"BEING IN CANADA BARELY FEELS LIKE BEING OUT OF THE U.S.," SAY LEAH BROOKS. YET accepting a teaching position at McGill University in Montreal meant being unable to pay credit card bills on time because mailed bills arrived late and companies balked at Internet access from Canada. To compound her financial woes, Brooks' U.S. brokerage house refused to use her Canadian mailing address.
As a "local hire"--working directly for a foreign entity--Brooks has to deal with these issues on her own. Your clients, on the other hand, are more likely to be cushioned by the U.S. employers assigning them to overseas positions. "More employees are going overseas today," says Geoffrey Latta, director of International Compensation at Organization Resources Counselors, "as companies move into new markets, become globalized, and need more help."
While accepting an overseas assignment can build careers, it can also add enormous complexity to your clients' financial lives. There are minefields galore in income tax planning alone, plus a host of related issues that can complicate estate planning and financial management. Working with your clients, you can help them sidestep potential pitfalls by understanding the impact of both federal tax rules and employer policies on American citizens working abroad.
Many employees embarking on foreign work assignments worry, with reason, about the looming threat of double taxation. The United States, unlike most other developed nations, taxes the worldwide income of its citizens no matter where they reside or where the income is earned. Since expatriates must also pay income tax in the host country (typically, after six months of residency), the same income may be taxed twice.
Fortunately, double taxation is rare for corporate employees, thanks to a combination of federal and corporate policies. The federal tax breaks apply to every U.S. citizen working in another country, whether local hire or corporate transfer.
First, income tax treaties between the U.S. and approximately 60 countries are designed to avoid taxing the same income twice. Secondly, no matter where in the world employees are deployed, the first $80,000 of foreign income is excluded from federal taxation under the Foreign Earned Income Exclusion provision of the Internal Revenue Code. The exclusion is fixed at $80,000 through 2007 and will be subject to cost-of-living increases starting in 2008. Since a portion of reimbursed housing allowances can also be excluded, the U.S. tax bill may be wiped out altogether for lower income personnel. For high-earning executives, however, the exclusion seldom makes a noticeable dent in the tax obligation.
In addition, through the Foreign Tax Credit (FTC), the U.S. allows a credit for foreign taxes paid by U.S. citizens. If the foreign tax rate is less than the U.S. tax rate, the U.S. tax is reduced by the amount paid overseas, but the net cost to the employee is the same. If the foreign tax rate is higher than the U.S. tax rate, all of the U.S. tax is offset by the foreign tax credit, but the employee still pays more. However, under the 2004 JOBS Act, "excess foreign credits" can now be applied for the preceding one year and succeeding ten years to offset future U.S. taxes on foreign earnings.
When could retroactive credits come into play? An example provided by Jim Yager, a partner in KPMG's International Executive Services practice in Toronto, illustrates the point: An executive who lives in New York but spends half of his time overseas on business might owe no foreign taxes if he travels from place to place for his employer and doesn't become resident anywhere outside the U.S. But he does pay U.S. tax on all of his income. Then he moves to Canada, where higher taxes generate excess FTC, and he can claim a refund for the prior year of U.S. taxes on income earned outside the U.S.
State income taxes are another issue. As Anne Spar has found, living and working in London does not halt New York in its tracks when it comes to trying to collect. "We have to go through hoops to prove that we live here and pay taxes here," she says. "Unless we keep very careful records and document our whereabouts, New York State assumes we were there."
Bolstering the federal provisions, most companies--88 percent of those in a 2005 survey by KPMG International Executive Services--reduce the tax burden for their overseas assignees through a policy called "tax equalization." Under tax equalization, overseas employees pay no more and no less tax than they would have, had they continued working in the U.S. for the same employer. There are no windfalls in lower no-tax countries. There is no penalty in high-tax jurisdictions.
However, all employers are not created equal when it comes to tax equalization policies. Housing allowances are typically included, with pay "grossed up" to cover the additional tax on the income represented by the allowance. But some employers include state income taxes in the equalization formula, while others do not. Furthermore, the "pay no more and no less tax" principle applies only to salary and other work-related compensation in the eyes of many employers. Even here, the definition of "work-related compensation" can be fuzzy. Close to half of the employers in the KPMG survey report that they exclude stock options from the equalization formula.
Stock options granted during an overseas stint can also haunt executives after they are back in the U.S. It "surprises a lot of clients," says Larry Brown, a PricewaterhouseCoopers partner in Chicago, but "people should be aware that they may be subject to tax in the foreign jurisdiction on the compensation element of the stock option, even after they have ended the foreign assignment." If the fair market value of an option is $20 when awarded and $50 when exercised, the foreign jurisdiction may take the position that $30 of appreciation over ten years is worth $3 a year. If the employee was in the U.K. for five of those years, then the U.K. wants the tax on the appreciation that occurred during that period.
