By Michael Bruno, Steven Hadjilogiou, Gregory Weigand, David Noren and Keith Hagan

Law360 (March 30, 2020, 6:55 PM EDT) --

Michael Bruno

Steven Hadjilogiou

Gregory Weigand

David Noren

Keith Hagan

Border closures, travel bans and stay-at-home orders have become commonplace throughout the world during the pandemic. This global immobility has been instituted for a good cause — to flatten the curve of the spread of COVID-19. On March 19, the U.S. Department of State elevated its travel advisory to its highest possible level — Level 4 — advising all U.S. citizens to avoid international travel. Similar advice has been recommended by countries around the world.

The Department of State has said, "U.S. citizens who live in the U.S. should arrange for immediate return to the U.S., unless they are prepared to remain abroad for an indefinite period." In many cases, U.S. citizens are returning to the U.S. temporarily from a country in which they may be employed by a local employer. In other cases, residents of a foreign jurisdiction may be forced to remain in the U.S. indefinitely because they have fallen ill, the conditions in their home countries are unsafe or for other reasons.

This immobility presents cross-border tax challenges for individuals and companies who suddenly find themselves conducting operations in a foreign jurisdiction. Specifically, individuals who are nonresidents of the U.S. may find themselves becoming U.S. tax residents subject to tax on worldwide income. Similarly, non-U.S. companies may find themselves conducting a trade or business in the U.S. based on the activities of employees who are present in the U.S. during the pandemic.

Conversely, U.S. companies may find that they have established a permanent establishment in a foreign jurisdiction because employees may be conducting business operations in a non-U.S. jurisdiction.

This article explores some of the tax implications of these scenarios.

Residency Considerations for Employees

Mobility restrictions resulting from the COVID-19 pandemic may give rise to situations where employees of multinational companies become tax residents outside of their home country.

In the U.S., there are generally three ways by which an individual is considered a U.S. income tax resident, namely, being a U.S. citizen, a lawful permanent resident or substantially present in the U.S. To the extent a nonresident employee becomes a U.S. income tax resident, the employee becomes subject to U.S. income tax on worldwide income.

In general, a nonresident employee will meet the substantial presence test if the employee is present in the U.S. for at least 183 days during any calendar year, or an average of at least 122 days over a three-year period, computed by applying a statutory formula. Exceptions to the substantial presence test are limited.

For example, a nonresident employee will not be a U.S. tax resident if the employee (1) spent less than 183 days in the U.S. during a calendar year and (2) can establish that their so-called tax home is in a foreign country and demonstrate they have a closer connection to that foreign country.

A nonresident employee that is a tax resident in a jurisdiction with which the U.S. has an income tax treaty may be able to utilize a treaty tiebreaker provision, even where the employee meets the substantial presence test by spending more than 183 days in the U.S. in a single year.

Another exception to the substantial present test involves medical conditions. That exception applies if a nonresident individual is unable to leave the U.S. because of a medical condition that arose while such individual was present in the U.S.

In other words, days are counted for purposes of the substantial presence test if a nonresident employee enters the U.S. for medical treatment or is otherwise aware of a condition prior to entering the U.S., regardless of whether the individual required medical treatment for such condition. Moreover, the medical condition exception ceases to apply if, on becoming well enough to travel, the individual remains in the U.S. beyond a reasonable amount of time to arrange travel outside of the U.S.

In view of the current public health crisis, the Internal Revenue Service has been requested to expand the medical condition exception to include nonresident individuals who cannot travel due to the COVID-19 pandemic. Thus far, the IRS has not allowed for any exceptions.

Even if a nonresident employee is not substantially present in the U.S., and in the absence of an income tax treaty, the performance of personal services in the U.S. may still cause the employee to incur a U.S. income tax liability to the extent the compensation sourced to the U.S. exceeds a certain de minimis exception.

Conversely, foreign country tax residency rules should be considered for U.S. tax resident employees trapped in foreign countries because of COVID-19. Generally, U.S. income tax residents have an election to exclude their foreign earned income (up to $107,600 in 2020) from their U.S. taxable income. However, to make such an election, the individual's tax home must be in that foreign country, which is unlikely to be the case in the event of temporary residency.

As a result, a U.S. tax resident employee unable to travel because of COVID-19 must assess whether they will become or have become an income tax resident of a foreign country, whether they will be able to claim an income tax treaty tiebreaker position, or whether they may claim foreign tax credits in the U.S. to the extent they are required to pay foreign income taxes.

Sourcing of Income from Performance of Personal Services

An employee who is detained within the U.S. and works remotely can cause income-sourcing issues to their employer. Even if an employee is not present in the U.S. long enough to become a tax resident, an employee who performs personal services on behalf of their employer while in the U.S. can cause the income earned by the employer on account of the employee's services to be U.S. source income. The consequences of this are manifold.

All compensation for labor or the performance of personal services performed in the U.S. is treated as U.S. source income. This means that the income earned by the employer as a result of the labor of employees who are temporarily detained within the U.S. will be U.S. sourced.

