Easier Said Than Done: Getting Assignee Payroll Documentation Right
by Andrew Gewirtz, KPMG LLP, Short Hills
(KPMG LLP in the United States is a KPMG International member firm)
How does that expression go: sometimes what's old is new again? There was a time when Form 673 and Form W-4 attracted attention like a stray piece of luggage at an airport. Waning attention over the years to the minutiae of payroll withholding for U.S. outbound assignees was reinvigorated on July 13, 2007 as it happens, a Friday the 13th. Final regulations were published1 that provide guidance for employers and employees regarding the submission by employers of Forms W-4 to the U.S. Internal Revenue Service (IRS) as well as the procedures for the IRS to question the number of withholding allowances claimed on those forms.2
For all the buzz created by these regulations, one would think there was something technically significant, something akin to last year's changes to the foreign earned income exclusions that was causing the stir. Actually, these regulations are procedural rather than technical. They do not change the law as it applies to determining the appropriate number of withholding allowances an employee is permitted to claim nor do they alter any of the technical requirements as to what constitutes a properly documented payroll file for U.S. outbound assignees ("U.S. assignees").
So much for what the regulations don't do. What they have done is produce an increase in the frequency of IRS-issued lock-in letters sent to employers and employees challenging employees' withholding allowances. This flurry of activity has motivated employers to take a closer look at their payroll documentation procedures for international assignees to make sure that their payroll files are up-to-date and accurate.
Proper payroll file documentation is a very appropriate and cost effective defense against IRS inquiries. This article presents some of the basics of the application of tax withholding laws as they apply to U.S. outbound assignees. We also include a brief discussion of the new regulations.
General Rules for Withholding Taxes for U.S. Outbound Assignees
Let's begin with the basic premise that generally U.S. citizens and residents are subject to personal income tax on their worldwide wages and that the law requires that every employer making a payment of wages to a U.S. citizen or resident should deduct and withhold taxes from those wages. For this purpose, "wages" includes all the standard items such as salary, bonuses, and equity-based compensation, but also includes non-cash remuneration such as a company-provided automobile, housing assistance, tax reimbursements, and other taxable fringe benefits.
The way U.S. tax law is written, the definition of wages for income tax withholding purposes includes all remuneration unless specifically exempted. There are, in fact, 22 such exemptions, of which two are of particular interest for purposes of the discussion here.
First, wages payable to a U.S. citizen are exempt from wage withholding tax if, at the time of the payment, it is reasonable to believe that the wages will be excluded from gross income under U.S. Internal Revenue Code (I.R.C.) section 9113. I.R.C. section 911 allows a qualified individual to exclude a certain amount of income earned while living and working in a foreign country from his or her taxable income.
Second, wages paid for services provided by a U.S. citizen employee in a foreign country or a U.S. possession are exempt from withholding if the employer is required by the law of that foreign country or U.S. possession to withhold income tax on those wages4. The regulations provide that this exemption is not available if wage withholding tax is not actually imposed under foreign law; so, for U.S. assignees in countries like France or Singapore where taxes are paid on a voluntary, self-assessment basis, this exemption is not available.
In addition to the usual withholding allowances available to all taxpayers and the special exemptions provided by law as mentioned above, a U.S. citizen or resident employee can also adjust withholdings to account for foreign tax credits that they expect to claim to reduce their personal income tax for the year.
Form 673 (Statement for Claiming Exemption from Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911)
The first of the two exemptions mentioned above is for individuals whose wages may be exempted under the foreign earned income exclusion. The law says that remuneration payable to a U.S. citizen is exempt from wage withholding tax "if, at the time of the payment of such remuneration, it is reasonable to believe that such remuneration will be excluded from gross income under section 911."5
When is it reasonable to believe that wages will be excluded from gross income under section 911? The regulations provide that a reasonable belief "may be based upon any evidence reasonably sufficient to induce such belief …that the remuneration is excludable…"6 Although not a definitive statement by the Treasury, it can be significant, as will be highlighted shortly. The regulations then go on to suggest that an employer may presume that an employee will qualify for the section 911 exclusions if the employee executes a statement, in the form prescribed and under penalties of perjury, that he or she expects to so qualify.
One way to substantiate this reasonable belief and provide documentation for your payroll files is to have the employee provide an executed Form 673. This form, when signed by the employee, is designed to satisfy all the requirements to establish what the IRS considers reasonable belief and allows the payroll department to implement the wage withholding exemption. It is not necessary that the employee submit a new Form W-4 to implement this exemption.
