With so many companies going global by starting branches or subsidiaries in other countries, covering employees overseas in US retirement plans is becoming an issue. There has been an increased interest in putting foreign employees in US plans (which are sometimes perceived to be safer) and in putting US workers in foreign plans. This article discusses a recent Internal Revenue Service (IRS) ruling letter that deals with covering certain foreign workers in a particular type of US retirement plan, an ESOP. The IRS held that employees of a foreign subsidiary with foreign earned income may participate in the parent's employee stock ownership plan (ESOP).
However, covering foreign workers in US plans, or covering US workers in foreign plans, can be difficult, and mistakes can be costly. The discussion below highlights some of the basic US retirement plan rules, and a few of the issues that should be considered before opening a US plan to foreign employees.
Background
Almost all US employees are covered by the US social security system, which is perceived, at least in part, as a retirement programme. Both employer and employee contributions are required to be made to the US government to help fund this programme.
While employers are not required to provide other retirement plans, most US companies also provide qualified retirement plans for their employees. These plans must be in writing and must be communicated to the employees. The plans are established using domestic tax-exempt trusts that are maintained by, but separate from, the employer. As a general rule, the employer is not permitted to take any amount out of the trust, or use trust assets to assist the company, until all retirement liabilities have been satisfied under the plan. If the employer chooses to maintain a qualified retirement plan, US law requires the employer to fund the plan's retirement benefit promises by making contributions into the retirement trusts.
Qualified retirement plans have several tax breaks that make them quite valuable to employees. First, contributions to the plan are generally tax deferred, so the employee does not pay tax on the employer contributions (or certain pre-tax employee contributions) when the contribution is made to the plan. Second, the earnings on the contributions are tax deferred within the plan trust. Third, the employer receives an immediate deduction for the contribution, even if the amount will not be paid until the employee retires.
Plan types
Defined benefit plans are plans that provide a promised benefit at retirement age. These plans do not have accounts for individual employees, but instead hold enough assets in the trust to satisfy the promised benefits. Typically, pension plans are designed to pay retirement income over the remaining life of the retiree and the retiree's spouse. Many of them now permit single sum distributions at separation from service or retirement.
Defined contribution plans are retirement plans in which each employee has an account into which employer and employee contributions are placed. A defined contribution plan provides a contribution formula, generally based, at least in part, on the employee's compensation. The employees enjoy the gains and suffer the losses on investments in their accounts. Many US defined contribution plans permit employees to direct the investments in their accounts.
There are several types of contribution arrangements that can be designed into defined contribution plans, including 401(k) arrangements and ESOP arrangements. 401(k) arrangements permit employees to elect to give up some of their compensation in exchange for a pre-tax employer contribution into a defined contribution plan. A 401(k) plan encourages employees to actively save for retirement and allows them to contribute more to the plan because they do not have to pay income tax on the amount contributed.
ESOPs are generally required to invest primarily in the stock of the employer. Thus, under an ESOP, the employees become part owners of the company, but the shares are held in the trust, rather than being given to the employees.
Nondiscrimination requirements
As a general rule, IRS nondiscrimination requirements provide that a large percentage of the rank and file employees must be covered by a given qualified retirement plan. The simplest of the nondiscrimination tests provides that a plan satisfies the nondiscrimination rules if it covers 70% of the rank and file employees. Thus, an employer can exclude certain groups of employees, but cannot cover just a portion of the company that is highly compensated (an employee is highly compensated if he or she made more than $85,000 in the previous year ($90,000 in 2002)). Moreover, under the IRS rules, these nondiscrimination requirements apply to the company and its related affiliates (a controlled group of companies, for pension purposes).
Example: parent owns 85% of SUB A and 100% of SUB B. SUB A is based in the US, SUB B is based in France. SUB B owns 100% of SUB X, based in the US. Parent, SUB A and SUB X are a controlled group of companies. Their qualified plans must cover enough rank and file employees to satisfy the nondiscrimination rules. SUB B is part of the controlled group, but because it is foreign, the non-resident aliens working for SUB B can be ignored in determining who must be covered in the US plans (see discussion below).
The controlled group rules are intended to prevent employers from avoiding the nondiscrimination rules by setting up different companies for different groups of employees. For example, if one company in a controlled group has a large percentage of highly compensated employees and a related company has mostly non-highly compensated employees, it is difficult to give the company with the highly compensated employees a significantly better plan than the employees in the other company, because they are treated as employees of a single company for purposes of the retirement plan testing rules.
