Puzzled about how the new tax ruling impacts your assignees and the administration of your expatriate programmes? We find out what employers of US expatriate employees need to know.

Many companies are still estimating the financial impact of the US tax changes.

The US tax legislation enacted in May 2006 has left many expatriate administrators wondering how it impacts their assignees and the administration of their expatriate programmes. 

Overview of the changes in the tax rules for expatriates

Prior to the tax law change, US nationals living and working outside the United States generally could exclude all or a portion of foreign-earned wage income assuming certain tests were met.  The maximum annual exclusion was USD 80,000 plus an additional housing exclusion equal to total foreign housing expenses in excess of a threshold (approximately USD 12,000).   Taxpayers in locations with higher housing costs were allowed to claim a higher housing exclusion. 

Several tax proposals have been offered over the years to revise the exclusion rules, but usually the proposals never made the final cut as a result of lobbying efforts from multinational employers and other interested groups.  But this year, the changes were added at the last moment during congressional conference even though the changes were not included in either the Senate or House versions of the tax bill. 

There was no opportunity for expatriate taxpayers or multinational employers to lobby Congress to keep the old tax rules intact.  It was determined by the tax writers that the tax rule changes on the foreign earned income exclusion were necessary to raise tax revenue, offsetting other provisions in the same tax law that reduced revenue. 

Basics of the tax law changes
Here are the key tax changes impacting US expatriates:

• Higher general exclusion – The annual exclusion was increased from USD 80,000 to USD 82,400 for 2006.  This exclusion amount will be indexed for inflation for subsequent years. 
  
• Reduced housing exclusion – The housing exclusion is now computed as a percentage of the general exclusion.  This generally limits the allowable foreign housing expenses considered for exclusion at 30 percent of general exclusion (USD 82,400 times 30 percent equal to USD 24,720). 
  
  From this amount a base threshold is subtracted that is set at 16 percent of the general exclusion (USD 82,400 times 16 percent equal to USD 13,184).  Therefore, the maximum housing exclusion is capped at USD 11,536 regardless of the actual housing costs incurred.  The US Treasury has been granted the authority to adjust the 30 percent maximum allowable housing exclusion for geographic differences in housing costs.  It is hoped this will allow for a higher housing exclusion for those locations with high housing costs.  Treasury and IRS officials are now working on a methodology for adjusting the housing costs by location on an annual basis. 
  
• Stacking rule – The tax on income remaining after the exclusions is calculated as if the exclusion were added back to taxable income.  This method of computing the tax is known as 'exemption with progression' or the 'stacking rule'.  The result is that taxpayers are claiming the exclusion at the lowest tax rates and lose the benefit of the lowest tax brackets of 10 percent, 15 percent and 25 percent on the non-excluded income.  The non-excluded income includes wages earned in the US that is not eligible for the exclusions, as well as certain non-wage income like interest income and rental income.
  
• Retroactive to January 2006 – The new tax rules are effective from the beginning of the 2006 tax year even though the law was only passed in May. 

 Implications for US expatriate taxpayers

Taxpayers hardest hit are those in high housing cost locations that are low-tax or no-tax countries like Hong Kong, Singapore, and the Middle East.  Taxpayers in high-tax countries will generally be able to offset the higher tax resulting from the exclusion changes by claiming more foreign tax credits.  However, even those expatriates located in high-tax jurisdictions will potentially be impacted by the stacking rule and may pay a higher rate of tax on non-excluded income that isn't completely offset by foreign tax credits. 

• What's it worth? – Because the exclusion is now used at the lowest tax brackets because of the stacking rule (tax rates between 10 percent and 25 percent) it generally will result in an effective tax rate savings of 18 percent.  At the maximum annual amount, the tax savings by claiming the exclusion is approximately USD 17,000. 
  
• Persona non grata – Already one of the most expensive types of expatriate employee to send on international assignment, US national employees may find themselves increasingly passed over for key international postings as companies gain an awareness of the increased costs.  This generally makes US national expatriates less competitive in the global labour market compared to citizens of other countries seeking international postings.
  
