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 firstname.lastname@example.org or (248) 244-3013.