Although Form 673 is designed to satisfy all of the IRS' requirements, it is not the only way to establish a reasonable belief. In fact, contrary to popular belief, technically one need not obtain Form 673 from the employee. In theory and here's where the Treasury's non-committal statement in the regulations comes into play adequate documentation that meets the test of the regulations may also be relied upon as substantiation that an employee satisfies the conditions for his or her income to be considered excludable and, therefore, not wages subject to withholding. For example, if the employer arranges the employee's compensation package and determines the number of days that he or she will be working outside the United States, presumably all information in the employer's personnel records relating to the employee's transfer abroad, such as the assignment letter, should be sufficient documentation for the employer to cease withholding under this exception as long as it appeared from the circumstances that the section 911 requirements would be satisfied.
Form W-4 (Employee's Withholding Allowance Certificate) and Withholding Allowances
Form W-4's purpose is clearly printed on the form. Taxpayers are advised to "Complete Form W-4 so that your employer can withhold the correct federal income tax from your pay." Communicating the correct amount of income tax to withhold is done by indicating on the form the number of requested "withholding allowances." The company's payroll system will translate these allowances into actual tax withholdings. The higher the number of allowances claimed, the lower the withholding.
A Form W-4 submitted to payroll remains in effect until the employee submits a new one. Considering that a U.S. outbound assignee's withholding obligations generally will change significantly beginning with the start of an international assignment, in many cases it is advisable that a new Form W-4 be prepared and submitted to payroll. Unless a new W-4 is submitted, the employer is technically required to honor the most recent Form W-4 on file.
The withholding allowances on the new Form W-4 should reflect the new anticipated withholding scenario applicable to the assignment period, recognizing the exemptions and credits previously discussed, as well as taking into consideration the impact of hypothetical tax retention and other assignment-related items. If the only change in withholding is attributable to exempt wages under section 911 or if wages are subject to mandatory foreign income tax withholding, then a new Form W-4 may not be necessary; whereas, the anticipated use of foreign tax credits to reduce or eliminate a taxpayer's tax liability on wages not otherwise exempted from withholding will likely require that a new Form W-4 be submitted. As with the application of most tax provisions, exceptions and special considerations are to be expected so consider discussing this further with your tax adviser.
(Although this article does not discuss state tax withholding, the employee's Form W-4 also affects his or her state tax withholding and any changes to the employee's state tax residency during the assignment period must also be considered.)
Why Full Compliance with Withholding Obligations for Assignees Can Be Difficult
Generally speaking, a company's payroll manager and tax director aim for full compliance with the company's tax withholding obligations. However, oftentimes situations arise that may frustrate attempts to achieve the full compliance goal.
For example, the following technical point can derail any effort to fully comply with withholding rules: to the extent that a U.S. citizen employee working abroad makes business trips back to the United States, the wage withholding exemptions previously described are theoretically not available against the income attributable to the time spent working in the United States since that income is not eligible for the section 911 exclusions or the foreign tax credit. The rationale here is better suited to a more detailed, technical article. Suffice to say, that this finer point of calculating the proper withholding for assignees is frequently overlooked.
Earlier we noted that Form 673 advises corporate payroll that a certain amount of the employee's wages is expected to be excluded from taxation and is therefore exempt from withholding. What Form 673 does not do and this is a common misconception about the form is to allow payroll to exempt all of an assignee's income from withholding just because he or she is an assignee. The only potentially exempt amount is the maximum amount of income that the employee expects can be excluded under section 911, which includes both the general and housing exclusion amounts. Any wages in excess of the maximum excludable amount are technically still subject to withholding. Further, for an employee whose anticipated total wages for the year exceed the anticipated exclusion amount, a pro rata amount of withholding is required during every pay period and not only in the first pay period after the employee's wages exceed the maximum exclusion amount.
For example, consider a U.S. citizen employee with wages of $120,000, all of which are for services performed outside the United States. The employee expects to qualify to exclude the maximum earned income under section 911 ($82,400 for 2006 not including the housing exclusion) and provides payroll with a signed Form 673 to document this expectation. Assuming the employer operates a monthly payroll, this employee's monthly reportable wage is $10,000. The way the withholding rules work, roughly 69 percent of the employee's regular monthly salary before the exclusion represents exempt wages ($82,400/$120,000 = 69%). So, $6,900 (69% of $10,000) of the employee's regular monthly pay is considered exempt from withholding, while the remaining $3,100 per month is subject to withholding during every pay period unless another exclusion or exception, such as the anticipated use of foreign tax credits, applies to the remaining wages.
It's no wonder proper payroll reporting compliance can be difficult to achieve! With complications like these, the cost of compliance can push the cost/benefit curve way off the charts.
