Tax Issues in International Endorsement Deals for U.S. Entertainers and Athletes Working Abroad

U.S. citizens and residents are taxed in the U.S. on their worldwide income. It doesn't matter where the income is generated. A U.S. actor who shoots a commercial in Japan must report the income in the U.S., the same as if he had shot a commercial in New York. The fact that the income is taxable in the U.S. does not mean that the income is tax-free outside the U.S. To the contrary, in many cases the income is also subject to tax in a foreign country, frequently at tax rates that are even higher than our own.

To mitigate against the burden of paying taxes on the same income to two different countries, U.S. tax law provides for a foreign tax credit. The rough theory of the foreign tax credit is that the U.S. government will reimburse U.S. taxpayers for taxes they pay to foreign countries. Unfortunately, it's not a perfect credit. If it were, and if a U.S. person received a dollar-for-dollar reduction or refund of U.S. taxes for every dollar of foreign taxes paid, we wouldn't have to pay attention to this issue.

But the foreign tax credit is a very limited source of relief against the burden of foreign taxes. There are many situations in which the payment of foreign taxes is not fully creditable in the U.S. The simplest example is when the foreign tax rate is higher than the U.S. tax rate. In the United Kingdom, for example, the top tax rate is 50%, while the top U.S. tax rate is only 35%. A U.S. endorser who earns $100,000 in the UK and is subject to tax there is likely to pay at least $15,000 more in taxes than if she had worked in the U.S. (ignoring graduated rates to simplify the example). The U.S. government does not want to subsidize high tax foreign tax rates and thus does not offer a full tax credit.

The converse is not true, however, and this is where the complications begin. Just because the tax rate in a foreign country is less than the tax rate in the U.S. does not mean that U.S. taxpayers will receive the full benefit of the foreign tax credit. There are a variety of limitations on the ability of a U.S. person to benefit from the foreign tax credit, many of which are not intuitive and defy easy explanation.

As a result, the name of the game in connection with planning for U.S. celebrities and athletes who do endorsement deals outside the country is trying to minimize foreign taxes. To minimize foreign taxes, we must understand exactly how the endorsement income will be taxed in the first place.

Compensation for Services vs. Royalties

Endorsement arrangements typically compensate the individual for a mixture of services and rights. A U.S. actress may travel to Paris to film a perfume commercial and sit for a photo shoot. The perfume company will market its products around the world using the commercials and the still photos. As a result, the consideration paid to the actress derives from two different components: the provision of services and the grant of rights to use her name and likeness. The extent to which consideration paid to the actress is characterized as compensation for services as contrasted to royalties for the use of her name and likeness may have a substantial impact on the tax consequences to the U.S. individual.

Note that if everything had occurred in the U.S., the distinction between royalties and compensation for services would in general have a much less significant impact. (I'm simplifying somewhat.) Both are taxed at the same ordinary income rates ' 35% at the top margin. While there are some differences (for example, compensation income is subject to payroll or self-employment taxes, while royalties are not), in a gross sense the income is taxed pretty much the same.

In other countries, though, the distinction in characterization may result in a material difference in after-tax income. Different levels of foreign country withholding and other taxes may be imposed on income depending upon whether that income is compensation for services or royalties. In addition to how the country itself may treat the income, the U.S. has double tax treaties with many countries that dictate the treatment of the two different types of income, in a manner that in many cases is more favorable to the individual than if there was no treaty.

Personal Service Income

Income from rendering personal services in a foreign country is generally taxable in that country unless there is a specific exception. Most of the treaties between the U.S. and its trading partners provide an exception if a U.S. individual is present in a foreign country for only a short period of time (usually no more than 183 days in a calendar year or, in some cases, any rolling 12-month period), and as long as the individual is not working for a company that is resident in that foreign country. This is a rough generalization and, of course, any applicable treaty must be examined carefully.

Although actors are frequently engaged to endorse products, typically endorsing is not considered acting for purposes of tax treaties. This is important because many treaties have so-called “artistes and athletes” clauses that allow the host country to tax actors and athletes on their acting or sports income, regardless of any exemption that might be found elsewhere in the treaty. The fact that endorsing is not treated as acting for treaty purposes can be highly beneficial.