Personal income is even more likely to be taxed directly to the employee, since fully two-thirds of employers exclude investment income from equalization. This makes sense when you consider another of Jim Yager's examples: An employee of a company with a generous all-inclusive equalization policy faced high Canadian taxes on a significant amount of inherited wealth. The employer was "totally blown away" by a tax liability far in excess of the executive's earnings.
Other tax issues can trip up the unwary expatriate. In many foreign jurisdictions, for example, contributions to tax-deferred retirement plans such as 401(k) plans are not deductible. In fact, when host countries tax money going in while the U.S. taxes it coming out, the result is double taxation. An exception is the U.K., where a recent revision in the income tax treaty between the U.S. and the U.K. allows the host country to deduct contributions to home country retirement plans. In most other host countries, the lack of deductibility can put a serious crimp in employees' retirement savings.
The picture is a bit brighter when it comes to the alternative minimum tax (AMT), where a big hurdle was eliminated in 2005. Under prior law, according to Yager, no more than 90 percent of the AMT could be wiped out with Foreign Tax Credits. The Jobs Creation Act removed the 90 percent limitation for tax years beginning in 2005, providing significant relief for high net worth expats--especially those in high-tax host countries.
Filing tax returns as an expat is complicated, to say the least, but most employers provide assistance in navigating the shoals. This isn't out of generosity, says Latta, but because "companies bear the legal burden of compliance." However, if you have clients who are abroad as local hires working for foreign companies or as self-employed entrepreneurs, they must be diligent about filing tax returns both in the host country and the U.S. Depending on the country of residence, they may also face the spectre of double taxation.
For corporate transferees, it's critical that clients have a pre-assignment briefing covering the details of tax policy. If a briefing isn't offered, clients should ask. For some employees, such as the executive who inherited wealth, a foreign assignment might be inappropriate.
Other odds and ends can haunt U.S. workers abroad. Should they hold on to their state-side homes? Maintain credit, banking and investment relationships? Write new wills reflecting the laws of the host country?
Most people on assignment abroad for two or three years hold on to their homes in the U.S. Employers generally urge them to do so because, if they sell, rising prices may prevent repurchase upon return. Buying property abroad, on the other hand, triggers potential estate tax issues and makes it wise to have a U.S. will plus a will that is valid under local law to cover the property owned in that country. According to Ralph Kelley of Sonnenschein Nath & Rosenthal in New York, without a local will drawn up by a local lawyer, "Probate in the U.S., with ancillary probate in the foreign jurisdiction for the foreign real estate, is likely to be both cumbersome and expensive."
In any case, clients should review estate plans before going overseas, whether or not the purchase of property is contemplated. They should be sure that powers of attorney, guardianship provisions and health care directives are all in place and up-to-date. Kelley points out that standard U.S. documents should be supplemented by powers of attorney and health care proxies in the local language that conform to local practice.
On the financial front, clients sometimes become entranced with investment opportunities abroad. Here the watchword is caution. Yager insists that it's "a complete disaster if U.S. citizens invest in foreign mutual funds." Under U.S. tax laws, these funds are considered passive foreign investment companies and are taxed at a much higher rate in the U.S., triggering an enormous tax liability.
Clients may also run into trouble with domestic investments. Brokers sometimes suggest terminating accounts rather than executing buy orders from overseas, due to unwillingness to register with the host country's securities commission. The answer, in Canada, is the use of an "immigrant trust" which can continue to own shares of mutual funds and stocks, sheltered from Canadian tax, for up to five years. Sometimes a revocable living trust in the U.S. will do the trick, but clients need to check out the laws in the countries where they will work.
With the Internet allowing online management of banking and investments, Klaus notes, there's less grumbling about playing catch-up with paper statements. But it's still a good idea to have a trusted person at home in the U.S. to oversee and coordinate investments. That person, of course, can be the client's financial advisor. You can manage investments and forward information, keeping your client in the total picture and eliminating the problem Leah Brooks had with so simple a matter as changing her address on credit cards and investment accounts. Your clients may also want to maintain bank accounts and credit cards in the U.S., to ease the eventual transition home.
When clients go overseas, they need working capital accounts in the host country as well as at home. They need to know where their documents are. Without a home base in the U.S., with the file cabinet or desk drawer holding accumulated statements and important documents, Brown notes, people "tend to become disconnected." Advisors need to work with their clients before they go on foreign assignment, and help to keep them organized while they're gone.
Grace W. Weinstein (firstname.lastname@example.org) is the author of 13 books, including The Procrastinator's Guide to Taxes Made Easy (NAL, 2004). A freelance financial writer based in Englewood, NJ, she has contributed to many national magazines and has been a columnist for the Financial Times and Investors Business Daily.