U.S. Government Contractors and Cross-Border Payroll Tax Issues

The cross-border global expansion of business activities continues to increase exponentially in the US 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 US 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 US expatriate individual employees to work in another country, it is necessary to consider how to structure the payroll. The foreign country where the US employees are performing the contract may require the US government contracting company to register with a foreign tax authority for foreign payroll tax reporting and compliance. Some countries allow a US 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 US expatriate employees’ compensation is reported through the US payroll. This structure allows the US employees to continue to make contributions into the US social security system and to 401(k) retirement plans. Depending on the length of the US expatriate employee’s assignment in the foreign country, a US 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 US. 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 US expatriate employees from foreign individual income taxation in the foreign country where they are performing the services under the contract. Under some SOFAs, the US 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 US government contractor from foreign payroll tax reporting and compliance. This exemption may be possible when the US expatriate employees also have tax exempt status and the work is being performed on a US 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 US 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 US expatriate employees are working on the contract. In some cases, the SOFA status may govern, to the extent, that a contractor may also be considered to have a permanent establishment in the foreign country under a US income tax treaty.

To avoid this, the contractor should coordinate with a US 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.

Contact Aprio’s Government Contracting Services team today to connect with an experienced advisor. 
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