Availability of the Foreign Earned Income Exclusion, FTCs and Combat Pay Exclusion for U.S. Government Contractors

Many individuals are working abroad in quasi-governmental capacities through contracts with the U.S. Department of Defense and the U.S. Agency for International Development (USAID). Al-though this is hardly new, more and more practitioners must now advise individuals who have sources of in-come earned in other countries as a result of being indirect members of the U.S. government. For government and USAID employees, tax treaties may be superseded or supplemented by Status of Forces Agreements (SoFAs) or USAID Bilateral Agreements. Often these agreements have a direct effect on how individuals are taxed in the host country and whether they can claim the foreign earned income exclusion and foreign tax credits (FTCs).

SoFAs

Under SoFAs, tax residency in a foreign country is prohibited. Residency treatment by the home country provides parity—individuals designated as part of the “civilian component” (often noted as “technical representatives”) are extended the same benefits that U.S. Forces enjoy in a host country. In essence, taxpayers are treated as if they never left the U.S. In this situation, they are indirect employees of the U.S. and cannot take a foreign earned income exclusion. At the same time, however, they are not subjected to tax in the foreign country, which simplifies the administrative burden by not having to file in multiple countries and to track FTCs.

Each individual’s circumstances must be examined carefully; not all employees assigned abroad under a given contract are part of the civilian component and extended SoFA protection. For example, under the NATO SoFA, benefits are generally limited to “white collar” positions, “blue-collar” positions of a sensitive nature and to other jobs considered indirectly linked to a U.S. military presence (e.g., teachers at a base school).

The situation becomes even more complex when individuals have other employment in the host country or marry a host-country national. Sometimes, their personal circumstances become so entangled with the host country that their SoFA benefits are lost. SoFAs only extend benefits to compensation earned in connection with a government contract; income from “moonlighting” is taxable under normal, host-country provisions and income tax treaties. When contractors who are otherwise covered by a SoFA have a second job, they may be eligible for the foreign earned income exclusion and FTCs for that employment.

USAID

USAID provides subsidized funds, expertise and humanitarian relief. In return, its policy is to negotiate broad tax exemptions with recipient nations. USAID employees and USAID-financed contractors are granted income tax and limited customs, value-added and property tax immunities through USAID Bilateral Agreements; see USAID ADS 155, paragraph 155.3.1.3.

USAID has three categories of personnel: direct hires, USAID personal services contract (PSC) employees and USAID-financed contractors. Because USAID is a U.S. government agency, direct hires and PSC employees are considered paid by the U.S. government and taxed by host countries as any other visiting diplomat. Host countries may grant relief under their own tax statutes. In other situations, income tax treaties can address the taxation of visiting government officials. As government employees, direct hires and PSC employees are ineligible for the foreign earned income exclusion; see 48 CFR Chapter 7, Appendix D, Direct USAID Contracts With A U.S. Citizen Or A U.S. Resident Alien For Personal Services Abroad, Section 4(c). They may claim an FTC, but often there is no foreign income tax paid.

A special opportunity exists for USAID-financed contractors. They are not considered employees of the U.S. and thus may claim the foreign earned income exclusion. In addition, the income tax exemption clause included in all bilateral agreements extends to USAID contractors. USAID contractors may also claim an FTC but, as a result of the income tax exemption under the applicable bilateral, there should be no foreign tax against which to claim a credit. Many USAID contractors are in a situation in which their earned income is virtually exempt from income taxation in any jurisdiction.

At times USAID has misclassified PSC employees and USAID-financed contractors. Courts have looked to the degree of control that USAID exercises over the individual to determine whether a person is in fact an employee or an independent contractor under common-law principles. If the individual rendering services through the USAID-financed contractor bears an independent contractor relationship to USAID, the foreign earned income exclusion is allowed.

Combat Pay

With very limited exception, compensation earned by employees of commercial enterprises, government contractors and civilian employees of the Federal government (including civilian employees of the Armed Forces) are not entitled to exclude earnings related to duty in a combat zone from taxable income; see Sec. 112(d)(2) and Regs. Sec. 1.112-1(a)(4). Only compensation paid to U.S. Armed Forces serving in combat zones or hospitalized as a result of injury while serving in a combat zone qualify for the combat pay exclusion; see Sec. 112(a). The Armed Forces are narrowly defined as U.S. military or naval forces, including reserves; see Regs. Sec. 1.112-1(a)(3), which refers to the definition of armed forces provided in Sec. 7701(a)(15). The amount of combat pay to be excluded as taxable wages on Form W-2 should already be reduced for any qualifying combat zone pay and would typically not need to be determined by return preparers; see IRS Pub. 3, Armed Forces’ Tax Guide For use in preparing 2005 Returns.

Conclusion

The applicability of the foreign earned income exclusion and FTCs are substantially modified for government contractors working abroad. SoFAs often prevent foreign country taxation. As U.S. government employees, USAID employees are ineligible for the foreign earned income exclusion, while employees of USAID contractors may have virtual tax exemptions, because both the foreign earned income exclusion and tax exemptions provided through USAID bilaterals are available. Combat pay exclusions are only available for members of the Armed Forces.

From Christine Ballard, MST, Washington, DC