Payroll Reporting and Withholding Requirements for Foreign Nationals Working in the U.S. — Part I
by Larry Ghirardo, KPMG LLP, Seattle
(KPMG LLP is the U.S. member firm of KPMG International, a Swiss association)

Note: This article is the first in a series on U.S. payroll issues for foreign nationals that will be published in upcoming editions of The Expatriate Administrator.

Do you have foreign nationals who are performing services in the United States? If so, it is important to be aware of the employee and employer U.S. payroll reporting and withholding requirements for these individuals.

U.S. payroll reporting and withholding on payments made to a foreign national can be affected by many factors such as the determination of who the actual employer is, the individual's U.S. residency status, the sourcing of income, and the application of income tax treaties. This article is a general discussion of some of these concepts as they apply to personal services provided by foreign nationals in the U.S. and can be regarded as a general guide to give international human resources and tax professionals a better understanding of the U.S. payroll reporting and withholding rules. Future articles on this subject area will address other factors in more detail such as exempt income, income tax treaties, social security agreements, and tax requirements for certain visa type holders.

Who is Required to Withhold?

Internal Revenue Code (IRC) section 3402(a)(1) requires that every "employer" making payment of wages shall deduct and withhold from wages a tax at a rate and in a manner prescribed by regulations. Generally, the term "employer" means any person for whom an individual performs or performed any service, of whatever nature, as the employee.

It is not necessary that the services be continuing at the time the payment is made for the status of employer to exist. Thus, a person for whom an individual has performed services in the past for which the individual is still receiving wages is an employer for withholding purposes.

However, section 3401(d) provides that if the person for whom services are rendered does not have legal control of the payment of wages for those services, the term employer means the person having such control.

The term employer also includes any person paying wages on behalf of a nonresident alien individual, foreign partnership, and/or foreign corporation, not engaged in business within the United States.

Wage Withholding for Foreign National Employees

Employers who have foreign national employees working in the U.S. are required to withhold U.S. income and other payroll taxes from the wages of these employees if the wages are not exempt from U.S. taxation under U.S. domestic tax law or treaty.

A foreign employer may be required to establish a formal U.S. payroll system, obtain an IRS employer identification number, make periodic deposits of tax, and file the applicable informational returns. The foreign employer may consider transferring the employee to the payroll of the U.S. affiliate. If it is not possible or desirable to place the employee on the U.S. payroll of a U.S. branch, subsidiary, or parent company, it will be necessary for the foreign employer to make U.S. withholding payments on behalf of the resident alien employee. Alternatively, the foreign employer may appoint its U.S. affiliate as an agent or enlist an outside payroll agent to perform these payroll functions.

A foreign national considered to be a resident for U.S. income tax purposes is taxed in the same manner as a U.S. citizen. Thus, a resident alien is taxed on and must report income from all sources, including sources outside the United States.

A nonresident alien is generally subject to U.S. income tax only on income from U.S. sources. Remuneration paid to a nonresident alien employee for personal services rendered outside the U.S. is not considered U.S. source earned income and is not subject to U.S. taxation. If a nonresident alien receives compensation that covers a period of employment in the U.S., then the portion of the compensation received that is U.S. source income is generally taxable in the U.S.

Determining status as a resident or nonresident is governed under a series of rules that are beyond the scope of this article.

Sourcing of Wages
In general, wages received by foreign national employees, whether resident or nonresident, for services rendered in the United States are normally subject to U.S. taxation, regardless of whether the wages are paid by a U.S. employer or a foreign employer. The place where the services are performed determines the source of the income, rather than factors such as the place of payment or the residence of the payee or payor.

If income is related to personal services performed partially within the United States and partially without the United States, an allocation to U.S. source income must be made. The allocation is made on the basis of time unless another method is justified (e.g., dual employment contracts).

Rate of Withholding—Income Tax
IRC section 1441 sets forth the regulations for the withholding of tax on nonresident aliens. Generally, section 1441 imposes a 30 percent rate of tax on gross income from U.S. sources that is (i) fixed or determinable, annual or periodic, and (ii) not effectively connected with a U.S. trade or business. Under section 1441(b), this income specifically includes interest, rent, salaries, wages, premiums, annuities, compensations, remunerations, and emoluments. However, salaries and wages subject to graduated income tax rates are excluded. Therefore, exempt from this 30 percent withholding are salaries, wages, remuneration, or any other compensation for personal services of a nonresident alien individual if the compensation is (i) effectively connected with a U.S. trade or business and (ii) the compensation is subject to wage withholding at source under section 3402 (i.e., graduated income tax rates). As a result, the 30 percent rate is generally not imposed on amounts paid to a nonresident alien employee by his or her employer for personal services performed in the U.S.

