Covid-19 is creating unexpected tax exposure for foreign-based businesses with employees detained in the US and vice versa as companies may now find themselves with more sourced income than expected causing unforeseen tax liability and filing requirements. Until the US and other countries provide temporary relief, businesses need to stay vigilant to avoid unforeseen tax traps in their supply chain infrastructure.
Border closures, travel bans and stay-at-home orders have become commonplace throughout the world during the COVID-19 pandemic. This global immobility has been instituted for a good cause – to flatten the curve of the spread of COVID-19. On March 19, 2020, the US Department of State elevated its Travel Advisory to its highest possible level – Level 4. This means that the Department of State advises all US citizens to avoid international travel. Similar advice is recommended by countries around the world.
For US citizens abroad, the Department of State says, “US citizens who live in the United States should arrange for immediate return to the United States, unless they are prepared to remain abroad for an indefinite period.” In many cases, US citizens are returning to the US temporarily from a country in which they may be employed by a local employer. In other cases, residents of a foreign jurisdiction may be forced to remain in the US indefinitely because they have fallen ill, the conditions in their home countries are unsafe or otherwise.
This immobility presents cross-border tax challenges to individuals and companies who suddenly find themselves conducting operations in a foreign jurisdiction. Specifically, individuals who are nonresidents of the US may find themselves becoming US tax residents subject to tax on worldwide income. Similarly, non-US companies may find themselves conducting a trade or business in the US based on the activities of employees who are present in the US during the pandemic. Conversely, US companies may find that they have established a permanent establishment in a foreign jurisdiction because employees may be conducting business operations in a non-US jurisdiction. This articles explores some of the tax implications of these scenarios.
Residency Considerations for Employees
Mobility restrictions resulting from the COVID-19 pandemic may give rise to situations where employees of multinational companies become tax residents outside of their home country.
In the US, there are generally three ways by which an individual is considered a US income tax resident, namely, being a US citizen, a lawful permanent resident (i.e., a Green Card holder), or “substantially present” in the US. To the extent a nonresident employee becomes a US income tax resident, the employee becomes subject to US income tax on worldwide income.
In general, a nonresident employee will meet the substantial presence test if the employee is present in the US for at least 183 days during any calendar year, or an average of at least 122 days over a three-year period computed by applying a statutory formula. Exceptions to the substantial presence test are limited. For example, a nonresident employee will not be a US tax resident if the employee (i) spent less than 183 days in the US during a calendar year and (ii) can (a) establish that their “tax home” is in a foreign country and (b) demonstrate they have a closer connection to that foreign country. A nonresident employee that is a tax resident in a jurisdiction with which the US has an income tax treaty, may be able to utilize a treaty “tie-breaker” provision of the relevant tax treaty even where the employee meets the substantial presence test by spending more than 183 days in the US in a single year.
Another exception to the substantial present test involves medical conditions. That exception applies if a nonresident individual is unable to leave the US because of a medical condition that arose while such individual was present in the US. In other words, days are counted for purposes of the substantial presence test if a nonresident employee enters the US for medical treatment or is otherwise aware of a condition prior to entering the US regardless of whether the individual required medical treatment for such condition. Moreover, the medical condition exception ceases to apply if, on becoming well enough to travel, the individual remains in the US beyond a reasonable amount of time to arrange travel outside of the US. In view of the current public health crisis, the IRS has been requested to expand the medical condition exception to include nonresident individuals who cannot travel due to the COVID-19 pandemic. Thus far, the IRS has not allowed for any exceptions.
Even if a nonresident employee is not substantially present in the US, and in the absence of an income tax treaty, the performance of personal services in the US (as described below) may still cause the employee to incur a US income tax liability to the extent the compensation sourced to the US exceeds a certain de minimis exception as described below.
Conversely, foreign country tax residency rules should be considered for US tax resident employees trapped in foreign countries because of COVID-19. Generally, US income tax residents have an election to exclude their foreign earned income (up to $107,600 in 2020) from their US taxable income. However, to make such an election, the individual’s “tax home” must be in that foreign country, which is unlikely to be the case in the event of temporary residency. As a result, a US tax resident employee unable to travel because of COVID-19 must assess whether she will or have become an income tax resident of a foreign country, whether she will be able to claim an income tax treaty “tie-breaker” position, or whether she may claim foreign tax credits in the US to the extent she is required to pay foreign income taxes.
Sourcing of Income from Performance of Personal Services
An employee who is detained within the US and works remotely can cause income sourcing issues to their employer. Even if an employee is not present in the US long enough to become a tax resident, an employee who performs personal services on behalf of her employer while in the US can cause the income earned by the employer on account of the employee’s services to be US source income. The consequences of this are manifold.
