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.
Income Tax Withholding
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 Internal Revenue Services 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 partnership 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 / United States possession. This latter exception would not apply in many (if not all) cases in the Middle East since generally most Middle Eastern countries (such as the UAE) have no income tax.
The IRS has issued a Revenue Ruling which 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, set out above. 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.
In my view, this Revenue Ruling oversteps jurisdictional boundaries as any US nexus is lacking. How can the IRS mandate that a foreign employer without US connections withhold on wages it pays to a US employee who is working in a foreign country? Regardless, I am seeing the trend that foreign employers are withholding in situations when the employer is a subsidiary of a US company or has other significant US contacts. In cases when the employer has no US parent or other US connections, I understand most are not withholding despite the IRS mandate to do so.
It should be noted that most employees working overseas pay estimated taxes and do pay fully on their income tax obligations; but 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 (for example, a US partner) it must seriously consider the implications of the income tax withholding rules.
Federal Insurance Contribution Act (FICA) / Federal Unemployment Tax Act (FUTA) Withholding:
The area of FICA and FUTA taxation is far more complex. FICA taxes are paid by both employers and employees, with the employee’s portion being withheld from his wages. On the other hand, only employers pay FUTA tax; it is not deducted from the employee’s wages.
If the employer is not an “American employer” and all services are performed outside the US, no FICA or FUTA taxes are imposed on either the employer or employee. When FICA obligations exist, payment of the employer’s share of the tax and withholding on the employee’s share are required. The employer is ultimately responsible for the tax when failing to withhold. Failure to withhold is serious business and has very harsh results.
Who is an “American Employer”?
Until 2008, for both FICA and FUTA purposes, an “American employer” was defined as (1) the United States itself, (2) an individual who is a resident of the U.S., (3) a partnership, if two-thirds or more of the partners are residents of the U.S., (4) a trust, if all of the trustees are residents of the U.S., or (5) a corporation organized under the laws of the United States.
In 2008, the law was changed with passage of “The Heroes Earnings Assistance and Relief Tax Act of 2008” (The “HEART Act). The HEART Act maintained the same definition of an “American employer”; but expanded that list to include certain foreign employers for FICA purposes. Under the HEART Act, a foreign employer can be treated as an “American employer” for FICA purposes with respect to an employee who is performing services in connection with a contract between the US government and any member of a domestically controlled group of entities which includes this foreign employer. The term “domestically controlled group of entities” means “a controlled group of entities the common parent of which is a domestic corporation”. The term “controlled group of entities” means a controlled group of corporations as specially defined; it generally includes parent-subsidiary / brother-sister controlled groups, generally with over 50% ownership.
US parent companies having controlled foreign entities that participate in government contracts should carefully review the employee population of those foreign entities to determine whether any US-citizen or US-resident employees are present. Immediate action may be necessary to meet the FICA withholding requirements.
Exceptions may apply if a so-called US totalization agreement is in effect.