Structuring Compensation Arrangements For U.S. Individuals Working Overseas

A frequently raised issue in tax planning for U.S. companies engaged in business operations overseas is the proper employment type relationship that should be used for the business person who is going to be rendering services in one or more foreign jurisdictions. There are at least four general ways that such relationshipo could be structured: (i) the service provider is treated as an employee of the foreign employer; (ii) the service provider is retained as the employee of the U.S. employer with a secondary relationship with the foreign affiliate; (iii) the service provider serves "two masters" by being employed by both the U.S. employer and foreign employer; or (iv) the service provider is treated as an employee of a special services company and then the special services company loans out the services the service provider to the foreign company.

The following is a short explanation of the various options present. No legal advice is being rendered in this summary and a reader may not rely or act upon this explanation as such. In all events the reader must consult with his company’s lawyer or law firm on the points discussed.

Service Provider Works as an Employee of the Foreign Company

This form of arrangement is good for long-term projects or working on a permanent basis. The foreign employer places the service provider on its payroll and such worker's proper immigration status must be obtained. The foreign employee may be paid in foreign currency (see section 988) and is permitted to participate in employee benefit plans, including share option agreements and other emoluments of service. The problem with this arrangement is that the U.S. individual may no longer be able to continue to participate in the U.S. employer's employee benefit plans. It is also possible that the foreign "wages" will not be counted for FICA purposes. But see §3121(l). Since the service provider is an employee of the foreign affiliate, it may not be possible for the U.S. company to expense the compensation and other deductible payments made. This could even apply to a bonus paid by the U.S. parent corporation for services rendered by the service provider to the foreign subsidiary. See Young & Rubicam, Inc. v. U.S., 410 F.2d 1233 (Ct. Cl. 1969). It could even extend to the employee’s exercise of previously issued (U.S. employer) stock options when the service provider is employed by the foreign subsidiary at the time of exercise. Some companies do permit foreign based employees to remain in U.S. employee benefit plans but again there may be issues on the deductibility of the contributions for services rendered through a foreign affiliate-employee relationship unless the foreign employer adopts the plan and is a member of the same controlled group.

Service Provider Remains Employee of U.S. Employer With Secondary Relationship with Foreign Affiliate

In this situation the employee is leased to the foreign employer by the U.S. employer with the contractual right retained by the U.S. employer to direct and control the service provider’s work regardless of where such services are being rendered. In general, such "secondary" arrangements are of relatively short duration. This arrangement keeps the U.S. employee as a participant in the U.S. employer’s qualified retirement programs and his compensation constitutes "wages" for FICA purposes. The U.S. employer can deduct the amounts of compensation paid in accordance with §162(a)(1). Frequently the employee will be "charged out" as a cost to the foreign based affiliate.

The problem with the "loan out" or "secondary arrangement" is that depending on the nature of the services rendered, especially where a key executive is involved, the foreign based services may give rise to a permanent establishment issue or engaged in a trade or business issue for the U.S. parent corporation. This possibility must be carefully evaluated in advance and monitored during the term or period that the foreign based services are rendered. There could also be awkward withholding and income tax rules based on the foreign taxing authorities possible approach that the income from the services rendered is taxable in the country in which the services are rendered and there is a withholding requirement. Pertinent treaty provisions must be reviewed.

Service Provider Serves "Two Masters" As Being Employed by a U.S. and Foreign Company

Under this form of arrangement, the executive is hired by both companies and has separate employment agreements with each. She is able to participate in both companies employee benefit plans. This arrangement will be used where there are also some tax benefits inuring to the employer or employee. While this arrangement may carry a greater administrative cost, depending on the jurisdictions involved, it could provide tax benefits for the three parties.

Service Provider is Hired by Services Management Company

Yet another variation is for the U.S. employer to establish a special management services company to hire service providers as employees and lease out such employees to foreign companies where and as needed. This is a well-used format for multinational companies having a pool of foreign service providers working in different companies. The practice has been to form the global service management company in a tax-haven or low tax jurisdiction to reduce the corporate income tax on profits earned by the leased employees. This arrangement may mitigate somewhat the risk of a permanent establishment issue for the U.S. employer. The risk with this arrangement is that it is subject to an "alter ego" attack based on all facts and circumstances by a foreign jurisdiction. The services management company must be a separate and profitable entity in its own right to reduce the risk. As with the foreign employee arrangement, the U.S. employer may lose the tax deduction associated with the compensation paid unless the management company is a domestic corporation.

The foregoing four options are by no means the exclusive means for establishing the relationship between a U.S. individual rendering services to a foreign affiliate. Other options such as a so-called "dormant contract" or even a joint venture could be considered. Moreover tax equalization clauses and calculations are important aspects of the employment agreement with a foreign based employer. In all cases it is important to assess the tax impacts and potential risks to the various parties.

Other Possibilities

The foregoing four options are by no means the exclusive means for establishing the relationship between a U.S. individual rendering services to a foreign affiliate. Other options such as a so-called "dormant contract" or even a joint venture could be considered. Moreover tax equalization clauses and calculations are important aspects of the employment agreement with a foreign based employer. In all cases it is important to assess the tax impacts and potential risks to the various parties.