Multinational corporations, particularly construction firms doing business in the Middle East, are preparing to capitalize on a provision of the 1981 tax act that significantly lessens the tax burden on their foreign-based employes.
This year, according to James H. Larkin II, president of the Houston-based Overseas American Tax Service, will be "the best year since the early '60s for a U.S. citizen working overseas . . . The Economic Recovery Act passed by Congress and signed into law by President Reagan offers the best tax break in more than two decades to help the expatriate."
It is, however, by no means clear if the benefits of the tax break will flow to overseas employes; major companies are in the process of trying to decide how to adjust pay in light of the tax change. One likely option will be to initiate "equalization" programs so that workers suddenly pulling ahead of colleagues at home and in other countries because of tax changes will receive reduced compensation.
In other words, the tax break would flow to the companies, not the workers, except in the cases of self-employed persons and those working overseas for foreign-based firms.
The new law represents a major victory for those who have argued that the U.S. tax system has functioned to hurt the nation's ability to compete in international markets.
The major lobby for the tax change was the National Constructors Association, which coordinated the creation of an ad hoc group called the U.S. and Overseas Employees Tax Fairness Committee. It got the support of industry groups such as the American Consulting Engineers Council, the Associated General Contractors, the National Consulting Engineers Council and the International Engineering & Construction Industries Council.
The provision in the 1981 bill represented a near-complete turnaround from the reform mood of the mid-1970s that produced legislation designed to make U.S. citizens working abroad pay rates of taxation equal to that of persons living here.
In this light, the legislation will serve, in part, as a test of whether the recent sharp decline in U.S. contracting in the Middle East results from tax policy--the claim made by the U.S. firms--or from the improved competitive abilities of firms from Korea, Japan and Western Europe.
One of the major arguments used by firms such as Bechtel Power Co. and Brown and Root has been that the cost of giving employes additional compensation to make up for increased tax liabilities has been a key factor in the decline of construction awards to American companies in Saudi Arabia from 9 percent of the work in 1975 to 6 percent in 1978 to 3 percent in 1979.
In contrast to the policies of other countries competing for this market, the United States is the only nation that taxes foreign earned income.
While not completely eliminating U.S. tax liabilities, the 1981 bill gave expatriate workers the right to take a flat $75,000 exemption from U.S. taxes on foreign income. In addition, it established a housing cost exclusion on all expenses in excess of $6,350. The income exclusion will grow by $5,000 a year until it reaches $95,000 in 1986.
The major beneficiaries will be companies, and perhaps their workers, in the Middle East, where there is little or no income tax on foreigners, and consequently the exclusion will function to shield pay from U.S. income tax.
It will make relatively little difference in foreign countries that impose a high rate of taxation on U.S. citizens working there because the foreign tax can be used as a credit against U.S. tax liabilities. And, in many cases, it would be against the interests of the taxpayer to elect to use the $75,000 exclusion.
"The new law will benefit Americans living in the Middle East, a few countries in Africa, and certain countries in the Far East and the Pacific Basin," according to Arthur Andersen & Co., an accounting firm that does extensive work for multinational firms. "However, individuals who reside in foreign countries whose effective tax rates are higher than the U.S. rate, such as Germany, Norway and Sweden, for example, will receive no benefit."
The cost of the provision, however, will be considerable. The Joint Committee on Taxation estimates that in the current fiscal year, revenue losses will be $299 million, growing to $544 million in 1983 and to $696 million by 1986.
Melchior Morrione, tax partner in the Andersen accounting firm and a specialist on the issue of taxation of expatriate income, said most multinational companies are moving toward what he described as a policy of "equalization" for employes.
Under this approach, the company attempts to make sure that there is some standardization of real net income for equivalent employes, no matter what the various tax situations are in various countries.
Under the new law, this would mean, in most cases, that employes now able to benefit from the $75,000 exclusion in low-tax countries would face a loss of compensation, while those in countries with higher tax rates than the United States would continue to get extra pay.
Using Dubai, a no-tax country, as an example, the Andersen firm has done a sample calculation showing the impact on a hypothetical executive with three dependents making $100,000 a year.
Under the old law, the executive could take deductions of $41,800 and $4,000 in exemptions for himself and three dependents, for a taxable income of $54,200 and a U.S. tax of $16,626. Under the new law, the same executive can get a $75,000 exclusion, a $14,000 housing exclusion and $4,000 for personal exemptions, for a net taxable income of just $7,000, on which the tax would be $462.
Use of the exclusion is a choice to be made by the taxpayer, and using Germany as an example, the firm showed that the exclusion would be disadvantageous in such a high-tax country.
The same $100,000-a-year executive using the exclusion would be able to reduce his U.S. tax to zero, but he would be able to achieve the same goal using the old law to credit taxes paid to Germany against his U.S. liability. By choosing to use the old law, however, the executive would also be able to get a $27,155 foreign tax credit carry-forward to use against U.S. taxes on future foreign income, while the exclusion would reduce the credit to just $4,488.
The 1981 law is the most recent chapter in what has been a series of major changes in foreign-earned income tax policy over the past six years.
Before 1976, Americans were allowed a $20,000 exclusion if they met foreign residency requirements in 17 of 18 consecutive months. The excluded income came "off the top," in accountants' parlance, so that the remaining taxable income stayed in the lower-rate brackets.
In 1976, however, legislation and two Tax Court decisions significantly increased the liabilities of expatriate workers. The Tax Court ruled that many of the side benefits--housing allowances, meals, etc.--were subject to income tax if they failed to meet tight standards.
More significant, the 1976 Tax Reform Act reduced the exclusion to $15,000 and shifted the exclusion so that it would be "taken off the bottom," making the remaining taxable income fall into high brackets.
The legislation was based on the tax reform concept of equity: A person working overseas should not have to pay less tax than someone remaining in this country. It never went into effect, however, because it was postponed in 1977 and then overtaken by the Foreign Earned Income Act of 1978.
The 1978 bill attempted to lessen the tax burden on expatriate workers. It created a complex system of permissible deductions for living cost differentials, education expenses, housing, home leave and expenses of living in hardship areas.
The 1978 bill, however, was attacked as excessively complex and for continually placing U.S. firms at a competitive disadvantage.