Employer cannot get a later-year refund of over-withheld income tax it paid on a tax-equalized foreign-assignment employee's behalf

Plain-English summary

Companies that send U.S. employees abroad often use "tax equalization," reducing the employee's salary by a hypothetical U.S. tax and then paying all the employee's actual taxes for them, so the foreign posting is tax-neutral to the employee. This Chief Counsel Advice addresses whether the employer can claim a refund, in a later year, of income tax withholding it over-paid on the employee's behalf. The answer is no. Because the employer pays the tax out of its own funds under a prearranged plan, those payments are additional wages to the employee and are deemed withheld from the employee under § 3402. Under § 6414, an employer cannot get a refund of amounts deemed withheld from an employee. The employer can only fix an over-withholding through an interest-free adjustment or refund claim within the same calendar year the wages were paid; merely realizing after year-end that the estimate was too high is not the kind of "administrative error" that allows a later correction. This is internal legal advice to IRS personnel, not a taxpayer ruling.

Ruling snapshot

• Question: Can an employer using a tax equalization program get a refund, in a later year, of income tax withholding it over-paid on the employee's behalf?
• Outcome: Advice given (no; the amounts are deemed withheld from the employee, so § 6414 bars an after-year-end refund to the employer)
• Key authorities: IRC §§ 3402, 6413, 6414, 6402; Treas. Reg. §§ 31.6413(a)-1, 31.6413(a)-2, 31.6414-1; Rev. Rul. 58-113

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 202202010
       Release Date: 1/14/2022
       CC:EEE:EOET:ET2
       POSTN-124935-21

UILC: 3402.00-00, 6402.00-00, 6413.00-00, 6414.00-00,

date: December 13, 2021

 to:   Jeremy Fetter
       Area Counsel
       (Tax Exempt & Government Entities)

from: Lynne Camillo
Chief, Employment Tax Branch 2
(Employee Benefits, Exempt Organizations, and Employment Taxes)

subject: Income Tax Refund to Employer in a Subsequent Year Following the Use of Tax
Equalization Methods

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       ISSUE

       Whether an employer is eligible to receive a refund of income tax withholding paid on
       behalf of an employee on a foreign assignment in a year after the calendar year in
       which the employer paid remuneration to which the income taxes are attributable in a
       situation where the employer uses a tax equalization program to adjust the employee’s
       pay so that the employee will have no net economic gain or loss with respect to tax
       liability because of the foreign assignment, and pays the income tax withholding
       attributable to the employee’s adjusted pay.

       CONCLUSION

       When an employer pays an employee on a foreign assignment a stated amount of
       remuneration that is subject to income tax withholding under § 3402, and pays the
       income tax withholding attributable to the remuneration on behalf of the employee, then
       the income taxes the employer pays to the Internal Revenue Service (Service) are
       considered withheld from the employee and thus may not be refunded to the employer
       after the calendar year in which the wages were paid.

POSTN-124935-21 2

BACKGROUND

Companies with an international presence often station employees in countries other
than the employee’s country of citizenship. When doing so, these companies frequently
offer tax equalization programs to employees on international assignments. Tax
equalization is a process that is intended to result in the employee having no economic
gain or loss with respect to tax liability because of the foreign assignment. After all
expected taxes are considered, an employee may be better or worse off economically
because of the foreign assignment if an adjustment to salary is not made. The tax
equalization program is designed to result in the employee paying approximately the
same amount of income tax as the employee would have paid if he or she had not been
placed on an international assignment.

Under the tax equalization process, a company will enter into a tax equalization
agreement with its employee prior to stationing the employee in a new country. As part
of the tax equalization agreement, the company and the employee will calculate what is
commonly referred to as a “hypothetical tax.” The hypothetical tax calculation made
before the beginning of the tax year constitutes an approximation of what the
employee’s overall tax liability would be for the upcoming year if that employee were to
remain in the United States (approximate hypothetical tax). The employee’s previously
agreed upon salary for the upcoming year is reduced by the amount of this approximate
hypothetical tax, and the employee is not entitled to receive that portion of the
employee’s prior salary. The company will usually pay all taxes owed on remuneration
the employee receives from that company on behalf of the employee for both the
country where the employee is stationed (host country) as well as the employee’s
country of citizenship.

