New Jersey is easier on foreign nationals, however, allowing them to remain nonresident while on temporary assignments there. New York on the other hand, although also a 'domicile state', allows a domiciliary of New York to break New York residence when leaving for a long-term assignment as long as certain conditions are met. Please note, however, that New York has introduced very onerous payroll withholding guidelines which affect assignees; so, New York withholding may still apply to certain compensation items paid to assignees on assignment, specifically stock option income, bonuses, and other equity compensation. It is very important, therefore, not to ignore state issues when considering payroll withholding issues for the company's assignee population. Conclusion As can be gleaned from the discussion above, there are a number of misconceptions regarding global payroll compliance. Employers don't always consider both sides of the story and can end up with large payroll withholding exposure and may incur large penalties and interest charges during payroll audits. Whether inbound or outbound, short-term assignments create a number of global payroll challenges. Time should be taken at the start of each assignment to review the payroll implications in both the home and host locations to ensure global payroll compliance. A system should also be in place to revisit the situation should the assignee or assignment details change during the assignment. Now is a good time to review payroll practices for your company's international assignee population before the pressure of year-end reporting kicks in. KPMG can assist you with this review and recommend best practices. KPMG has also developed useful technology to assist with payroll compliance for both long- and short-term international assignments, including assistance with global payroll compliance for equity compensation. ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. |