The U.S. program for social security has been much in the news lately, with characterizations that are both favorable and unfavorable. No matter how it is described, it remains an important program in the U.S., and it also has a significant role for persons working in an international context. Following is a discussion describing how U.S. social security operates for multinational employers and employees, and how it currently coordinates with other countries’ social security systems.
The Jurisdictional Basis of U.S. Social Security
Under the domestic law of the U.S. (that is, the law applicable under U.S. statutes and regulations, without regard to treaty overrides) employers are obligated to pay FICA and Medicare taxes (“Social Security tax”) for all employees working in the geographic U.S. Of course, employees are obligated to pay a matching Social Security tax (in a break from the historical 50/50 approach to this tax, employees in 2011 had to pay only 4.2%, as opposed to employers’ 6.2%). Social Security tax will apply for services in the U.S., even if the employer is not a U.S. entity, and even if the employee is not a U.S. person. So under the domestic law of the U.S., a Brazilian national working in the U.S. for a branch of a Hong Kong company will be in U.S. social security, and the employer and employee tax will apply. In determining who is the “employer”, the U.S./IRS tests of employment apply.
For services performed outside the U.S., the domestic law of the U.S. also requires that U.S. social security will apply for a “U.S. person” (U.S. citizen or green-card holder) employed by an “American Employer” (U.S. corporations, also certain partnerships and trusts). So a U.S. citizen working for a foreign branch of a U.S. company will be covered by U.S. social security. An American employer can also elect a special status for a foreign subsidiary (called a “3121(l) election”), but this is not popular since such an election will apply to all U.S. persons employed by the foreign subsidiary, will require the employer to pay both employer and employee taxes, and is irrevocable. Thus, if the U.S. person is employed outside the U.S. by a foreign subsidiary, U.S. social security will not apply (absent that special election). There is no “voluntary” coverage by U.S. social security; either it applies or it doesn’t apply.
In addition to the domestic law of the U.S., there are important treaty provisions.
Social Security Totalization Agreements
In 1977 Congress authorized the U.S. to enter into treaty arrangements with other countries in connection with social security coverage and benefits. In regard to benefits, the statue (section 233) permits the U.S. president to enter into agreements “totalizing” benefits under U.S. social security. This basically means that two countries can agree on a system whereby the benefits are paid on a proportionate basis from each system, as if all service were in one of the systems, but then with each system paying a proportional benefit. This is a good thing for beneficiaries, in that it will usually increase the social security benefits payable from the U.S. system and the foreign system. Since 1977, the U.S. has entered into totalization agreements with 24 countries. This “totalization” approach does not apply for countries that have not entered into a totalization agreement with the U.S.
However, the legislation also provides that “coverage” (which system collects the taxes) will be sorted out such that there will be “a period of coverage under the [U.S. system] or under [the foreign system] but not under both [emphasis added].” If you look at the Social Security Administration website (“SSA Website”), it will explain that totalization agreements “eliminate dual Social Security taxation, the situation that occurs when a worker from one country works in another country and is required to pay social security taxes to both countries on the same earnings [emphasis added].” This is an important concept: for the treaties to apply to employer and employee taxes, it should start with duplicative coverage. If no duplicative coverage, then there should be no treaty application to taxes (but see the discussion on France below). So when a U.S. person is sent on assignment outside the U.S. to a treaty partner country, the first step is to determine if there is duplicative coverage. If not (for example, where the person works for an employer who is not an American employer), then the treaty shouldn’t apply to taxable coverage (but as a practical matter that isn’t always the case; see below). As the SSA Website states “the agreements, moreover, do not change the basic coverage provisions of the participating countries’ Social Security laws—such as those that define covered earnings or work. They simply exempt workers from coverage under the system of one country or the other when their work would otherwise be covered under both systems [emphasis added].”
It should be pointed out that as an administrative practice, many U.S. companies file for totalization treatment without looking closely at whether the U.S. system actually covers the individual working outside the U.S.; they will treat the individual as “seconded” (a term without meaning in the U.S.) and somehow employed by the U.S. company for social security purposes, and employed by the non-U.S. affiliate for corporate tax, corporate law (permanent establishment) and immigration purposes. Like many areas of international taxation, this area historically has had loose compliance but we probably can look forward to more strict compliance in the future.