The company will generally file quarterly Forms 941 and remit income tax withholding
consistent with the quarterly filings. The company will also show the income tax
withholding amounts remitted to the Service as income tax withheld from the
employee’s wages on the Form W-2 it files and furnishes to the employee after the end
of the calendar year.

After the end of the calendar year, the company and the employee calculate the exact
amount of taxes that the employee would have owed had the employee remained in the
United States as the “actual hypothetical tax.” Upon making the new calculation, the
company and the employee adjust payments to make up the difference between the
actual hypothetical tax and the approximate hypothetical tax computed before the
beginning of the year. If the approximate hypothetical tax was too high, the company
pays the employee the difference between the actual hypothetical tax amount (generally
calculated by a third-party accounting firm) and the approximate hypothetical tax
amount that was deducted from the previously agreed upon salary. The company
usually pays any additional taxes on this additional income. If the approximate
hypothetical tax is too low, however, the employee is generally required to repay a
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portion of the employee’s remuneration paid in the prior year back to the company.
The issue presented is whether a United States company that pays United States
income tax withholding in excess of what should have been withheld is entitled to claim
a refund of the excess withholding in a year subsequent to the calendar year in which
the remuneration that gave rise to the United States tax liability was paid to the
employee.

FACT SITUATION:

A United States company sends a United States citizen employee on international
assignment and pays the employee remuneration subject to income tax withholding
under § 3402. Under the company’s tax equalization program, the company agrees in
advance of the international assignment to pay the employee a stated amount of
remuneration, net of any taxes owed on the remuneration, which is intended to equal
the after-tax remuneration the employee would receive if they had remained in the
United States instead of accepting a foreign assignment. The United States company
reduces that employee’s salary by the approximate hypothetical tax and pays the
required income tax withholding throughout the year in which remuneration is paid to
the employee.

LAW

Employers are generally required to deduct and withhold federal income tax from wages
paid to their employees under § 3402(a). Section 31.3403-1 of the Treasury regulations
establishes that an employer is liable for the withholding and payment of employment
taxes, whether or not amounts are actually withheld.

The term “wages” for purposes of income tax withholding is defined in § 3401(a) as all
remuneration for services performed by an employee for his employer. Section
3402(p)(3) provides that the employer and the employee can agree that the employer
will withhold taxes from payments for services that do not constitute “wages.” If the
employer and employee agree to the voluntary withholding, then any payments with
respect to which the agreement is made shall be treated as if they were wages paid by
an employer to an employee.

Section 31.3401(a)-1(b)(6) of the Treasury regulations provides that the term “wages”
includes the amount paid by an employer on behalf of an employee (without deduction
from the remuneration of, or other reimbursement from, the employee) on account of
any payment required from an employee under a State unemployment compensation
law, or on account of any tax imposed upon the employee by any taxing authority,
including the taxes imposed by §§ 3101 and 3201.

Rev. Rul. 78-374, 1974-2 C.B. 67, provides that a ‘staff assessment’ withheld from the
salary of a U.S. citizen employed by the International Civil Aviation Organization that is
neither available to, or received by, the employee nor part of a deferred compensation,
POSTN-124935-21 4

pension, or disability plan is not includible in the employee's gross income.
Sections 6402, 6413 and 6414 permit interest-free adjustments and claims for refund to
correct overpayment errors related to income tax withholding. Section 6402 establishes
the procedures for filing claims for refund. Section 6402(a) provides, in part, that in the
case of any overpayment, the Secretary may credit the amount of such overpayment
against any tax liability of the person who made the overpayment and shall refund the
balance to such person.

