Recent Changes to U.S. Federal Income Tax Rules for U.S. Employees Relocated Abroad

The Tax Reconciliation Act of 2006, signed into law on May 17, 2006 (the ”Act”), includes provisions that will generally increase the U.S. federal income tax liability of U.S. employees who are relocated outside the U.S. The provisions were highlighted in recent articles in the Wall Street Journal and the New York Times, copies of which are attached. These changes should be of particular interest to employers that provide tax equalization benefits or housing allowances to U.S. employees relocated abroad. The provisions are retroactive to January 1, 2006.

Generally, U.S. citizens or residents working abroad are subject to U.S. federal income taxation on all income wherever earned. Under Section 911 of the Internal Revenue Code of 1986 (the ”Code”), however, the first $80,000 of income earned by an employee from foreign sources is excludable from U.S. taxable income (the “foreign earned income exclusion” or “FEIE”), subject to certain conditions concerning residence or physical presence outside the U.S. Section 911 also provides that certain amounts attributable to housing costs of U.S. employees working abroad (the “housing cost amount”) are excluded from U.S. taxable income or, to the extent that housing costs are paid by the employee rather than being provided under a housing allowance or similar arrangement by the employer, are deductible in calculating the employees adjusted gross income.

The Act amends these rules in three notable respects. First, the Act modifies the maximum foreign earned income exclusion by providing an inflation adjustment for calendar years following 2005, bringing the cap to $82,400 for 2006. Second, the Act alters the method of calculating the income tax rate that applies to foreign earned income, so that the amount of tax saved due to the exclusion is based not on the taxpayers marginal rate (i.e., the rate applicable to the last dollar of income earned) but on the lower rate that would have applied had the excluded amount been the taxpayers total income. As a result, tax savings due to the exclusion will be reduced. For example, an unmarried employee earning $500,000 in 2006 would have saved $28,840 in taxes but for this change; under the new rules, the tax savings due to the FEIE is reduced to $17,403. (This example and the others set forth in this note disregard the effect of any other exclusions, deductions or credits that may be available depending on the taxpayer’s individual circumstances.) Calculation of the alternative minimum tax for employees who are subject to it will be similarly affected.

Third, and most significantly for many employees working abroad, the Act imposes a new limitation on the housing cost amount that may be excluded or deducted. Previously, the total of all qualifying “reasonable” housing expenses (including rent, utilities, repairs, real and personal property taxes and residential parking fees) in excess of a base amount specified in Section 911 (which was $12,190 for calendar year 2005 and increases to $12,447 for 2006) could be excluded or deducted. Section 911 did not set a specific ceiling on the allowable housing exclusion; the only limitation was that the costs excluded fit within certain categories (e.g., no exclusion of salaries for domestic help or extravagant entertainments). The Act imposes a new upper limit on housing exclusions of (i) 30% of the taxpayers foreign earned income exclusion minus (ii) the base amount. Under this new rule, the maximum that may be deducted or excluded as housing expenses (i.e., for taxpayers claiming the total $82,400 of FEIE) is approximately $12,273. This new, restrictive limitation could have a significant effect on the U.S. tax liability of employees working abroad, especially those employed in jurisdictions where housing costs are relatively high and the applicable foreign income tax rate is low.

For example, consider an unmarried employee living in country X earning a salary of $500,000 and receiving, in addition, an employer-provided housing allowance of $50,000. Last year, the employee could have excluded $80,000 of his salary from his U.S. taxable income as an FEIE. In addition, the employee could have excluded $37,810 of his housing allowance from his taxable income. As a result, his U.S. taxable income would be $432,190.

The new rules allow $82,400 to be excluded from U.S. taxable income, but the housing cost amount is now limited to $12,273. As a result, the employee would have taxable income of $455,327. Under the new rules, the employees U.S. taxable income is increased by $23,137, and U.S. income tax is increased by $19,785, as summarized in the following table:

U.S. employees who pay income taxes in the foreign jurisdictions in which they work will usually be entitled to claim a credit in respect of foreign taxes paid. However, no credit is allowable for foreign taxes paid on income that is excludable under Section 911. Accordingly, the new limitations on the amounts of housing allowances that are excludable from income under Section 911 will be (in whole or in part) offset for employees who pay foreign income taxes by their increased ability to use their foreign tax credits. This foreign tax credit offset will not come into play for employees who are relocated to jurisdictions that do not impose an income tax on U.S. employees who are temporarily relocated to those jurisdictions (such as, for example, Saudi Arabia), and its effect will likely be reduced for employees who work in jurisdictions where effective income tax rates are lower than they are in the U.S.

For employers who cover all or part of the taxes of employees working overseas, the rules outlined above may result in additional costs, depending on how tax gross-up or equalization payments to such employees are calculated. To the extent that the employer does not cover the additional U.S. tax liability imposed under the Act, the new rules may alter the economics to U.S. employees accepting or continuing with a foreign assignment.

Finally, since the new rules are retroactive to the beginning of this year, employers should take steps to ensure that they adjust their income tax withholding in a manner that is consistent with the changes.

For your convenience, we also attach a copy of Section 911 as in effect before and after the changes described above. Please feel free to call any of your regular contacts at the firm or any of our partners and counsel listed under Employee Benefits in the Our Practice section of our web site if you have any questions.