Starting in June, we understand that Cathay Pacific Airlines will commence withholding 30 percent of its American pilots’ salary every month. The withholding will be for US taxes and will be passed on to the US Internal Revenue Service (IRS). In addition, Cathay will remit the pilots’ personal information to the IRS so that the proper records will be maintained and tax credit given to the taxpayer-pilot. It has been reported that the move will affect about 18% of the cockpit crew.
Tax professionals in Hong Kong have queried the legal grounds for Cathay’s decision and are understandably befuddled. Some have wondered if the decision is due to the “Foreign Account Tax Compliance Act”, known as FATCA.
By brief background, under FATCA, foreign financial institutions (FFIs) and non-ﬁnancial foreign entities (NFFEs) must agree to certain verification and due diligence procedures – meaning they must be on the look-out for customers, owners or beneficiaries evidencing any “US indicia”. They must identify and report directly to the IRS or their own government via an intergovernmental agreement (IGA), information on US account holders/owners. They must look through their customers and counterparties’ ownership to find “substantial US owners” (generally, more than 10 per cent ownership). If they don’t agree to the due diligence and reporting, the institution/entity itself will suffer a 30% withholding tax on all US source payments, including sales proceeds on US stocks and securities. Simply put, the FATCA focus is on reporting by foreign financial institutions and a 30% withholding tax is the cost of not reporting.
It would not make sense that FATCA is the underpinning for Cathay’s decision, however. Cathay is not a FFI, and while it is remotely possible that it could qualify as a NFFE, FATCA would not apply to Cathay’s pilot employees since they are clearly not “substantial US owners” of Cathay within the purview of FATCA.
Something else must be going on. What is it? I believe it is the long and strong arm of the US tax authority continuing to assert its might beyond US borders.
US Tax Shock
It may come as a shock to foreign (non-US) companies and other foreign businesses to learn that they may have US tax withholding obligations with respect to their US employees, even if the foreign business is not in any way involved in US activity. Pursuant to the US Internal Revenue Code, an employer is required to withhold federal income and social security taxes from the wages of its US employees. Every quarter, the employer must file a Form 941, the Employer’s Quarterly Tax Return, reporting the amount of income and social security tax withheld during the period. A Federal Tax Deposit Form must be filed with the remittance of the withholding taxes the month following the close of each quarter.
Foreign Employers Supposed to Withhold US Tax on Wages Paid to US Employees
With certain exceptions, every employer making payment of “wages” to US employees is required to deduct and withhold upon those wages an income tax determined in accordance with IRS procedures.
For income tax withholding purposes, “wages” is defined, with certain exceptions, as all remuneration for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash. The term “wages” includes remuneration for services performed by a citizen or resident of the United States as an employee of a nonresident alien individual, foreign partnership, or foreign corporation whether or not such alien individual or foreign entity is engaged in a trade or business within the United States. Thus, for example, a foreign corporation without any US activities is responsible for income tax withholding on wages paid to its US person employees.
There are two possible exceptions to income tax withholding that may apply to US citizen employees. Generally, these are for amounts paid to US citizens (note, not to green card holders) when the amounts are covered by the foreign earned income / housing exclusions of Code section 911. There is also an exception for amounts on which the employer is required to withhold income tax by the laws of any foreign country or United States possession.
If Cathay were following these rules, the flat 30% withholding would not make any sense. This is so because withholding is not imposed on a flat-rate basis. Instead, income tax withholding on wages is based on the employee’s particular tax situation. The employer is advised how much withholding should be undertaken by the employee’s submission to his employer of a completed Form W-4. Generally speaking, the Form W-4 allows a taxpayer a certain degree of control over how much of his salary he wants subject to federal income tax withholding by permitting him to specify the number of so-called “withholding allowances” he can claim with regard to his paycheck. The number of “withholding allowances” claimed by the employee on the Form W-4 will have a direct impact on the amount of income that is withheld by the employer for federal income tax. A taxpayer can adjust his withholding allowances at any time during his employment.
Revenue Ruling 92-106 and the Long Arm of the IRS
Implementing Code sections 3401 and 3402 regarding withholding duties of employers making payment of wages, the IRS issued Revenue Ruling 92-106 1992-2 C.B. 258. The Ruling provides that when a US citizen or resident performs services overseas as an employee of a foreign employer income tax withholding applies to the wages paid. The Ruling discusses the two exclusions from withholding for amounts paid to US citizen employees, mentioned above (that is, no withholding is required for amounts paid to US citizens if the amounts are excludable from income under the foreign earned income / housing exclusions of Code section 911; or for amounts on which the employer is required to withhold income tax by the laws of a foreign country). In the Ruling the IRS makes clear that a foreign employer of a US citizen or resident must withhold US income taxes, even though the foreign employer has no US trade or business or other US connection, such as a US payroll system.
Tax practitioners have expressed doubt about the validity of this IRS view, basically on grounds that the Revenue Ruling oversteps jurisdictional boundaries. This is because a US nexus or “connection” is missing in a case of a foreign employer without US connections being required to withhold on wages it pays to a US employee who is working in a foreign country. The might of the IRS, however, has not gone unnoticed in the international sphere. Aside from FATCA, I am seeing the trend that foreign employers are withholding income tax on US employees working abroad when that foreign employer is a subsidiary of a US company or has other significant US contacts. This seems to be the case with Cathay Pacific.
While most employees working overseas pay estimated taxes and do pay fully on their income tax obligations; the law is clear that the employer bears ultimate tax liability for not withholding. Furthermore, stiff monetary penalties apply for the failure to withhold. If a foreign employer has US connections of any sort (in the case of Cathay Pacific, all important US landing rights) it just might be strong-armed to seriously consider and implement the income tax withholding rules.
Original Source By: Virgina La Torre Jeker, J.D.