Implications of Secondment employees in a company

International assignments may have a significant effect on companies' corporate taxes. A variety of U.S. Internal Revenue Code (IRC) provisions that impact international assignments can be traps for the unwary. The following discussion will focus on three areas of planning opportunities that companies should consider regarding their expatriates and their international assignment programs:

• Determining the appropriate allocation of compensation expense between the U.S. and foreign company
• Establishing whether a transfer of technology has occurred
• Examining whether an expatriate's activities create or will create a permanent establishment.

Allocating Compensation Expense between Related Entities

Many multinational companies often transfer individuals to work in their foreign subsidiaries. U.S. companies typically keep the expatriate on the U.S. payroll for administrative convenience. A question arises as to which entity is entitled to the deduction for the compensation and related expense—the parent, subsidiary, or both?

Generally, a corporation is entitled to deduct compensation expense from gross income if the expense is directly connected with, or pertains to, the corporation's trade or business.¹ Thus, if a corporation incurs compensation expense for services that are performed primarily for its own benefit, even if they are performed in connection with a foreign subsidiary, the expense may be deductible by the paying corporation. If, however, the corporation incurs compensation expense that is related to services that are primarily for the benefit of the foreign subsidiary, the corporation may not deduct such expense. Finally, if the corporation incurs compensation expense that benefits both companies, then it may be appropriate to divide the compensation expense between the two entities, thereby allowing each entity to claim a deduction for its respective share of expense.

Illustration
Consider the following: a U.S. company, USP, sends an employee, Mr. E, to work for USP's wholly-owned Country X subsidiary, FS. If Mr. E were working in the U.S. for USP, Mr. E's annual salary would be $100,000. In comparison, Mr. E's Country X peers presently earn $140,000 annually on average. Mr. E's annual total compensation package while working at FS in Country X is $260,000. For illustrative purposes, four alternative divisions of the compensation deduction are listed below.

		USP		FS
1.		$260,000		$ 0
2.		$ 0		$260,000
3.		$120,000		$140,000
4.		$100,000		$160,000

The extent to which any of these alternatives may be supportable will depend in part on the type of services performed and on the entity that directly benefits from the services.

TaxbyManish Observation: The expatriate may gain valuable experience while on foreign assignment that directly benefits the USP, during or after the assignment, which may justify a partial allocation of the assignment cost to USP.

Compensation allocation alternatives need to be addressed and the best alternative selected to help reduce the company's overall U.S. and foreign tax liabilities. However, the allocation of expatriate compensation expense may affect the foreign tax credit position of the company. Furthermore, in evaluating the allocation, variables such as transfer of technology and permanent establishment should be taken into consideration.

Transfer of Technology

U.S. companies have certain intangible assets they may or may not want to share with their foreign affiliates. Intangible assets include, but are not limited to, patents, inventions, formulas, processes, and know-how. If one of the intangible assets is transferred, the Internal Revenue Service (IRS) requires that an arms-length price be paid for such transfer, typically paid through a royalty agreement.² When a company does not charge an arms-length price, the IRS has the authority to impute what is known as a "super-royalty." A super-royalty is considered income for U.S. tax purposes; however, the foreign jurisdiction may not allow a deduction to the foreign affiliate.

Where a U.S. corporation transfers employees to work for a foreign affiliate, or a foreign corporation sends its employees to work for a U.S. affiliate, a cross-border transfer of technology may occur, either intentionally or unintentionally.³ Such a transfer may have significant U.S. federal income tax consequences and, therefore, should be monitored closely.

With respect to international assignments, the issue thus becomes whether the transfer of know-how by an expatriate employee involves the transfer of an intangible property. Generally, the mere transfer of an employee should not constitute the transfer of intangible property. A possible transfer of know-how occurs when expatriates train the local staff using proprietary knowledge. The company receiving the transfer of know-how may derive substantial economic benefits. This provides an opportunity to evaluate whether a royalty charge is appropriate.

Actual royalty income generally is beneficial to a U.S. corporation in an excess foreign tax credit position since the royalty income should be foreign source. Moreover, unlike a deemed royalty, an actual royalty may be deductible in the foreign jurisdiction.

Permanent Establishment

Under a typical income tax treaty, business profits of a taxpayer resident in one country may be taxed in another country where the taxpayer has a permanent establishment (PE) in the country where the profits are attributable. A PE is generally defined as a fixed place of business through which the business of an enterprise is wholly or partly carried on.⁴ The term PE includes, but is not limited to, a branch, an office, or a workshop. In addition, in certain situations, individuals working locally may create a PE.

Given the above definition, a PE may be created inadvertently by employees or officers of a domestic company working in a foreign jurisdiction, or by employees or officers of a foreign company working in the U.S. It is necessary, therefore, to closely plan and monitor assignments and duties of individuals sent outside the home country, whether they are U.S. employees sent to foreign jurisdiction or foreign employees sent to the U.S.; it is also necessary to determine which entity is actually employing them. Significant tax implications may arise, depending on the particular facts and circumstances.

Conclusion

Through careful planning and monitoring, companies can avoid corporate tax traps related to their expatriates and international assignment programs. In the process, the companies may save a significant amount of tax by evaluating the expatriates' compensation deduction and whether their employees are transferring technology abroad.

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Footnotes:
¹U.S. Treas. Reg. Section 1.162-1(a).
²Section 482.
³Sections 367(d) and 482.
⁴U.S. Model Treaty articles 5(1), 5(2); OECD Model Treaty articles 5(1), 5(2).