Practical Considerations When It Comes to Assignee Payroll Documentation
Given the often small amount of net U.S. tax that must be withheld for U.S. assignees and IRS enforcement efforts in this area, compliance can be spotty, and some U.S. employers that transfer U.S. citizens abroad simply stop U.S. withholding when the international assignment begins. Technically, there is no justification for this position and the IRS has not codified an "international assignment administrative convenience" exception to the wage withholding rules that would make this a supportable position.
An employer who simply stops withholding on wages for U.S. assignees without an updated Form W-4 on file that substantiates this position should understand that if the IRS undertakes a payroll audit or a review of the employees' Forms W-4 and uncovers significant amounts of apparent under-withholding, it could require the employer to withhold on those employees in full with as little as one withholding allowance. And, although in certain instances the amount of under-paid taxes may be minimal, there would nevertheless remain the possibility that the employer could be assessed for interest and penalties. Those with potential exposure here would be employees whose incomes exceed the maximum foreign earned exclusions and whose incomes are not subject to mandatory foreign income tax withholding and, therefore, might rely on anticipated foreign tax credits to reduce their withholding obligations.
What about updating Form 673 to reflect changes in an assignment or to recertify every two years the employee's eligibility to exclude income under the foreign earned income exclusion? If an employer satisfies the "reasonable belief" standard previously discussed for the two consecutive taxable years immediately preceding the current year and if the employee was residing in a foreign country on the first day of the current taxable year, then it may not be necessary to obtain an updated Form 673 from the employee. In this case, the reasonable belief standard should be maintained. It is important to remember, you may rely on other sources to satisfy the reasonable belief standard; so, updating Form 673 once obtained is not a mandatory effort.
Although Form 673 is not mandatory, it is still recommended that you obtain a signed form from your employee at the start of the assignment. Should the IRS question a particular assignee's payroll record, you may rely on other sources to satisfy the reasonable belief standard; thus, not having the form on file is not detrimental in the event of a payroll audit. However, it should be easier and less time consuming to support your case in the event of a payroll audit if the signed form is on file.
New Regulations Provide Guidance on New Procedures for Submitting Forms W-4 to IRS
As previously mentioned, the new regulations are procedural rather than technical. They generally change the procedures for employers to submit copies of Forms W-4 to the IRS and for the IRS to question the number of withholding allowances claimed by an employee.
Under prior rules, an employer was required to send to the IRS any Form W-4 claiming more than 10 withholding allowances. The new regulations abandon this procedure in favor of new rules that require employers to submit copies of Forms W-4 to the IRS only if instructed to do so in published guidance or in a written notice to the employer from the IRS. This written notice is commonly referred to as a "lock-in letter." Along with these new procedures, the regulations give the IRS the authority to issue a notice to an employer specifying the maximum number of withholding allowances permitted for an employee based on IRS records without first obtaining a copy of the Form W-4 from the employer.
The IRS will send the lock-in letter to both the employer and employee. Regulations provide that the earliest the IRS notice may be effective is 45 calendar days after the date of the notice. Once a lock-in letter that adjusts an employee's maximum withholding allowances has been issued, the employer is out of the process. If the employee takes exception to the IRS' adjustment, he or she must respond directly to the IRS for permission to change the number of allowances before giving a new Form W-4 to the employer. The employer cannot honor a Form W-4 submitted directly by the employee that reflects more allowances than the maximum number specified by the IRS without the employee first obtaining IRS approval of the increased amount.
One technical point specified in the regulations is that the receipt of an IRS notice does not impose a requirement to withhold income taxes where one does not already exist. To understand the application of this provision, consider once again our previous discussion on income that is exempted from wage withholding (e.g., income excluded under section 911 and income subject to mandatory foreign income tax withholding). There is no requirement to withhold tax on such income and where a requirement to withhold does not exist, such a requirement cannot be imposed by the receipt of an IRS notice, so the employer can properly continue to rely on the exemptions. All the more reason to have your payroll files properly documented with current Forms W-4 and 673.
The regulations also contain some additional administrative provisions that:
- Clarify that a substitute withholding exemption certificate developed by the employer may be used instead of Form W-4 under certain conditions
- Provide that employers may refuse to accept a substitute form developed by an employee and treat this as a failure to furnish a withholding exemption certificate.
Setting up appropriate systems and implementing proper payroll documentation procedures are important elements in supporting a company's tax compliance goals. The new guidance issued under T.D. 9337 in July refocused attention on completion, submission, and maintenance of properly documented payroll files in respect of Forms 673 and W-4.
International assignment program administrators and payroll professionals should confirm that payroll files are up-to-date and properly documented and monitor lock-in letters received at the employer level and by their assignees, as well as assist them to properly respond in a timely manner.
If assistance is required, consider contacting your international assignment tax services provider to clarify any questions that you may have about proper withholding process and procedure and initiate a Form W-4 review program, if necessary.
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.