All compensation for labor or the performance of personal services performed in the US is treated as US source income. This means that the income earned by the employer as a result of the labor of employees who are temporarily detained within the US, will be US sourced. In particular, a foreign-based multinational may now find itself with more US sourced income than it expected. Indeed, a company who might otherwise have no employees in the US, may find itself with unforeseen US tax liability and filing requirements.
Domestic entities may also suffer unanticipated tax consequences, particularly those with foreign operations and who have made the operating decision based on the availability of the foreign tax credit. In general, a domestic company is entitled to credit against its US tax liability the foreign income taxes paid. Under the foreign tax credit rules, the amount of this credit is limited to a fraction of the US income tax liability. Ignoring some of the finer details, the numerator of that fraction is essentially the company’s foreign source income and the denominator is the company’s worldwide income. If an employee of a foreign branch who would ordinarily work in a foreign jurisdiction works while in the US, the result is that the numerator of this fraction is reduced and therefore the company will be entitled to less foreign tax credit, notwithstanding that the tax liability in the foreign jurisdiction may remain the same.
To mitigate these consequences, the employer should evaluate and determine whether the facts may support a position that the portion of its income earned due to this employee’s labor performed while in the US is relatively small. In that case, less of the company’s income will be treated as US source income. Generally, this may be done by showing that the income earned is predominantly attributable to some other item or activity, for example, employees working outside of the US, plant and equipment or intellectual property located outside of the United States.
Companies Should Reconsider their Nexus to the Source Jurisdiction
COVID-19 may have a significant impact on nonresident companies that have employees temporarily present in the US. Under US domestic law, aside from a modest $3,000 de minimis exception, a nonresident company is taxable in the US on a net basis to the extent it earns income that is effectively connected to a US trade or business (the ECI Regime). A nonresident company is generally engaged in a US trade or business if its employees or personnel perform personal services within the US at any time during the taxable year. Certain exceptions apply for nonresidents that trade in securities or commodities. However, in other cases, it may only take the act of one employee performing services in the US to cause the nonresident company to be engaged in a US trade or business. Nonresidents that are currently faced with the issue of having employees temporarily present and working in the US because of COVID-19, should consider its US tax filing obligations and whether any of its income is taxable under the ECI Regime. It should also examine its employees’ activities to determine whether they are in fact “performing” services. In borderline cases, the nonresident company should consider filing a protective Form 1120-F to claim no tax residence in the US and begin the running of the three year statute of limitations clock.
In cases where the nonresident company qualifies for the benefits of a US income tax treaty, it should consider whether the permanent establishment (PE) article provides relief from its US tax nexus. Nonresidents should be wary of the fixed place of business PE (FPOB PE) provision if they have an employee currently working out of an office in the US. Interesting questions arise in the case of employees working in other fixed locations, such as a temporary or permanent residence. Even if no FPOB PE exists, most, if not all, US income tax treaties contain PE provisions on dependent agents habitually negotiating and concluding contracts in the US, subject to the potential application of specific activity exceptions for functions thought to be “preparatory or auxiliary.” Nonresident companies should consider the extent of their agents’ activities, for example, whether they rise to the level of “habitual,” and to the extent possible, might want to consider restricting their agents’ contracting and negotiating power to avoid creating a PE. Further, some US income tax treaties contain personal services PE provisions that focus on the number of days a nonresident company’s employees or personnel spend in the US. Due to limitations on travel to or from the home jurisdiction, it is possible that an employee may spend more time than expected in the US. Of course, even if a nonresident company has a PE in the US, it should carefully examine the amount of its business profits are “attributable to” such PE based upon the facts and circumstances of the given arrangement. Nonresident companies should assess their reporting positions to determine whether they have US tax filing obligations and potential US tax exposure.
In light of COVID-19, US companies face similar challenges to the extent they have employees temporarily stranded in a local jurisdiction. US companies should consider whether they have nexus to the particular jurisdiction, and if they are required to pay tax in the local jurisdiction and comply with local tax filing obligations. In addition, the application of the US Subpart F rules in many cases hinges on the location of various activities of foreign subsidiary employees (for example under the foreign base company sales and services rules), and thus may require reevaluation if certain functions are moved from one foreign country to another. Further, US companies should monitor whether any of their foreign subsidiaries’ employees are performing services in the US. It is possible that a foreign subsidiary might also be subject to the ECI regime, which can lead to tax inefficiencies in their supply chain.
It is hoped that the US and other countries around the world will provide temporary relief from tax exposures of this nature stemming from disruptions caused by the pandemic. In the meantime, virtually all multinational enterprises need to be vigilant for new traps that may have arisen within their supply chain structures.