A company is permitted to design a qualified retirement plan to exclude "all non-resident aliens with no US sourced income (non-resident aliens)". None of the non-resident aliens are counted in determining whether the nondiscrimination rules (such as the 70% test) are satisfied. However, designing a plan to exclude non-resident aliens does not exclude US citizens who work abroad.
Ruling facts
Under the IRS ruling, a closely held domestic corporation wholly owns several subsidiaries, including one foreign corporation. The foreign corporation has two employees who are US citizens. These two employees receive foreign earned income as defined in section 911. The domestic corporation maintains an ESOP.
Section 2 of the ESOP plan document defines "employer" as the domestic corporation and any affiliate which elects to cover its employees under the ESOP. Affiliate is defined by section 2 of the plan document as the domestic corporation and any other corporation that is a member of a controlled group of corporations with the domestic corporation, as well as other entities which are required to be aggregated under sections 414(c), (m), and (o). Section 2 of the plan document goes on to define "participant" as a common law employee of the employer who has met the eligibility requirements set out in the ESOP. The plan excludes non-resident aliens with no US sourced compensation. Compensation is defined, also at section 2, as the total cash compensation paid to an employee by the domestic corporation or an affiliate that is not in excess of $160,000 (as adjusted for inflation under section 401(a)(17)). It appears that the affiliate subsidiaries have elected to cover their employees under the ESOP. Thus, employees of the domestic corporation and its subsidiaries are eligible to participate in the ESOP.
Ruling requested
The domestic corporation requested that the IRS issue a PLR stating that the employees of the foreign subsidiary who are US citizens and have foreign earned income could participate in the ESOP without disqualifying the plan. In addition, the employer requested a ruling that those employees' foreign earned income could be used to determine the amount of the contribution to the plan.
The ruling
The IRS ruled that foreign earned income as defined in section 911 may be used as the basis for contributions to a qualified plan because regulation section 1.415-2(d)(2) includes foreign earned income in the description of compensation for purposes of section 415.
The IRS also ruled that the foreign subsidiary is a member of a controlled group with the domestic corporation, and therefore, under section 414(b), is part of a single employer. Section 414(b) looks to section 1563 for its definition of controlled group of corporations. The IRS ruled that section 1563(b), which excludes foreign corporations taxed under section 881 from the definition of controlled group of corporations, does not apply for purposes of section 414(b). Thus, the foreign affiliate, if it elects to cover its employees under the plan, can do so. In addition, if the plan continues to exclude non-resident aliens, only the employees of the foreign company that are not non-resident aliens will be covered. This will be the US citizens and possibly US green card holders.
The PLR clarifies that foreign earned income can be used as a basis for contributions to a domestic qualified plan. The PLR does not discuss the deductibility of the ESOP contribution. Section 414(b) does not aggregate controlled group members for purposes of section 404. Thus, it is possible that neither the foreign subsidiary nor the domestic corporation will be able to deduct the ESOP contributions to the employees of the foreign company.
Conclusion
In both this PLR and in prior IRS guidance, it is clear that a US plan can be designed to cover employees who work exclusively overseas and earn no US sourced income. However, because of the complexity of the qualified plan rules, great care must be exercised when deciding to cover overseas employees in a US qualified retirement plan.
There are many issues that should be addressed up front when deciding to bring foreign workers into a US retirement plan. While this is not an exhaustive list, these are the issues that companies often have to confront early in the process. First, it is important to determine the current coverage rules of the plan. Some plans inadvertently apply to all employees of all affiliated employers and thus mandate coverage for all employees worldwide. If this is not intended, it is preferable to find and change this language before the company becomes affiliated with or owns a company overseas. Second, it is important to understand the taxation scheme of the country in which the employees are working, and any treaty rules that may apply. There are still countries that do not recognize deferred compensation, which can cause hardship for employees who must pay tax on amounts that they have not received. Third, it is advisable to determine exactly who will be eligible under the plan. If the company intends to only cover US citizens who are working overseas, it is a very good idea to discover whether any of the foreign employees have dual citizenship (foreign and US) and thus must be covered under the plan. Finally, most qualified retirement plans do not permit distributions to employees who are still working for the employer (though certain plans can provide hardship distributions, and many plans permit employees to take out loans). US workers are familiar with this rule, but a foreign worker may need to understand that amounts contributed to the plan will not be readily available until retirement or separation from service.
As an aside, covering US workers in a foreign trust arrangement may be equally perilous. In many cases, contributing amounts to a foreign trust on behalf of US citizens may subject the employees to immediate taxation on the contributions.
Coverage of non-US-based employees under a US plan can be a great benefit, but failing to take the proper precautions can be very expensive to correct.