• What is it going to cost? - The estimated financial impact to companies employing tax-equalised US expatriates will depend on the level of housing costs incurred and the host country of the expatriate.  It is worse in high housing cost locations coupled with low or no tax jurisdictions.  In other locations with moderate to high tax systems there may be no direct impact.  It is typical to expect increased tax equalisation costs to vary anywhere from zero to USD 50,000 per assignee per year or an average of USD 10,000 per expatriate per year for typical expatriate populations in typical locations.
  
• More decisions to make - Claiming the exclusion is not mandatory.  In some cases it may be more beneficial to only claim a foreign tax credit to reduce the US tax liability and skip the exclusion.  Whether or not to claim the exclusion will require careful analysis to optimise the tax bill not only for the current year but future tax years.  Potentially affected are the availability of foreign tax credit carryovers to future years and the flexibility to elect the exclusion in future years.  This especially would be a problem if the expatriate were planning to take a subsequent assignment from a high-tax country to a low-tax or no-tax country. 
  
  Additionally, there are specific rules to be followed when electing to claim the exclusion or deciding to revoke the exclusion once elected.  Once revoked, the exclusion election cannot be made again during the five tax years following the revocation.   Discussions will be necessary with your tax preparers as to how to make these decisions as the 2006 US return is prepared. 

Issues to consider in administering your expatriate programme

• Budgets - Review and update your assignment costs for the increased tax equalisation costs.  Update company budgets and accruals, and notify business units in the field of these increased costs beforehand.  Many companies are currently in the process of estimating the financial impact of these changes.
   
• Employee relations - Review compensation packages for US nationals on localised or hybrid tax arrangements where the expatriate is not completely tax equalised to a US hypothetical tax.  Those expatriates will argue that personal after-tax income has diminished because of these unexpected tax changes, making the assignment unattractive financially.  For those expatriates on a policy of tax protection (typically in low-tax or no-tax countries) consideration may be needed to provide some type of modified tax equalisation or adjustment to compensation.
  
• Impact to your company's clients - Where expatriate costs are passed onto customers directly (typically defence- or project-based assignments), companies may need to re-price or renegotiate the customer contract terms.
  
• Administrative updates – If you have your US expatriates on US payroll, two US payroll forms should be updated: New Form 673 – For those expatriate employees on US payroll, wages that are eligible for the exclusion are not subject to US tax withholding if a Form 673 is completed and submitted to the payroll department.  Since the exclusion generally will be smaller, the form should be updated for the expected housing exclusion for 2006 and future years.
  
  New Form W-4 – Revised Form W-4’s generally should also be submitted to adjust the withholding exemption allowances.  Even if correctly calculated originally, the old Form W-4 may no longer provide sufficient withholding to avoid underpayment penalties. 
  
• Underpaid taxes for 2006 - Consider your employer requirements to withhold US tax on non-excluded income.  Since the tax law change is retroactive to January, expatriates potentially are already under-withheld for the first half of 2006.  Those expatriates on non-US payrolls may need to make estimated tax payments to avoid underpayment penalties.  Being proactive now to adjust withholdings and tax payments will minimise surprise tax bills when the expatriate files their 2006 US return next year and make it easier to settle the tax equalisations with the expatriate.
  
• Housing guidelines – Consider a review of your policy on housing reimbursements.  If you currently do not withhold a home country housing norm, you may be able to achieve significant savings by asking the employee to contribute a housing norm towards the global housing costs.  You may also want to review how the housing budgets in the host country are administered to ensure that overly generous rental guidelines do not exist.
  
• Get involved - Consider getting involved with efforts to roll back the rules. Lobby your Congressional Representatives to revise the rules.  The strongest argument is for US competitiveness - that the exclusion was intended to place US nationals working abroad on equal footing with their peers on assignment.  Note that this exclusion was not intended to be relief from double taxation as the foreign tax credit system achieves this goal.  Unfortunately, these tax rules make US expatriate employees more expensive than their non-US counterparts.

 To round up, because the tax is retroactive and done with little publicity, companies are just beginning to realise that they will have to adjust budgets and their tax compliance process to make up for the underpaid taxes.  Potential employee relations issues may come up if the expatriate believes that the tax law change has adversely affected his/her after-tax income.  Be proactive and take action now.

July 2006     

Next week we look at how companies are facing up to the challenge of the new ruling.

The author Patrick Jurgens is Director of Global Tax Research & Consulting
Associates for International Research, Inc. (AIRINC), USA.

Subject: New US tax regulations, expatriate tax compliance