Section 6413(a)(1) generally provides for interest-free adjustments in such manner and
at such times as the Secretary prescribes by regulation if more than the correct amount
of tax imposed by §§ 3101, 3111, 3201, 3221, or 3402 is paid with respect to any
payment of remuneration.

Section 6413(b) generally provides for a refund if an overpayment cannot be adjusted
under § 6413(a) in such manner and at such times as the Secretary prescribes by
regulation if more than the correct amount of tax imposed by §§ 3101, 3111, 3201,
3221, or 3402 is paid with respect to any payment of remuneration.

Section 6414 provides that in the case of an overpayment of income tax withholding, a
refund or credit shall be made to the employer or to the withholding agent only to the
extent that the amount of such overpayment was not deducted and withheld by the
employer or withholding agent.

Section 31.6413(a)-2 generally provides procedures for the interest-free adjustments of
overpayments of income tax withheld from wages. Section 31.6413(a)-2(c)(2) provides
that if an employer files a return for a return period on which income tax required to be
withheld from wages is required to be reported and reports on the return more than the
correct amount of income tax required to be withheld, and if the employer ascertains the
error after filing the return, and repays or reimburses the employee in the amount of the
overcollection as provided in § 31.6413(a)–1(b)(2), the employer may correct the error
through an interest-free adjustment.

Section 31.6413(a)-1(b)(2) provides that if the employer ascertains the error after filing
the return but before the end of the calendar year in which the wages were paid, the
employer shall repay or reimburse the employee in the amount of the overcollection
prior to the end of the calendar year.

An interest-free adjustment for an overcollection of income tax withholding can only be
made if the employer discovers the error and repays or reimburses the employee within
the same calendar year as the payment of the wages. However, under § 31.6413(a)-
2(c)(2), an employer can correct an overpayment of income tax withholding due to an
administrative error even if the employer did not discover the error until after the
employer filed the return and did not repay the employee within the calendar year.

An administrative error involves the inaccurate reporting of the amount withheld due to a
POSTN-124935-21 5

transposition error or math error. In other words, an administrative error occurs when
the amount the employer reported as withheld on the employer’s employment tax return
does not agree with the amount actually withheld from the employee’s wages. An
employer can’t make an interest-free adjustment to correct income tax withholding for
prior years for non-administrative errors. Thus, an employer can’t correct income tax
actually withheld in a prior year if the employer discovers that the correct amount was
not withheld, because the failure to withhold the correct amount of income tax is not an
administrative error.

Section 31.6402(a)-1 refers to §§ 31.6402(a)–2, 31.6402(a)–3, and 31.6414–1 for
regulations under § 6402 of special application to credits or refunds of employment
taxes. Section 31.6414-1 provides rules under which a claim for credit or refund of an
overpayment of income tax withholding may be made. While § 6402 provides a process
for refund of an overpayment of income tax withholding as noted above, § 31.6414-1(a)
provides that no refund to the employer will be allowed for the amount of any
overpayment of tax which the employer deducted or withheld from an employee.
Situation 2 of Rev. Rul. 2009-39, 2009-52 I.R.B. 951 illustrates the application of the
interest-free adjustment and claim for refund processes as it relates to the overpayment
of income tax withholding.

In Old Colony Trust Company v. Commissioner, 279 U.S. 716 (1929), the Supreme
Court considered whether the payment of income taxes payable on an employee’s
salary by his employer pursuant to a contractual agreement constitutes additional
taxable income to the employee. The Court held that the payment of the taxes was
made in consideration of services rendered by the employee and was includible in the
employee’s gross income. The Court stated that it is immaterial that employer paid the
taxes directly to the Government. The discharge by a third person of an obligation
owed by the taxpayer is equivalent to the receipt of the amount of discharge by such
taxpayer.

