Whether the U.S. rules for withholding and reporting on income even apply to compensation paid to foreign employees working abroad depends on the residency status of the employee.
U.S. citizens and green-card holders who work abroad for U.S. companies remain subject to U.S. payroll taxes and Form W-2 income reporting. Substantially present residents remain subject to these rules if they are not away long enough to become nonresident aliens.
Qualifying U.S. expatriates can use IRC §911 foreign earned income exclusions and foreign tax credits to avoid double worldwide taxation while working abroad. IRC §911 limits the calendar-year Bona Fide Residence (BFR) test to U.S. citizens. Foreign nationals who are nationals of a treaty country may, however, use the BFR test under a nondiscrimination clause of an applicable treaty. Regardless of eligibility for the BFR test, resident aliens may use the 330-day physical presence test if they otherwise meet the requirements.
Special payroll rules allow for reductions in wage withholding (but not FICA) for employees who expect to qualify for IRC §911 foreign earned income exclusions (claimed on Form 673) or whose wages are subject to foreign wage withholding. The IRC sections allowing these exceptions specifically limit them to U.S. citizens. Foreign nationals who are nationals of a treaty country may also use these procedures (explaining the exception on a statement) because of the nondiscrimination clause of the applicable tax treaty.
Nonresident employees performing services abroad are not subject to U.S. withholding because the source of income from services is where the services are performed (not where payment is made). Nonresident aliens are not subject to tax on foreign-source income. Employers should request that these employees document their foreign status on Form W-8BEN(no Taxpayer Identification Number required) and the location of the services in their contracts. Compensation paid to nonresident (and resident alien) employees working abroad is not subject to FUTA.
