The cross-border global expansion of business activities continues to increase exponentially in the U.S. government contracting industry. Many government contracting companies are performing contracts more often in other countries and on a greater scale than ever before. As a result, contractors are being faced with some critical planning opportunities to manage the cross-border flow of resources into other countries. It is important for a contractor to plan in advance, with as much lead time as possible, before beginning to perform a contract in another country. The necessary planning and due diligence will mitigate the risk of exposure to certain U.S. and foreign tax liabilities.
A major consideration for government contractors with outbound activities is the cross-border payroll tax reporting and compliance. When a contractor sends U.S. expatriate individual employees to work in another country, it is necessary to consider how to structure the payroll. The foreign country where the U.S. employees are performing the contract may require the U.S. government contracting company to register with a foreign tax authority for foreign payroll tax reporting and compliance. Some countries allow a U.S. company to operate directly through a branch activity in the foreign country. However, in certain countries, it may be necessary to form a foreign subsidiary company that will register for the foreign payroll tax reporting. In some cases, it may be possible to set up a split or shadow payroll so that a portion of the U.S. expatriate employees’ compensation is reported through the U.S. payroll. This structure allows the U.S. employees to continue to make contributions into the U.S. social security system and to 401(k) retirement plans. Depending on the length of the U.S. expatriate employee’s assignment in the foreign country, a U.S. Social Security Totalization Agreement may provide an exemption from the requirement to make contributions into the foreign social security system.
Some countries have Status of Forces Agreements (SOFAs) in effect with the United States. A SOFA may allow the government contractor to qualify for an exemption from foreign corporate income taxation that may apply to the business. The SOFAs also may exempt the U.S. expatriate employees from foreign individual income taxation in the foreign country where they are performing the services under the contract. Under some SOFAs, the U.S. government contractor may qualify for a foreign value added tax (VAT) exemption on purchases of assets and supplies. In some countries, SOFA status could exempt the U.S. government contractor from foreign payroll tax reporting and compliance. This exemption may be possible when the U.S. expatriate employees also have tax exempt status and the work is being performed on a U.S. or foreign government installation or a military base.
While the SOFAs can provide helpful benefits, it is necessary to consider the coordination of the SOFA provisions with other U.S. income tax treaties. The government contractor could be considered to have a taxable presence in a foreign country where the contractor has an office or a fixed base of operation in the foreign country where the U.S. expatriate employees are working on the contract. In some cases, the SOFA status may govern to the extent that a contractor also may be considered to have a permanent establishment in the foreign country under a U.S. income tax treaty. To avoid this, the contractor should coordinate with a U.S. government contracting officer to make sure that appropriate language is reflected in the contract to confirm SOFA status and qualification for SOFA tax exemption benefits.
For more information about this issue and other international tax matters, please contact Alison Dougherty at 301.222.8262 or ADougherty@aronsonllc.com.