Today’s global workers and their employers are at risk of triggering US tax and compliance obligations. The stakes are high for CPAs serving global clients, such as executives on US assignments or cross-border business owners. Errors in residency determinations can lead to US taxation, penalties, or extensive reporting obligations. The post-COVID rise in remote work exacerbates these issues, as foreign employees in the United States may inadvertently trigger employer filing obligations or expose the foreign entity to US taxation. This article provides CPAs with a framework to identify these risks.
Introduction
The first step for foreign individuals—individuals who are neither US citizens nor green card holders, and who therefore determine their US residency status under the substantial presence test—to navigate the intricate realm of US tax law is to determine their US tax residency status. A non-citizen is treated as a US resident if she (i) is a lawful permanent resident (e.g., green card holder); (ii) meets the substantial presence test; or (iii) makes a first-year election [IRC § 7701(b)(1)(A)]. Making that determination accurately requires understanding the substantial presence test, the closer connection exception, and any applicable treaty tie-breaker rules. CPAs who are facile with these concepts can help global clients avoid unintended US residency, thereby easing worldwide tax and tax reporting burdens.
Many advisors neglect the potentially drastic US tax consequences for foreign employers in connection with their employees’ services in the United States. Foreign employers can face withholding obligations on compensation for US-based work, potential creation of a US trade or business through employee activities, and risks of an additional layer of tax under the branch profits tax rules, if effectively connected income arises.
For CPAs hoping to optimize client outcomes in an era of global mobility, it is crucial to understand these concepts when advising international clients on US compliance, elections, and information reporting.
Substantial Presence Test
Determining tax residency for foreign individuals in the United States forms a cornerstone of international tax planning and compliance, as it dictates whether those individuals face US income taxation on their worldwide income or only on their US-source earnings. Under domestic law, these individuals can become residents via the substantial presence test, but exceptions like the closer connection provision and treaty-based tie-breakers offer avenues to retain nonresident status.
The substantial presence test offers an objective method to classify a foreign individual as a US tax resident. This test often ensnares frequent travelers to the United States, but individuals can potentially plan absences to stay below the applicable thresholds.
An individual satisfies the substantial presence test in the current year if they are present in the United States (i) for at least 31 days that year and (ii) a sum total of 183 days or more over a three-year period, calculated based on a different multiplier for each year: 1/6 for days present in the United States two years ago, 1/3 for days present in the United States last year, and 1 for days present in the United States this year [IRC § 7701(b)(3)(A)]. It is important to note that these calculations ignore fractional rounding, and some days do not count toward presence at all, including certain brief transits under 24 hours between foreign locations, medically required stays originating in the United States, or time as exempt individuals such as diplomats or students [IRC § 7701(b)(7); Treasury Regulations §§ 301.7701(b)-3; 301.7701(b)-1(c)(1), (e) Ex.1].
Closer Connection Exception
Foreign individuals meeting the substantial presence test can nonetheless claim nonresident status through the closer connection exception if present fewer than 183 days in the current year [IRC §7701(b) (3)(B)]. These individuals must also have a foreign tax home and stronger ties to the foreign country before qualifying to make the election using Form 8840 [IRC § 7701(b) (3)(B); Treasury Regulations § 301.7701(b)-8(a)(1), (b)(1)(i)].
The tax home requirement generally aligns with the individual’s principal place of business, although the complexity of this determination is often underappreciated [Treasury Regulations § 301.7701(b)-2(c)(1)]. For multiple occupations or “posts of duty,” a three-factor test assesses time spent, business activity level, and income share [Markey v. Commissioner, 490 F.2d 1249 (6th Cir. 1974); Revenue Ruling 54-147]. Temporary employment assignments may qualify for exceptions if anticipated to last one year or less. But authorities provide nuanced interpretations when distinguishing temporary from indefinite, and when shifts due to circumstances alter status from one to the other.
