The Agreement between Japan and the United States of America on Social Security (“the Agreement”), which has a significant impact on employees of Japanese companies on assignment to the U.S., entered into force on October 1, 2005. Five years have already passed since then, and the time is approaching to apply for the first extension. The Agreement is an important agreement which makes it possible to reduce salary expenses not only for Japanese companies with employees sent to the U.S., but also for U.S. companies with employees on assignment from the U.S. to Japan. A basic summary of the Agreement and an explanation on how to extend it are provided below.
The Agreement entered into force on October 1, 2005, after lengthy discussions between Japan and the U.S. Like many other social security agreements, this Agreement has two main purposes: First, relief from double social security taxes in both U.S. and Japan for multinational corporations and overseas assignees, and second, the totalization of social security benefits. As the table below shows, the U.S. has exchanged comparable agreements with 24 countries including Japan, and Japan has similar agreements with 10 countries, namely, the U.S., Germany, the United Kingdom, South Korea, Belgium, France, Canada, Australia, the Netherlands, and the Czech Republic. In addition, Japan currently is in the process of negotiating similar agreements with Spain, Italy, and Ireland.
List of countries with which the U.S. has exchanged agreements on social security
||South Korea |
In the U.S., social security tax is imposed on employers and employees under the Federal Insurance Contribution Act (“FICA”). FICA effectively consists of two taxes: The tax for old-age (retirement), survivors and disability insurance, referred to as “OASDI” tax (commonly called “social security tax”), and the health insurance for old age, or “Medicare” tax. Generally, under Internal Revenue Code Section 3101, FICA imposes tax on employees and their employers for wages for the services performed in the U.S., and also for services performed outside the U.S. by U.S. citizens or residents employed by a U.S. employer.
OASDI tax is imposed at the rate of 6.2 percent on the employer and employee on wages up to a limit that is adjusted annually; for FY2010 the OASDI wage base is limited to $106,800 (thus, the maximum tax amount is $6,621.60 each for employer and employee). Medicare tax is imposed at the rate of 1.45 percent on the employer and employee, but there is no limit on the amount of wages subject to Medicare tax as there is with OASDI tax. This tax is imposed on both the employer and employee and must be withheld and remitted by the employer to the IRS by the applicable due date of each pay period.
Under United States tax law, irrespective of where wages are paid, wages paid for services performed in the U.S. are regarded as U.S. source income and are subject to FICA tax. Therefore, employers are required to withhold and remit FICA taxes for wages received by employees of Japanese companies on assignment in the U.S. for services performed in the U.S., as well as wages received in Japan (e.g., family separation allowances, bonuses, etc.).
In Japan, on the other hand, the premium for social insurance includes welfare pension insurance which provides for retirement, disability, and death, and health insurance that provides medical benefits in case of illness, injury, maternity, and death. The employer and employee both pay 8.029 percent (effective since September 2010, before 7.852 percent) each of the predetermined average monthly salary and bonus (up to 1.5 million yen) as the premium for welfare pension insurance. For health insurance, the employer and employee together pay a premium, the rate of which varies from 3 percent to 10 percent depending on the type of insurer (either public or private). Currently, the insurance premium rate for insurance by a government agency is on average 9.34 percent of the standard average monthly salary and actual bonus (up to 5.4 million yen cumulative per year).
In both the U.S. and Japan, wages paid for services performed in the host country are subject to social security tax (insurance tax) regardless of nationality. Therefore, when assignees start working in the U.S., OASDI tax and Medicare tax are imposed on all of their wages under U.S. tax law. In Japan, wages paid to employees of U.S. employers were originally not subject to social security tax in Japan. However, in order to prevent a gap from arising between assignees from the U.S. and other local employees in Japan in pension and other benefits in the future, most employees in fact paid into the welfare pension program. Consequently, complete double taxation was occurring before the Agreement entered into force.
After the Agreement entered into force, in order to prevent this double taxation, generally the “territorial rule” is applied, whereby individuals on assignment from their home country to the U.S. are subject only to the social security system of the host country where they are assigned to work. However, based on the “detached worker exception,” an individual may remain in Japan’s social security system if he or she pays into Japan’s social security system, has been employed in Japan for the six months prior to being sent to the U.S., is expected to work in the U.S. for five years or less, and is sent to the U.S. based on an employment relationship with a Japanese employer. Therefore, if Japanese assignees on assignment to the U.S. for five years or less remain in Japan’s social security system and employer and employees pay social security tax in Japan, then there is thus no longer a need to make contributions to the U.S. social security system.
Many companies guarantee salaries on a net basis to employees on assignment in the U.S. By doing this, the employer pays both the income taxes and social security taxes on salaries, and because these taxes paid by the employer are treated as additional income, more taxes must be paid, which leads to snowballing salary expenses. Depending on whether an employee is exempt from or subject to social security taxes in the U.S., an annual difference of approximately $20,000 to $30,000 per person arises in salary expenses for assignees who are commonly guaranteed a net salary. Therefore, the difference in salary expenses during a four-year assignment period reaches from $80,000 to $120,000 per person, and because this applies to all assignees working in the U.S., the impact of this Agreement has been significant on multinational companies that send employees to work in the U.S.
