I. Domestic Administration of Social Security Taxation and the Scope of International Coordination – continued

a. The First Aspect: Contributions

Social security contributions are imposed as a tax via the Internal Revenue Code (Code) and collected by the Department of Treasury through the Service. Two statutes apply. With respect to employers and their employees, the Federal Insurance Contributions Act (FICA) applies. With respect to self-employed persons, the Self Employment Contributions Act (SECA) applies. Under FICA, employers and employees contribute to social security based on wages paid. Under SECA, contributions are based on self-employment income received.

In each case, the tax consists of two parts: old age, survivors, and disability insurance (OASDI) and hospital insurance (HI). The rates are 12.4% and 2.9%, for OASDI and HI respectively. The employee and employer each pay one half of the tax. Employers collect the employee portion by withholding as wages are paid. The employer’s half is deductible as a business expense against revenue. Employer contributions are excluded from the income of employees, but employee contributions are not deductible.

Self-employment tax is similar to Social Security tax. The difference is that, as the individual is self-employed, he takes on the role of both employer and employee for purposes of social security contributions. As such, the self-employed individual must pay both halves of the Social Security tax when he files his individual income tax return. The rates are 12.4% and 2.9%, for OASDI and HI, respectively, and half of the contributions are deductible.

The social security contribution provisions in the Code are a funding mechanism for the Federal Old-Age and Survivors Insurance Trust Fund. The latter is a fund in which contributions collected from taxpayers are deposited. Thus, while social security contributions are taxes, the Service’s role is merely to collect the taxes. The agency responsible for administering the social security program is the Social Security Administration (SSA).

The international coordination issue that arises in this area is the possibility that two or more countries might simultaneously require contributions on the same item of income. Eliminating this form of double taxation is accomplished through Social Security Totalization Agreements (SSTAs).

Under an SSTA, individuals are exempt from social security contribution requirements in one country (i.e., the home country) to the extent their self-employment income or wages are subject to requirements under the social security system of another country. This means that the country in which the taxpayer is employed has the primary right to tax. The applicable provision of the Social Security Act states the following, “a person employed within the territory of one of the contracting states and the person’s employer shall, with respect to that employment, be subject to the laws of only that contracting state.”

Under this allocation rule, a resident of the United States who works abroad will make social security contributions in the foreign country, while individuals from foreign countries working in the United States will make social security contributions in the United States.

An example illustrates this point. John is an American citizen who lives in New Jersey. He is an architect. John is hired by a United States company to design and build a hotel in Frankfurt. The project is expected to last over a year, with John working overseas the whole time.

How is John taxed for social security purposes? The United States requires that U.S. employers withhold Social Security tax from employees, whether citizens or resident aliens, working overseas for U.S. companies. Here, the withholding requirements of the United States apply because John is working overseas for a U.S. company, not a German company. The fact that John performed the services outside of the United States does not exempt him from paying U.S. social security taxes.

The next issue is whether John is excused from making social security contributions to the United States? This issue raises several sub-issues. First, does Germany have its own social insurance program? Yes. Second, must John pay social insurance tax to the German government? Yes, because John works in Germany and an employee is subject to the social insurance taxes of the foreign country in which he works.

Third, does a totalization agreement exist between the United States and Germany? If so, John is excused from making social security contributions to the United States because he is already paying taxes to the German government, the country which has the primary right to tax. In the absence of a totalization agreement, John may be subject to the social insurance tax of Germany as well as the social security tax of the United States. However, as will be discussed in the next section, John can take a credit on the social insurance tax paid to Germany but only to the extent that there is other U.S. federal tax against which to apply that credit.

There are several exceptions to this “place of employment” rule. For example, the self-employed, who would otherwise be subject to the laws of both contracting states, are required to make social security contributions only in the contracting state in which they “ordinarily reside,” rather than where the work is performed.

“Ordinarily resides” means that “a person has established a home in that country intending to remain there permanently or for an indefinite period of time.” This can be established by assuming “certain economic burdens, such as the purchase of a dwelling or establishment of a business,” and by participating “in the social and cultural activities of the community.” This exception to the “place of employment” rule for U.S. citizens working abroad as self-employed individuals can be reduced to a simple rule: the self-employed individual must always pay U.S. social security tax under the Internal Revenue Code.

Perhaps the biggest exception to the place of employment rule pertains to workers who are sent overseas on temporary assignments. The issue is whether they can escape social security contribution requirements in the country in which they perform the work. The answer is “maybe.” Workers on “temporary” assignments may be exempt from social security contribution requirements in the host country for as long as five years. Under this rule, the place of employment rule gives way to a preference for the country of initial residence.

The rationale seems to be that for temporary overseas assignments, it makes sense to allow the worker’s home country to continue to collect social security contributions, since it is expected that the worker will return home after the assignment, as well as retire and seek benefits in the home country.

Without this rule, foreign workers in the United States would have to make social security contributions even if their time in the United States was brief and their earnings were minimal. As a preliminary matter, wages earned by foreign workers employed by foreign persons may be exempt from United States income taxation under statutory de minimis thresholds. However, these thresholds do not apply to social security contributions.

What does this mean for the temporary worker? Without an SSTA in place, they would receive disproportionate treatment for social security and income tax purposes. In other words, they would have to report and pay social security taxes even though they have no income tax obligations with respect to their wages. Relief from this potentially devastating result may be attained under tax treaties, SSTAs, or both.