Depending on the facts, endorsement services may be exempt from tax in the foreign country. For example, if an actor shoots a watch commercial in Paris for a company based in Germany, the actor may be exempt from French and German tax on his endorsement income. On the other hand, if instead the German company shoots the commercial in Germany, there is no treaty exemption and the individual is subject to tax in Germany. Figuring this out in advance can allow for significant tax savings.

Royalty Income

As mentioned above, endorsement deals also typically involve the licensing of the endorser's name and likeness, and other intangible rights. Consideration for those rights is not usually compensation for services but instead is treated as a royalty. There are some important exceptions to this, though, and each fact situation must be analyzed carefully.

Royalties are frequently taxed differently from personal services in foreign countries and under tax treaties. The U.S. treaty with Spain, for example, imposes three different levels of withholding tax on royalties ' 5%, 8% or 10% ' depending on the nature of the underlying rights.

Understanding in advance how the income will be taxed allows for planning and structuring to reduce the overall tax to the maximum extent possible. There is no precise formula to determine in all cases how much of the consideration should be allocable to services versus royalties. This lack of certainty allows for a certain degree of flexibility in arriving at a fair yet tax-efficient allocation.

Address Tax Issues in Agreement

It is a great idea to reflect the tax planning in the endorsement agreement itself. There should be a specific provision allocating the gross consideration to be paid between compensation for services and royalties for the use of the individual's name and likeness. To the extent appropriate, the agreement should describe the location of the provision of services and the exploitation of rights.

Finally, keep in mind that for U.S. persons to take advantage of treaties with foreign countries, the foreign company will ask for documentary proof that the endorser is a U.S. taxpayer. None of the typical means of proving residence (e.g., passport, driver's license, certified articles of incorporation, etc.) suffice as proof. The only acceptable proof is an IRS letter of U.S. residency certification on Form 6166, which is obtained by submitting Form 8802 to the Internal Revenue Service. Foreign companies will typically not make full payment until they receive a Form 6166, even if they are absolutely convinced that the endorser is a U.S. person. If you have advance warning that a foreign endorsement deal is in the works, it is good practice to submit the Form 8802 right away, because it can take six weeks for the Form 6166 to be issued.

The news abounds with entertainers and athletes making fortunes from international endorsement deals. Whether it's a U.S. actress shooting a perfume commercial in Paris or a Swiss tennis player wearing a sponsor's clothing during the U.S. Open, there has been an explosion of lucrative arrangements.

As with many transactional entertainment and sports matters, there are a number of critical tax issues that bear upon the endorser's ultimate take-home pay. This topic divides neatly into U.S. persons working outside the U.S., and non-U.S. persons working inside the U.S. This article discusses U.S. persons working abroad.

Foreign Tax Credit

U.S. citizens and residents are taxed in the U.S. on their worldwide income. It doesn't matter where the income is generated. A U.S. actor who shoots a commercial in Japan must report the income in the U.S., the same as if he had shot a commercial in New York. The fact that the income is taxable in the U.S. does not mean that the income is tax-free outside the U.S. To the contrary, in many cases the income is also subject to tax in a foreign country, frequently at tax rates that are even higher than our own.

To mitigate against the burden of paying taxes on the same income to two different countries, U.S. tax law provides for a foreign tax credit. The rough theory of the foreign tax credit is that the U.S. government will reimburse U.S. taxpayers for taxes they pay to foreign countries. Unfortunately, it's not a perfect credit. If it were, and if a U.S. person received a dollar-for-dollar reduction or refund of U.S. taxes for every dollar of foreign taxes paid, we wouldn't have to pay attention to this issue.

But the foreign tax credit is a very limited source of relief against the burden of foreign taxes. There are many situations in which the payment of foreign taxes is not fully creditable in the U.S. The simplest example is when the foreign tax rate is higher than the U.S. tax rate. In the United Kingdom, for example, the top tax rate is 50%, while the top U.S. tax rate is only 35%. A U.S. endorser who earns $100,000 in the UK and is subject to tax there is likely to pay at least $15,000 more in taxes than if she had worked in the U.S. (ignoring graduated rates to simplify the example). The U.S. government does not want to subsidize high tax foreign tax rates and thus does not offer a full tax credit.