Generally, to qualify for US pension benefits, an individual must have earned at least 40 credits (approximately 10 years) of coverage under the U.S. Social Security system and 25 years of coverage under Japan’s Social Security program. (Different requirements apply to disability, dependents’ and survivors’ benefits). In the U.S., the period of work is counted using credits, and one credit is granted for every $1,120 in wage income for 2010. A maximum of four credits can be earned in one year; therefore, employees who earn $4,480 ($1,120 × 4) or more in annual employment income receive only four credits per year regardless of when the income is earned.
Prior to the Agreement, except for cases in which an individual is assigned twice to the U.S. or for a very long period of time, assignees almost always worked in the U.S. for less than 10 years; therefore, they were unable to qualify for benefits or receive refund payments even though they paid social security tax in the U.S. However, under the Agreement, such individuals are entitled to combine or “totalize” the periods during which they have paid social security contributions in both countries. By combining the periods for which they have paid social security tax in the U.S. and welfare pension premiums in Japan, it became possible to satisfy the eligibility requirement of earning 40 quarters (approximately 10 years) of coverage in order to receive future pensions in the U.S. However, in order to receive future pensions in the U.S., the assignees must have earned at least six credits in the U.S. Social Security system. In addition, if a pension becomes payable as a result of totalization, the amount of future pension benefits will be calculated based only on the amount of social security tax paid in the U.S. without taking into account the welfare pension insurance premiums paid in Japan. Therefore, pension money corresponding to paid-in social security tax will apply. (Discussion of pension amounts payable in the future is beyond the scope of this article. Interested persons should contact the author separately.)
Also, it should be noted that the Agreement does not cover Medicare (health insurance) benefits. Hence, credits earned in Japan cannot be taken into account to establish entitlement to free Medicare health insurance in the U.S.
Each Japanese assignee claiming exemption from U.S. social security taxes under the “detached worker exception” must document his or her eligibility for the exemption by obtaining a “Certificate of Coverage” that certifies that the employee is paying into the social security system in Japan from the applicable social security office in Japan and submitting the original copy to his or her U.S. employer. Certificates of coverage issued by Japanese authorities should be retained by the employers in the U.S., but need not be submitted to the Internal Revenue Service or other U.S. government agencies unless specifically requested.
As described above, if the period of assignment is expected to be five years or less, then the “detached worker exception rule” is applied and a Certificate of Coverage is issued by the Social Insurance Agency of Japan. Because the Agreement entered into force on October 1, 2005, Certificates of Coverage for Japanese individuals who were already on assignment in the U.S. at the time will expire after five years on September 30, 2010, at which time they normally would be required to switch to the U.S. social security system under the “territorial rule.” However, if the period of assignment exceeds five years due to unforeseen circumstances such as a delay in an assignee’s work project or for the schooling of an assignee’s child(ren), an extension can be granted for a fixed period.
Initially, when the Agreement entered into force, extensions could be grated for a period of one year except in special circumstances, but in recent discussions between the U.S. and Japan, this was lengthened to three years. As a result, Japanese assignees who will have worked in the U.S. for five years as of this September and expect to continue working in the U.S. may be able to obtain extensions on Certificates of Coverage and remain solely in the Japanese social security system if the duration of the assignment is expected to last no more than three years (i.e., a total assignment period of 8 years). In serious special circumstances, such as the resignation, illness, or death of an assignee’s successor, or an organizational change or restructuring of the company, extensions up to four years are possible. However, in the case of four-year extensions, approval of both the U.S. and Japan is required, so the extension process is expected to take six months to one year. According to the person in charge at the Japan Pension Service, as of now (July 20, 2010), no applications for four-year extensions have yet been approved, so for now it seems that only applications for three-year extensions are being accepted.
In order to apply for an extension, the reason for extension and duration must be written on the “Application Form for the Continuance/Extension of Certificate of Coverage for Welfare Pension Insurance and Health Insurance under the Agreement between Japan and the United States of America on Social Security,” and this must be submitted to the applicable social security office in Japan. Applications for extensions currently are accepted at any time, and an extended Certificate of Coverage is issued and mailed within approximately two weeks after an application arrives at the Japan Pension Service headquarters. Since it is expected to take one to two weeks for mailing before and after filing an application, we recommend that applications be sent by the end of August.
For extensions up to three years, in the case of unforeseen circumstances, there does not have to be special circumstances, so almost all applications for extension are expected to be approved. If the extension application process is delayed for some reason and the current Certificate of Coverage expires and results in a blank period while waiting for approval, the employee would normally be required to switch from the Japanese social security system to the U.S. social security system based on the “territorial rule.” If this switchover is neglected, additional taxes may apply for violations of tax withholding obligations or late payments. However, when an application for extension is approved after switching once, (because extension applications are expected to be accepted in almost all cases) it is necessary for the employer to file an amended Employer’s Quarterly Federal Tax Return in order to claim back any social security and medicare taxes paid in the U.S. Filing an amended return may be cumbersome, and require considerable time and efforts. Employers who have not yet filed extension applications are strongly recommended to do so as soon as possible so that the effective period of Certificates of Coverage continues without interruption.
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This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.