The closer connection requirement involves a comprehensive evaluation of factors, including the location of the foreign individual’s permanent home, family, belongings, affiliations, banking activities, non-tax home business, driver’s license, voting, and document designations [Treasury Regulations § 301.7701(b)-2(d)]. When these factors reflect predominantly non-US ties, the closer connection exception may apply.
Treaty Tie-Breaker Rules and Dual Residents
Even when the closer connection election is not available, if the individual is a resident in a country with an income tax treaty with the United States, relief may be available under the treaty’s tie-breaker rules. Dual residents—classified as residents under both US and foreign domestic laws—can use tax treaty tie-breakers to assign residency. Sequential criteria generally include permanent home, center of vital interests, habitual abode, and citizenship, with a final resort to competent authority determination in rare cases.
Although definitions can vary, a permanent home generally demands ongoing availability, not transient use. For example, US courts have recognized a significant other’s apartment as a permanent home (Podd v. Commissioner, T.C. Memo 1998-418).
If a foreign individual has a permanent home in both countries (or neither), the next criteria for determining treaty residency is center of vital interests, which weighs both personal and economic ties such as the location of family, activities, and place of business. This test examines all the facts and circumstances and requires examination of both personal and economic relations, much like the closer connection determination discussed above. Despite having personal relations almost entirely in the US, strong foreign economic relations can preclude a clear assignment of an individual’s center of vital interests [Escobedo v. United States, No. 12cv 0471, 2013 WL 6058485, at *4 (S.D. Cal. Nov. 14, 2013)]. The United States also considers historical shifts, such as a change from foreign to US-focused work (PMTA 2007-00020).
The next criteria is habitual abode, which examines stay frequency and routine. There have been cases where more US days tipped the balance (Podd v. Commissioner, T.C. Memo. 1998-418). Yet since 2017, the habitual abode analysis may extend beyond mere day count to include frequency, duration, and regularity of stays that are part of an individual’s settled routine [OECD, “Commentary to OECD Model Tax Convention on Income and on Capital,” art. IV, para. 2(b)].
Citizenship is usually the final criteria, if all of the preceding ones are indeterminate. Dual residents taking a return position under a US treaty file Form 8833 with Form 1040NR and compute tax as nonresidents, limiting liability to US-source income or effectively connected income (ECI). But they retain US resident status for all other purposes, which can result in onerous reporting obligations, including on Forms 5471, 8621, 5472, 926, 8865, 8858, 3520, 3520-A, and on FBARs [Treasury Regulations § 301.7701(b)-7(a) (3)]. One notable (though seemingly random) exception from this list is Form 8938 [Treasury Regulations § 1.6038D-2(e)]. Moreover, to avoid potential pitfalls, dual residents should file a separate Form 8833 for each type of income qualifying for exclusion, or a reduced rate of tax, under the treaty, as the IRS has been known to require that manner of reporting for a treaty election to be valid.
In summary, the closer connection exception fits short-term US stays for individuals with robust foreign ties, sidestepping treaty-related reporting burdens. Residency under treaty tie-breaker rules suits cases that exceed 182 days, but it is accompanied by often voluminous information reporting obligations.
Implications for Foreign Entities
Foreign individuals’ US presence can affect their foreign employers as well. Foreign employers with US-based employees risk engaging in the conduct of a trade or business within the United States (USTB) because employees’ activities are attributable to the foreign employer. Existence of a USTB triggers US filing obligations, and potentially two layers of tax, for the foreign corporation.
A foreign entity conducts a USTB if activities are considerable, continuous, and regular, with profit intent [Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987)]. With limited exceptions, the Internal Revenue Code defines a USTB to include personal services in the United States [IRC § 864(b)]. However, case law requires that certain quantitative and qualitative thresholds be met [Scottish American Investment Co. v. Commissioner, 12 T.C. 49, 59 (1949)]. For example, isolated acts rarely rise to the level of a USTB, but significant, ongoing efforts—like an executive actively managing operations—may suffice [compare United States v. Balanovski, 236 F.2d 298, 303-04 (2d Cir. 1956) with Linen Thread Co. v. Commissioner, 14 T.C. 725, 737 (1950); but see, e.g., Johansson v. United States, 336 F.2d 809 (5th Cir. 1964)]. In addition, ministerial or clerical services may not be sufficiently profit-oriented, whereas services that are more closely tied to the entity’s profit-making activity are more likely to prove sufficient [Scottish American Investment Co. v. Commissioner, 12 T.C. 49 (1949)].