Federal Insurance Contributions Act (FICA)
FICA taxes are required to be withheld on wages for services performed by an employee within the U.S., regardless of citizenship or residence of the employee or employer. Therefore, foreign employers who have employees working in the U.S. are required to withhold FICA taxes from the wages of these employees. Foreign nationals on assignment in the U.S. may be subject to both home and host country social security taxes absent the application of a totalization agreement (an international social security agreement entered into between two countries to provide integrated coverage and relief from double taxation).

Federal Unemployment Tax Act (FUTA)
Employers are liable for FUTA taxes with respect to wages actually or constructively paid for services performed by an employee within the U.S., regardless of citizenship or residence of the employee or employer. FUTA is a direct tax imposed on the employer and therefore is not withheld from wages of employees. Employers are entitled to a credit against their FUTA tax liability for actual state unemployment taxes timely paid.

Exceptions to Withholding—in General
Compensation paid for services performed within the United States by a nonresident employee is not subject to withholding if the compensation is, or is expected to be, exempt from federal income tax through a provision of the Internal Revenue Code or a treaty. If the employee does not meet a Code or treaty provision exception, the wages are subject to federal income tax and withholding. The following are some of the exceptions relevant to foreign nationals:

  • Travel Expenses (Section 162): Nonresident alien employees with a tax home in a foreign country may receive reimbursements for certain travel expenses (e.g., transportation, meals, lodging) in the form of reimbursed employee business expenses. Eligible expenses that are reimbursed pursuant to an accountable plan are tax deductible under section 162(a) by the employer and excluded from an employee's gross income. These amounts are exempt from wage withholding.
  • Short Term Business Visitor: Section 861(a)(3) provides that compensation for labor or personal services performed by a nonresident employee in the United States will not be deemed to be income from sources within the United States if the following tests are met:
    • The individual is temporarily present in the United States for a period or periods not exceeding a total of 90 days during the taxable year;
    • The individual's compensation for services performed in the United States does not exceed $3,000 in the aggregate. If compensation exceeds $3,000, the entire amount, not just the excess, is taxable as income from U.S. sources; and
    • The compensation is for services as an employee of a foreign employer not engaged in a trade or business in the United States or as an employee of an office maintained outside of the United States by a U.S. employer.
Failure to meet any one of these three tests will result in taxable compensation, classified as wages, upon which the employer must withhold.

This exemption does not apply to social security taxes under the FICA or unemployment taxes under the FUTA.

  • Visa Exceptions: Exemption from withholding is available under the Code to nonresident alien employees temporarily present in the United States for certain exchange or training programs. The individuals must be temporarily present in the United States on qualifying F (academic student), J (exchange visitor or trainee pursuant to an approved program), or Q (cultural exchange visitor) and must be paid by a foreign employer. For this purpose, "foreign employer" is defined as a nonresident individual; foreign partnership or foreign corporation; or an office or place of business maintained in a foreign country or U.S. possession by a U.S. corporation, partnership, or individual who is a citizen or resident of the United States. Foreign nationals with these visas are treated as nonresident aliens under the IRC.

    Also note that F, J, and Q visa holders are exempt from FICA and FUTA taxes.

KPMG Observation: Performing services outside the scope of the visa may jeopardize a taxpayer's status as an "exempt individual" for residency purposes. While an individual is present in the U.S. under a qualified visa, and "substantially complies" with the visa requirements, days of presence are not counted towards U.S. residency under the substantial presence test. In addition, individuals present in the U.S. with J visa status who obtain employment outside the approved J-visa program may jeopardize the qualification of the employer's approved program.

Conclusion

U.S. payroll reporting and withholding rules with respect to payments made to foreign nationals (nonresident and/or resident aliens of the United States) are quite complex. Due to the complexity of the rules and the myriad of possible scenarios, it is highly impractical to cover all possible permutations here and is beyond the scope of this article. This article simply provides a basic understanding of the rules and requirements for foreign nationals and their employers. The information in this article is based upon the relevant provisions of the IRC of 1986, as amended, the regulations thereunder, and the judicial and administrative interpretations thereof. These authorities are subject to change, retroactively and/or prospectively, and any such changes could affect the validity of the information presented in this article.