During my tenure as a Global Compliance Manager, I can recall having to explain to taxpayers some confusing tax law. One law that has really upset clients is the Bona Fide Residence Test which qualifies expatriate taxpayers (U.S. persons working abroad) to exclude income (approximately $95,000 & a housing exclusion amount which differs by what country you reside in) under the Foreign Earned Income/Housing Exclusion. The example that I remember was when a taxpayer left for assignment on February 1, 2008. The assignment package offered by the company stated the company would pay their foreign taxes, any increase in U.S. Taxes, common assignment allowances (foreign housing, foreign auto, family’s foreign education), and a Global Compliance package that included:

• Preparation of U.S. Tax Returns
• Preparation of Foreign Tax Returns
• Tax Equalization

Without mentioning the complexity of international tax law within U.S. Tax Law, this example differs from the common U.S. Tax Return in two ways:

1. Foreign Returns are being prepared and the company is paying the foreign taxes
2. Tax Equalization

Let me briefly explain what a Tax Equalization is.  In very broad terms, a typical Tax Equalization attempts to have the assignee pay their stay at home (their home country and state) tax and no more.  However, in this example there was an exception.  The taxpayer rented out his primary residence and was responsible for the tax on the net rental income. Thus, he paid his stay at home tax and the additional tax on the net rental income. Consequently, if the rental activity resulted in a loss and the taxpayer was able to take the loss, the taxpayer would have received a windfall as the loss would have decreased his tax. At the beginning of the year a Hypothetical Tax Calculation is prepared to estimate the stay at home tax and the tax is deducted from payroll over the course of the year as an alternative to federal tax withholding. At the end of the year, the taxpayer was made whole based on actual income and deductions. Foreign returns were prepared and the foreign taxes were paid by the company.  Due to the requirements of the Bona Fide Residence Test, the U.S. Returns could not be filed until 1 year later. In broad terms, the requirements of Bona Fide Residence require that you are a Bona fide Resident of a foreign country or countries for an uninterrupted period that includes an entire tax year (January –December). In my example, the taxpayer did not qualify for the income exclusion until December 31, 2009 (uninterrupted period from 1/1/2009- 12/31/2009) and did not file the returns until January 2010. The taxpayer typically received a $3000 tax return and used it to purchase holiday gifts. As a result of the Bona Fide Residence requirements, he could not file the returns by April 2009 as he typically would. Regrettably, the taxpayer was left scrambling for holiday funds to purchase family gifts. The taxpayer had federal withholding replaced with Hypothetical Tax Withholding. On his actual U.S. Tax Returns, he had small balances due:

• Federal Balance Due $982
• State Balance Due $480

Fortunately, when the Tax Equalization was completed, the taxpayer actually received a refund from the company as we anticipated the situation (withheld a little extra Hypothetical Tax). As if a traditional U.S. Tax Return is not complicated enough, foreign taxpayers may also have to manage the following:

• U.S. and Foreign Payroll Departments
• Foreign Tax Law and Foreign Tax Deadlines
• Tax Equalizations

“Keeping an Eye On the Calendar” is much more complicated for international employees and the guidance of a skilled tax professional is very helpful. In the example, the taxpayer should have been informed before he started the assignment that the entire compliance process would take longer than usual in order to meet the requirements of the Bona Fide Residence Test. We commonly recommend Pre-assignment Consultations (PACs) to inform employees of the potential obstacles and suggest planning measures that may be taken. Communication between the taxpayer and the skilled professional is essential. For more information, please contact the EFPR Group International Tax Team at 585.427.8900 or email Expat@EFPRgroup.com.