If engaged in a USTB, the foreign employer generally must file a US return and report any effectively connected income (ECI) or other US-source taxable income [Treasury Regulation § 1.6012-2(g)(1) (i)]. ECI generally includes certain US-source income tied to the USTB under special asset-use or business-activities tests, plus certain foreign-source income attributable to a US office [IRC § 864(c)].
Foreign corporations also potentially face an extra level of US tax—namely the branch profits tax, a 30% tax applied to a foreign corporation’s effectively connected earnings and profits, adjusted based on investment in US business operations (IRC § 884).
Even if good arguments exist that a foreign employer does not have USTB or ECI issues, if there is a risk that the IRS may disagree, it may make sense to file protective returns to preserve deductions and credits if the activities are later reclassified [Treasury Regulations § 1.882-4(a)(3)(vi)].
It is important to keep in mind that, just as tax treaties can override domestic US law determinations of an individual’s residency, US tax treaties may also limit the authority of the United States to tax business profits generated by a foreign entity. In general, treaties only permit US taxation to the extent that the foreign entity carries on business through a permanent establishment (PE) in the United States, and profits are attributed to the PE. Some treaties recognize two types of PE, commonly referred to as material PEs and agency PEs. Material PEs generally require a fixed place of business (e.g., an office, branch, or place of management) through which the business of a company is wholly or partly carried on, unless the activities are of a preparatory or auxiliary nature. Agency PEs can be established without a fixed place of business when a person (individual or entity) acts on behalf of the company and has the right to, and habitually exercises, an authority to conclude contracts in the name of the company, unless the actions of the person are preparatory or auxiliary to business activities of the company.
US tax treaties may also limit the authority of the United States to tax business profits generated by a foreign entity.
The PE rules are quite nuanced but, when applicable, can significantly narrow the authority of the United States to tax foreign entities as compared to domestic USTB and ECI rules. Nevertheless, just because a foreign entity was incorporated in a treaty country does not mean that it can benefit from the business profits rules under the treaty. Foreign entities must cross several hurdles, including the residency and limitation on benefits (LOB) articles of a treaty. For example, pursuant to many LOB articles—which were designed to address “treaty shopping” by residents of third countries—resident entities must satisfy certain tests before claiming benefits under the treaty. Once an entity qualifies and wishes to claim benefits under the treaty, it may still have US filing obligations, such as notifying the IRS using Form 8833.
Regardless of the extent to which a foreign employer is itself subject to US tax, the employer is generally subject to withholding and filing obligations with respect to compensation paid to employees in the United States [IRC § 3402; Treasury Regulations § 31.3401(a)(6)-1(a)]. Certain exceptions apply, however, like when wages paid are exempt from tax under a provision of the IRC or a tax treaty, but only if the corporation receives the correct documentation from its employee. Accordingly, CPAs should assess foreign entity exposure to US tax and tax reporting, as well as tax withholding obligations.
Take Proactive Steps
CPAs desiring to optimize client outcomes in an era of global mobility must guide both foreign individuals and their foreign employers through US tax residency and related issues. For individuals, the substantial presence test broadly captures potential residents–though targeted use of the closer connection exception and treaty relief can safeguard nonresident status for many foreign individuals, thereby minimizing US tax liability. The closer connection exception is often preferable due to its simplicity, particularly because of the ongoing US resident status for non-income tax purposes in treaty cases. It is helpful to promote proactive measures, such as tracking days meticulously and substantiating foreign tax homes and all personal and economic connections to a foreign country. Foreign entities connected to foreign individuals should evaluate USTB risks related to employees (including remote workers) in the United States and may need to take steps to mitigate filing, withholding, and tax liabilities.
