Doing Business in the USA: A Brief Summary for Foreign Investors. Part II: Brief Summary of U.S. Tax System

February 7, 2007
Karen A. Monroe

Taxation in the United States involves payments by businesses and individuals at several different levels, including federal, state, and local government taxes. At the federal level, federal income tax is levied on income of U.S. citizens and resident aliens and on certain types of U.S. income of nonresidents. The federal income tax rules also apply to trusts, partnerships, corporations, and other types of entities. All individuals and businesses except partnerships must file an annual income tax return. Partnerships must file an informational return. The U.S. federal income tax is a “pay-as-you-go” tax, which means that generally you must pay the tax as you earn or receive income during the year. Depending on the legal structure of the business, the business itself may be subject to tax in addition to tax paid by the business’ owners on their share of the business’ profits. For example, the income tax assessed on regular C corporations results in double-taxation of the dividends paid to shareholders because the corporation pays taxes on the profits earned, and the shareholders pay taxes on the dividends received.

Federal payroll taxes owed by individual employees in the U.S. are primarily collected by employers and remitted to the Internal Revenue Service (IRS). Employers typically collect these taxes through a system of direct withholding. Employers pay a portion of a taxpayer’s income tax directly from an employee’s earnings. The amount of taxes so withheld is based on the employee’s salary and other factors such as his or her marital status and number of dependents.

In addition to the payroll tax, another significant tax paid by employees is the Social Security tax. Half of this tax is paid by the employee and the other half is paid by the employer. Self-employed people are responsible for both halves of the Social Security tax. Social Security taxes are taken from wages but not from other sources of income such as interest or dividends, and there are certain caps on the amount of Social Security taxes assessed. In addition, individuals are subject to Medicare taxes which are used to fund the Medicare program, a health insurance program for the elderly and disabled. Like the Social Security tax, half of the Medicare tax is paid by the employee and the other half is paid by the employer. Unlike Social Security, there is no cap on the Medicare tax. Dividend and interest income is not subject to Medicare tax.

BRIEF SUMMARY OF U.S./SWISS TAX TREATY

Double Taxation Treaty
The formal name of the U.S./Swiss tax treaty is the “Convention between the Swiss Confederation and the United States of America in view of avoiding double taxation in the matter of income taxes of October 2, 1996” (the Convention). For purposes of the Convention, a resident of a contracting state means a person who is subject to taxes according to the laws of that state. Criteria used to determine residency include substantial presence, permanent home or extended stay in a contracting state.

A person who does not have a permanent residency visa or “green card” but has a substantial presence in the United States may be deemed a resident of the United States for tax purposes, although that person is NOT a resident of the United States for immigration purposes.

Dividends received by a resident of the United States or Switzerland are taxable in the country of residence. Dividends are also subject to taxes in the country where they are distributed; however, the rate may not exceed 5 percent of the amount of the dividend if the beneficiary is a company which owns at least 10 percent of the votes of the company that distributes the dividend, or in all other cases, 15 percent of the dividend.

In general, interest paid to a Swiss or a United States resident is taxed only in the country of residence. Gains from the sale of real estate property by a resident of the United States or Switzerland are taxable in the country where the property is located. Profits of American or Swiss enterprises are taxable in the State where they are generated. As a general rule, if a United States-based enterprise has a branch in Switzerland, the profits made in the United States will be taxed in the United States, and the profits made by the branch in Switzerland will be taxed in Switzerland.

Salaries are typically taxed in the country of residence. However, there is a different rule if the work is not performed in the country of residence. For example, in general, if a Swiss resident performs his/her work in the United States, his/her salary will be taxed in Switzerland if: the worker stays in the United States for not more than 183 days per taxable year; the employer is not a resident of the United States; and the employer who pays the salary has no stable establishment in the United States (for instance a branch office). Conversely, if the salary is paid by a United States enterprise or the United States branch of a Swiss company, or the worker stays in the United States for more than 183 days, in general, the salary will be taxed in the United States.

Social Security Treaty
The Social Security agreement between the United States and Switzerland (the “Agreement”) eliminates the need for a person to pay Social Security taxes to both the United States and Switzerland on the same earnings. The Social Security coverage depends on employment circumstances. As a general rule, Social Security taxes are due in the country where the work is performed. For an employee hired in the United States, Social Security taxes will be paid in the United States, while for an employee hired in Switzerland, Social Security taxes will be paid in Switzerland.

However, there is an exception to the rule if an employer in one country sends an employee to work in the other country for 5 years or less. In that case Social Security taxes will continue to be paid in the country from which the employee was sent, and no Social Security taxes will be due in the other country. If the employer sends the employee to work in the other country for more than five years, Social Security taxes will generally be due in the other country.

For example, if a Swiss employer sends an employee to work to the United States for 3 years, Social Security taxes will continue to be paid in Switzerland, while if that employee is sent to work in the United States for 6 years, Social Security taxes will be paid in the United States; if that employee is sent to work in the United States for an undetermined period of time, the general rule applies and Social Security taxes will be due in the United States.

The Agreement allows consideration of credits earned in the other country to qualify for retirement benefits. The respective laws of the United States and Switzerland provide for allocating Social Security credits in their respective territory. Each country pays its own benefits. A resident of the United States who paid social security taxes in Switzerland may apply for Swiss benefits at the social security office in the United States where he/she resides, and a Swiss resident who paid social security in the United States may apply for benefits from the United States at the Swiss Compensation Office where he/she resides. A beneficiary may not collect concurrently under both systems.