The tax benefit for United States citizens living and working in Bermuda continues to diminish and this is before legislation proposed by the incoming administration has even been introduced. 

 

 

The tax benefit of living and working in Bermuda started to decline in 2006 when legislation was passed that changed how the tax benefit of the foreign earned income exclusion and the foreign housing exclusion was calculated. Prior to 2006 the foreign earned income excluded was from the highest tax bracket that an individual was in and for many expatriates this was the 35% bracket producing a tax benefit of $28,000. The 2006 tax legislation changed the law so that foreign earned income excluded was now from the lowest tax bracket producing a benefit of about $12,800 or a diminishment of $15,200.

 

Likewise the tax benefit of foreign housing exclusion was also changed from the highest tax bracket to the lowest tax bracket and further diminished the foreign housing amount that could be excluded by capping the amount spent for housing at $72,000.

 

 

To mitigate this increase in income tax many expatriates elected to have some or all of their bonuses or salary deferred until a time when they expected to be in a lower tax bracket. The time frame ran from when they expected to return to the United States or till retirement. As an example, an expatriate might make an election to defer a bonus of $100,000 until they reached the age of 65. Employers typically put these funds into their non-qualified pension plans where they grew on a tax deferred basis.

 

 

This legislation was enacted to provide hundreds of billions of dollars in loans to troubled investment banks, insurance companies and other institutions affected by the sub prime mortgage crisis. Included in this legislation was a new section of the tax law applicable only to tax haven jurisdictions (including Bermuda) that requires that deferred compensation that will be put into a non-qualified plan be included in an employee’s taxable income in the year it is earned, as of 2009. If an employer has a matching contribution program with respect to a non-qualified plan the employer contribution will also need to be included in taxable income in the year in which it is earned. Thus, the practice in Bermuda of deferring compensation to a non-qualified plan has come to an end.

 

 

 

 

 

The tax legislation is devastating in that it is also applicable to compensation deferred in prior years. Under rules yet to be developed, compensation that was deferred to non-qualified plans in prior years must be distributed and taxed by the later of; the end of 2017 or the taxable year in which there is no substantial risk of forfeiture of the rights of such compensation.

 

 

While it is not entirely clear, there may be some “wiggle room” for a select number of employees. Most Bermuda based parent companies do not want to be classified as “doing business in the United States” so they are not subject to US tax on some or all of their global income. They resolve this potential problem by setting up a US subsidiary to do business in the United States. As it is likely that a US expatriate living and working in Bermuda will also from time to time travel to the United States on business, this individual will usually have two employment contracts, one from the Bermuda employer and one from the United States employer. For example, if the individual has a compensation of $200,000 and works 75% of his time in Bermuda and 25% of his time in the United States, the Bermuda employment contact will pay compensation of $150,000 and the United States employment contract will pay compensation of $50,000. Under this legislation the United States employer should be allowed to set up a non-qualified deferred compensation plan and the employee would be allowed to defer $50,000 of his compensation.

 

As has been noted on a regular basis in The Royal Gazette, a number of Bermuda based companies have changed their domicile to Switzerland. The specific section of the tax law dealing with deferred compensation refers to “a non-qualified deferred compensation plan of a nonqualified entity.” A non-qualified entity is defined in part as a foreign corporation subject to a comprehensive foreign income tax. The term comprehensive foreign income tax means the income tax of a foreign country if such entity is eligible for the benefits of a comprehensive income tax treaty between such country and the United States. Switzerland has such an income tax treaty with the United States.

 

A second possibility, again unclear at this time, is to have the expatriate employment contract be with the new Swiss parent company while being secunded to work for the Bermuda subsidiary. If the Swiss parent company sets up a non-qualified deferred compensation plan, would this allow the employee to continue to defer compensation?

 

 

With the United State Congress increasingly willing to change corporate and individual income tax law on a retroactive basis, it is now more difficult for US citizens working and residing outside the United States to effectively minimize income tax. This is the second time in just 4 years in which there have been major changes in deferred compensation affecting expatriate employees.