Rev. Rul. 58-113, 1948-1 C.B. 362, provides that the term “wages” includes the amount
paid by an employer on behalf of an employee (without deduction from the
remuneration of, or other reimbursement from, the employee) on account of any tax
imposed upon the employee. See also § 31.3401(a)-1(b)(6). Thus, an employer that
wishes to pay an employee a stated amount of take-home pay as a bonus and, to pay
on the employee’s behalf, the income tax required to be withheld under § 3402 must
include in the employee’s income and wages both the stated amount of take-home pay
and the income tax required to be withheld.

Sections 3101 and 3111 impose taxes under the Federal Insurance Contributions Act
(FICA) on “wages” as that term is defined in section 3121(a), with respect to
“employment” as that term is defined in section 3121(b). The term “wages” is defined in
section 3121(a) as all remuneration for employment, with certain specific exceptions.
Section 3121(b) defines the term “employment” as any service, of whatever nature,
performed by an employee for the person employing him, with certain specific
POSTN-124935-21 6

exceptions.

Rev. Rul. 86-14, 1986-5 C.B. 304, determines that FICA payments that are made on an
employee’s behalf are additional income to the employee and should be reported as
additional wages. The ruling also states that any FICA payments made on the
employee’s behalf should be reported as “Social Security Tax Withheld” on the Form W-
2.

Generally, an employer may correct overpayments of FICA tax after an error has been
ascertained using the adjustment process under section 6413 or using the refund claim
process under section 6402. An error is ascertained when the employer has sufficient
knowledge of the error to be able to correct it.

Under section 31.6413(a)-1(a) and section 31.6413(a)-2(b) of the Treasury regulations,
before making an adjustment of an overpayment of FICA tax with respect to an
employee, an employer generally must repay or reimburse the employee in the amount
of the over-collection prior to the expiration of the period of limitations on credit or
refund, and, for FICA tax overcollected in a prior year, must also secure the employee's
written statement confirming that the employee has not made any previous claims (or
the claims were rejected) and will not make any future claims for refund or credit of the
amount of the overcollected FICA tax.

Section 31.6402(a)-2 provides rules under which a refund claim for an overpayment of
FICA tax may be made. Pursuant to § 31.6402(a)-2(a), no refund or credit for FICA
employer tax will be allowed unless the employer has first repaid or reimbursed its
employee for the employee FICA tax or has secured the employee's consent to the
allowance of the claim for refund and includes a claim for the refund of such employee
tax. However, this requirement does not apply to the extent that the employee FICA
taxes were not withheld from the employee or, after the employer makes reasonable
efforts to repay or reimburse the employee or secure the employee's consent, the
employer cannot locate the employee or the employee will not provide consent.

ANALYSIS

In the tax equalization program described, the United States company reduces the
employee’s previously agreed upon salary by an approximate hypothetical tax. Under
the arrangement, the employee is not entitled to receive the approximate hypothetical
tax, and his salary is now equal to the previously agreed upon salary minus the
approximate hypothetical tax amount. As such, the approximate hypothetical tax that is
removed from the employee’s previous salary is no longer wages or income as
demonstrated in Rev. Rul. 78-374.1 The Form W-2 filed for and furnished to the
employee includes the new, lower agreed upon salary amount plus any income taxes

1 PLR 8204074 deals with a similar hypothetical tax issue as the one described in this memorandum.

That PLR also concludes that the removed “hypothetical tax” does not constitute income or wages.
POSTN-124935-21 7

that are paid by the employer on the employee’s behalf during the calendar year.

The United States company is required to withhold income taxes on all wages or
payments for services that the employer and employee agree to treat as wages under
§ 3402(p)(3) that are paid to the employee, including taxes paid on the employee’s
behalf. Under tax equalization programs, the employee agrees to the reduced salary in
exchange for the United States company paying all of the employee’s taxes owed on
remuneration the employee receives from that company in both the United States and in
the host country. Thus, the employer has a prearranged plan to pay an amount of
stated wages to the employee net of income tax withholding (and thus, pay the income
tax withholding of the employee out of its own funds rather than deducting the
withholding from the employee’s stated wages in the year of payment).

