Equalizing foreign assignees

Companies that tax equalize their U.S.
international assignees who work
abroad may experience an increase in the total cost of their international
assignment program due to the Tax
Increase Prevention and Reconciliation
Act of 2005 (TIPRA). TIPRA has made
three changes to the Foreign Earned-Income and Housing exclusions allowable
under Section 911 of the Internal Revenue
Code, effective for tax years beginning
after Dec. 31, 2005.

Smart Business talked to Max Koss, CPA
and director, international tax with Moore
Stephens Doeren Mayhew, about the
changes to the code.

What kind of changes were made?

First, an increase to the Foreign Earned-Income Exclusion. The annual exclusion
amount has increased from $80,000 in 2005
to $82,400 in 2006. Starting in 2006, the
exclusion will be indexed for inflation.

Second, a limitation on the Housing Exclusion. Based on percentages imposed by
TIPRA, the housing base amount is $13,184
and the standard cap on housing expenses
is $24,720, hence the maximum annual
standard Housing Exclusion that can be
claimed in 2006 is $11,536. Notice 2006-87
adjusts the housing cap for various locations in order to take into consideration
higher housing cost locations. For example, the Hong Kong housing cap has been
adjusted so that the maximum Housing
Exclusion for an assignee in Hong Kong
will be $101,116.

Third, a change in tax calculation
methodology. Excluded income is now
included for determining the marginal rate
applicable to any remaining taxable
income. Remaining taxable income will
now be taxed at the same marginal rate it
would have been taxed at without considering the exclusions.

How will the changes affect U.S. companies?

While the first change has allowed for a
modest increase in the Foreign Earned-Income Exclusion to create a small U.S.
tax benefit, the other two changes expose companies to increases in U.S. tax cost,
which can vary depending on the expatriate’s host location.

The financial impact of the tax law
change on companies with employees
working in high tax-cost locations such as
Germany, Italy and Canada would be low,
due to the fact that foreign tax credits will
generally serve to offset the increased U.S.
tax cost resulting from the tax law change.
Conversely, the financial impact on companies with employees working in low tax-cost locations such as Singapore, France
or Saudi Arabia, could be significant
because foreign tax credits will not be
available to offset increased U.S. tax costs.

Take into consideration point two above.
Historically, housing amounts in excess of
the cap were not limited, as long as they
were reasonable. Therefore, an executive
living in Singapore who incurred housing
costs of $60,000 would be able to exclude
the entire amount in excess of the base
amount. In 2006, the housing cap is limited
to $42,900, decreasing the potential exclusion by $17,000. Assignments in countries
where the standard cap has not been
adjusted such as China, Saudi Arabia and
the UAE could suffer an even greater financial impact.

In reference to point three above, historically the lowest marginal rates were
applied to taxable income after the exclusion in order to calculate U.S. tax. TIPRA
now requires that nonexcludable income
be taxed at higher marginal rates since tax
is calculated assuming the lowest marginal
rates apply to the excluded income
amount. For example, before 2006, taxable
income after claiming the exclusion would
be subject to tax starting at the 10 percent
bracket and then work its way up. Starting
in 2006, marginal rates applied to taxable
income after exclusion will start at 25 percent for married taxpayers and 28 percent
for single taxpayers.

Can corporate tax exposure escalate even
more?

The combination of a decreased Housing
Exclusion and a higher effective rate of tax
could expose companies to an increase in
tax cost, especially if they have equalized
employees working in lower tax-cost jurisdictions or countries with high housing
costs. This exposure could escalate if an
international assignee is living in a country
or an area of a country where the standard
housing cap has not been adjusted by
Notice 2006-87.

All things considered, a company should
not discount the value of the Foreign
Earned-Income Exclusion in decreasing
U.S. tax cost, especially in a time when the
Alternative Minimum Tax (AMT) affects a
significant portion of the taxpayer population. In addition, when planning foreign
assignments, a company may want to
review Notice 2006-87 in order to determine if living in a certain locality creates a
tax cost benefit that exceeds any increased
housing costs.

MAX KOSS, Certified Public Accountant, is director, international tax with Moore Stephens Doeren Mayhew. Moore Stephens
Doeren Mayhew is an independent member firm of Moore
Stephens International Limited (MSIL), one of the world’s leading
consulting and accounting networks. Moore Stephens Doeren
Mayhew, located in Troy, Michigan, is a regional accounting and
consulting firm providing a complete range of international tax,
accounting, financial, business and consulting services. Contact
Koss at [email protected] or (248) 244-3013.