Income Taxation of Social Security Benefits
Over the years, U.S. social security benefits subject to U.S. income tax has grown from zero to 50% to 85% (for higherincome recipients). The general rule under U.S. domestic tax law (again, ignoring treaties) is that non-U.S. social security benefits are fully taxable (less any basis the taxpayer may have). However, there are issues as to what is social security from other countries, and in addition there are income tax treaty overrides for many countries.
The general income tax treaty position is that only the country providing the social security can tax it. While the U.S. has income tax treaties with many countries, a number of important trading partners do not have income tax treaties with the U.S. (e.g., Brazil, Hong Kong).
Comparison of Social Security Tax Rates and Benefits, and Selected Totalization and Income Tax Treaty Provisions
The following is a very brief discussion of the social security benefits and treaty provisions for a few important trading partners, each of which has an interesting, distinctive aspect.
Australia: Historically, Australia had a strong private, funded defined benefit system, called “superannuation.” At one time in the past the benefits were largely (95%) tax exempt to the employee. In 1992 the system became compulsory for all employers, with a choice to be either defined benefit or defined contribution. In a few years, the bulk of Australian superannuation will become funded, defined contribution plans. As part of retirement policy, Australia also has “social security” but it is a fully means tested system, something like “welfare” to U.S. eyes. In a surprise move, the U.S. agreed in 2002 to a social security totalization treaty with Australia in regard to the private, funded superannuation system (but not the means tested social security system). Does that mean that the U.S. income tax treaty applies to superannuation as if it were social security? Apparently not. The IRS seems to think the totalization characterization is irrelevant for income tax purposes. That means the vested, funded retirement benefits are taxable in advance of payment, with no income tax treaty relief. The Australian mandatory employer contribution rate is 9%, although there can be voluntary supplemental contributions. In terms of benefits, like any defined contribution plan that will depend upon the amount of contributions and the earnings rate.
China: In 2011 China promulgated its first comprehensive social insurance law. Social security coverage is mandatory for employees of companies operating in the PRC. Both employers and employees are required to make contributions (regardless of citizenship), with contribution rates determined at the provincial or municipal level. There is no totalization agreement between the U.S. and China, but under the U.S.-China income tax treaty, social security benefits are only taxable by the country providing them.
France: The French social security system is complex, comprehensive and expensive. Contribution rates are extremely complex, but for salaried employees, the employee contribution rate is around 25% and the employer’s 45%. Benefits are about 50% of pay. The U.S.-France totalization agreement is one of the few that (notwithstanding the U.S. statute) actually grants coverage under the treaty where it would not exist under U.S. domestic law. This is the result of the unusual provision that deems an employee’s service to be treated “as if he were employed in its territory” when a person is sent on assignment from that territory to the other country. So, for example, if a French citizen is hired by a French employer in the U.S., the employee is in U.S. social security under the U.S. domestic system (there is no treaty override to this situation). But if that French company then directs that French national to go from the U.S. to France, the treaty permits the employer to treat the service “as if” rendered in the U.S. (for up to five years) and subject to U.S. social security tax. This will eliminate French social security tax. Under the U.S.-France income tax treaty, generally the country paying the social security benefit taxes the benefits.
United Kingdom: The UK has a system somewhat like the U.S., although more complicated. The UK system is called “National Insurance.” Employee contributions are given a modified cap, and are about 12% of compensation. Employer contributions are 12.8% and are essentially not capped. Benefits are modest (on an EU basis) and along the lines of the U.S. programs’s, with a very complicated formula. There is a totalization treaty, which is technically only applicable for individuals in both the U.S. and UK systems. For example, a U.S. citizen transferred to the UK to work for a branch of the U.S. company will be in U.S. social security. If the assignment is expected to be for less than five years, the U.S. company will get a “certificate of coverage” in the U.S. system, which will permit the UK operation to keep the U.S. citizen out of UK national insurance (social security). By contrast, the transfer from the U.S. to employment with a UK subsidiary in the UK will not continue U.S. social security, so the UK can apply its social security tax. As noted above, this is often ignored for “seconded” employees. The UK is the source of this “seconded” concept, and leads to considerable confusion when compared with the U.S. employment concept. In any event, when a certificate of coverage is issued by one country, the individual need not pay Social Security/national insurance taxes to the other.