This prearranged plan results in additional current income and current wages to the
employee in addition to the stated wages. See Rev. Rul. 58-113. Any payments made
on behalf of the United States citizen employee by the United States company for taxes
owed in the United States and in the host country are included in the employee’s
income and wages, unless otherwise excepted. See § 31.3401(a)-1(b)(6). The amount
of taxes paid on behalf of the employee by the United States employer is deemed to
have been withheld by the United States company and should be included in income
and wages on the employee’s Form W-2, unless otherwise excepted. See Rev. Rul. 58-
113; see also Rev. Rul. 86-14(pertaining to FICA wages).

To the extent that the employer of a United States citizen employee working in a foreign
country pays an amount of income tax withholding in excess of the amount due under §
3402, the employer can correct any overcollection of income taxes through an interest-
free adjustment if the employer discovers the error and repays or reimburses the
employee within the same calendar year in which the wages were paid to the employee.
See §§ 31.6413(a)-1(b)(2) and 31.6413(a)-2(c)(2); see also Rev. Rul. 2009-39.
However, the employer can correct an overpayment of income tax withholding due to an
administrative error even if the employer did not discover the error until after the
employer filed the return and did not repay the employee within the calendar year. See
§ 31.6413(a)-1(c)(2). An administrative error involves the inaccurate reporting of the
amount withheld. An employer’s payment of a specific amount of income tax
withholding to the Service based on an estimate of an employee’s United States income
tax liability does not constitute an “administrative error” simply because the employer
realizes after the end of the calendar year that the amount paid over to the Service was
excessive.

The United States company can also correct an overwithholding error using the claim
for refund process. The employer must first repay or reimburse the employee for the
overcollected amount. However, the employer can only claim a refund of overpaid
income tax withholding after the close of the calendar year if the employer did not
actually withhold the amount from the employee’s wages under § 3402. See § 6414
and § 31.6414-1.
POSTN-124935-21 8

In this case, remuneration paid by the United States company, including income tax
withholding paid on an employee’s behalf, is subject to United States income tax
withholding under § 3402. The amounts of United States income taxes paid by the
employer are deemed to have been withheld under § 3402 from the employee’s wages,
and should be reported on the employee’s Form W-2 as withheld income taxes. See
Rev. Rul. 58-113. Taxes paid under § 3402 are subject to § 6413, so adjustments of
overpayments may be made for income tax withholding within the calendar year of
payment, but no adjustments may be made in a subsequent calendar year.

No amounts are actually withheld from the regular paycheck of the employee, because
the employee has agreed to accept a lower salary in exchange for the employer’s
agreement to pay all taxes on the employee’s behalf. Nevertheless, the United States
company is still required to pay over to the Service the amount of income tax
withholding owed on the wages paid to the employee. See § 31.3403-1. In the event of
an overpayment by the employer of income tax withholding, unless the employer follows
the procedures for making an interest-free adjustment or claiming a refund of the
overpayment within the same calendar year as the year the wages are paid, these
amounts are considered additional wages to the employee under § 31.3401(a)-1(b)(6).

The employer’s overpayment does not constitute an administrative error under these
circumstances. Although these wages were never paid to the employee, but rather
were paid over to the Service to satisfy the employer’s obligation to withhold income
taxes, they are deemed to be withheld from the employee. Since these payments are
wages under § 3401, § 6414 bars the refund of these payments after the close of the
calendar year because such payments are considered to have been withheld from the
employee’s wages.

For FICA tax, under Rev. Rul. 86-14, tax payments that are made on an employee’s
behalf are additional income to the employee and are FICA wages. Under
§ 31.6402(a)-2(a), before claiming a refund or credit for FICA tax, the employer must
make reasonable efforts to first repay or reimburse its employee for the employee FICA
tax and must make reasonable efforts to secure the employee's consent to the
allowance of the claim for refund.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call Mikhail Zhidkov at (202) 317-4774 if you have any further questions.