In particular, a foreign-based multinational company may now find itself with more U.S. sourced income than it expected. Indeed, a company that might otherwise have no employees in the U.S., may find itself with unforeseen U.S. tax liability and filing requirements.

Domestic entities may also suffer unanticipated tax consequences, particularly those with foreign operations and who have made the operating decision based on the availability of the foreign tax credit.

In general, a domestic company is entitled to credit foreign income taxes paid against its U.S. tax liability. Under the foreign tax credit rules, the amount of this credit is limited to a fraction of the U.S. income tax liability.

Ignoring some of the finer details, the numerator of that fraction is essentially the company's foreign-source income and the denominator is the company's worldwide income. If an employee of a foreign branch who would ordinarily work in a foreign jurisdiction works while in the U.S., the result is that the numerator of this fraction is reduced, and therefore the company will be entitled to less foreign tax credit, notwithstanding that the tax liability in the foreign jurisdiction may remain the same.

To mitigate these consequences, the employer should evaluate and determine whether the facts may support a position that the portion of its income earned due to this employee's labor performed while in the U.S. is relatively small. In that case, less of the company's income will be treated as U.S. source income.

Generally, this may be done by showing that the income earned is predominantly attributable to some other item or activity, for example, employees working outside of the U.S., or plant and equipment or intellectual property located outside of the U.S.

Companies Should Reconsider Their Nexus to the Source Jurisdiction

COVID-19 may have a significant impact on nonresident companies that have employees temporarily present in the U.S. Under U.S. domestic law, aside from a modest $3,000 de minimis exception, a nonresident company is taxable in the U.S. on a net basis to the extent it earns income that is effectively connected to a U.S. trade or business — the ECI regime.

A nonresident company is generally engaged in a U.S. trade or business if its employees or personnel perform personal services within the U.S. at any time during the taxable year. Certain exceptions apply for nonresidents that trade in securities or commodities. However, in other cases, it may only take the act of one employee performing services in the U.S. to cause the nonresident company to be engaged in a U.S. trade or business.

A nonresident company that is currently faced with the issue of having employees temporarily present and working in the U.S. because of COVID-19, should consider its U.S. tax filing obligations and whether any of its income is taxable under the ECI regime.

It should also examine its employees' activities to determine whether they are in fact performing services. In borderline cases, the nonresident company should consider filing a protective Form 1120-F with the IRS to claim no tax residence in the U.S., and begin the running of the three-year statute of limitations clock.

In cases where the nonresident company qualifies for the benefits of a U.S. income tax treaty, it should consider whether the permanent establishment, or PE, article provides relief from its U.S. tax nexus. Nonresidents should be wary of the fixed place of business PE provision if they have an employee currently working out of an office in the U.S.

Interesting questions arise in the case of employees working in other fixed locations, such as a temporary or permanent residence. Even if no fixed place of business PE exists, most, if not all, U.S. income tax treaties contain PE provisions on dependent agents habitually negotiating and concluding contracts in the U.S., subject to the potential application of specific activity exceptions for functions thought to be "preparatory or auxiliary."

Nonresident companies should consider the extent of their agents' activities, for example, whether they rise to the level of habitual, and to the extent possible, might want to consider restricting their agents' contracting and negotiating power to avoid creating a PE.

Further, some U.S. income tax treaties contain personal services PE provisions that focus on the number of days a nonresident company's employees or personnel spend in the U.S. Due to limitations on travel to or from the home jurisdiction, it is possible that an employee may spend more time than expected in the U.S.

Of course, even if a nonresident company has a PE in the U.S., it should carefully examine the amount of its business profits that are attributable to such PE, based upon the facts and circumstances of the given arrangement.

Nonresident companies should assess their reporting positions to determine whether they have U.S. tax filing obligations and potential U.S. tax exposure.

In light of COVID-19, U.S. companies face similar challenges to the extent they have employees temporarily stranded in a local jurisdiction. U.S. companies should consider whether they have nexus to the particular jurisdiction, and if they are required to pay tax in the local jurisdiction and comply with local tax filing obligations.

In addition, application of the rules under Subpart F of the Internal Revenue Code hinges, in many cases, on the location of various activities of foreign subsidiary employees (for example, under the foreign base company sales and services rules), and thus may require reevaluation if certain functions are moved from one foreign country to another.

Further, U.S. companies should monitor whether any of their foreign subsidiaries' employees are performing services in the U.S. It is possible that a foreign subsidiary might also be subject to the ECI regime, which can lead to tax inefficiencies in their supply chain.

It is hoped that the U.S. and other countries around the world will provide temporary relief from tax exposures of this nature stemming from disruptions caused by the pandemic. In the meantime, virtually all multinational enterprises need to be vigilant for new traps that may have arisen within their supply chain structures.

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Michael J. Bruno, Steven Hadjilogiou, Gregory M. Weigand and David G. Noren are partners, and Keith Hagan is an associate at McDermott Will & Emery LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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