When our company sends U.S. employees overseas, where do they pay income tax?

Employers should be aware that almost every country has some type of income tax that applies to all workers. In addition to the tax requirements of the host country, the employee is also responsible for U.S. tax on income regardless of where the income is earned. The Internal Revenue Service (IRS) has two provisions to help ease the tax burden for employees on international assignment.

The first provision is Internal Revenue Code (IRC) Section 901 , which provides that if the U.S. tax is higher than the host country tax, the employee pays the U.S. tax. If the host county tax is higher, the employee is able to take a credit, or the host country tax can be claimed as an itemized deduction.

The second provision is IRC Section 911 . This section allows employees to claim an exemption for a portion of their foreign income. The Tax Increase Prevention and Reconciliation Act, enacted in May 2006, changed the maximum amount of foreign earned income that an employee working abroad can exclude from gross income under this section.

If the employee is planning on claiming this exemption, he or she will be required to meet either the bona fide residence test or the physical presence test. The employee is also required to complete the IRS tax form 673 for payroll tax purposes.

Generally, Social Security and Medicare taxes are deducted from wages of employees working outside the U.S. if one of the following applies:

• The employee is working for an American employer.
• The employee performs the services on or in connection with an American vessel or aircraft, and either the employee entered into the employment contract within the United States, or the vessel or aircraft touches at a U.S. port while the employee is working on it.
• The employee is working in one of the countries with which the United States has entered into a totalization agreement (also called a binational Social Security agreement).
• The employee is working for a foreign affiliate of an American employer under a voluntary agreement entered into between the American employer and the U.S. Treasury Department.

State income taxes can further complicate the situation. Each state has requirements on residency as it relates to income tax liability. The employee will need to contact the specific state to determine the tax requirements.

Employers should encourage employees to discuss tax issues with their financial advisors before beginning international assignments.

Please Note: This material is provided as general information and is not a substitute for legal or other professional advice. Contact the Knowledge Center for more information.

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