The converse is not true, however, and this is where the complications begin. Just because the tax rate in a foreign country is less than the tax rate in the U.S. does not mean that U.S. taxpayers will receive the full benefit of the foreign tax credit. There are a variety of limitations on the ability of a U.S. person to benefit from the foreign tax credit, many of which are not intuitive and defy easy explanation.

As a result, the name of the game in connection with planning for U.S. celebrities and athletes who do endorsement deals outside the country is trying to minimize foreign taxes. To minimize foreign taxes, we must understand exactly how the endorsement income will be taxed in the first place.

Compensation for Services vs. Royalties

Endorsement arrangements typically compensate the individual for a mixture of services and rights. A U.S. actress may travel to Paris to film a perfume commercial and sit for a photo shoot. The perfume company will market its products around the world using the commercials and the still photos. As a result, the consideration paid to the actress derives from two different components: the provision of services and the grant of rights to use her name and likeness. The extent to which consideration paid to the actress is characterized as compensation for services as contrasted to royalties for the use of her name and likeness may have a substantial impact on the tax consequences to the U.S. individual.

Note that if everything had occurred in the U.S., the distinction between royalties and compensation for services would in general have a much less significant impact. (I'm simplifying somewhat.) Both are taxed at the same ordinary income rates ' 35% at the top margin. While there are some differences (for example, compensation income is subject to payroll or self-employment taxes, while royalties are not), in a gross sense the income is taxed pretty much the same.

In other countries, though, the distinction in characterization may result in a material difference in after-tax income. Different levels of foreign country withholding and other taxes may be imposed on income depending upon whether that income is compensation for services or royalties. In addition to how the country itself may treat the income, the U.S. has double tax treaties with many countries that dictate the treatment of the two different types of income, in a manner that in many cases is more favorable to the individual than if there was no treaty.

Personal Service Income

Income from rendering personal services in a foreign country is generally taxable in that country unless there is a specific exception. Most of the treaties between the U.S. and its trading partners provide an exception if a U.S. individual is present in a foreign country for only a short period of time (usually no more than 183 days in a calendar year or, in some cases, any rolling 12-month period), and as long as the individual is not working for a company that is resident in that foreign country. This is a rough generalization and, of course, any applicable treaty must be examined carefully.

Although actors are frequently engaged to endorse products, typically endorsing is not considered acting for purposes of tax treaties. This is important because many treaties have so-called “artistes and athletes” clauses that allow the host country to tax actors and athletes on their acting or sports income, regardless of any exemption that might be found elsewhere in the treaty. The fact that endorsing is not treated as acting for treaty purposes can be highly beneficial.

Depending on the facts, endorsement services may be exempt from tax in the foreign country. For example, if an actor shoots a watch commercial in Paris for a company based in Germany, the actor may be exempt from French and German tax on his endorsement income. On the other hand, if instead the German company shoots the commercial in Germany, there is no treaty exemption and the individual is subject to tax in Germany. Figuring this out in advance can allow for significant tax savings.

Royalty Income

As mentioned above, endorsement deals also typically involve the licensing of the endorser's name and likeness, and other intangible rights. Consideration for those rights is not usually compensation for services but instead is treated as a royalty. There are some important exceptions to this, though, and each fact situation must be analyzed carefully.

Royalties are frequently taxed differently from personal services in foreign countries and under tax treaties. The U.S. treaty with Spain, for example, imposes three different levels of withholding tax on royalties ' 5%, 8% or 10% ' depending on the nature of the underlying rights.

Understanding in advance how the income will be taxed allows for planning and structuring to reduce the overall tax to the maximum extent possible. There is no precise formula to determine in all cases how much of the consideration should be allocable to services versus royalties. This lack of certainty allows for a certain degree of flexibility in arriving at a fair yet tax-efficient allocation.

Address Tax Issues in Agreement

It is a great idea to reflect the tax planning in the endorsement agreement itself. There should be a specific provision allocating the gross consideration to be paid between compensation for services and royalties for the use of the individual's name and likeness. To the extent appropriate, the agreement should describe the location of the provision of services and the exploitation of rights.

Finally, keep in mind that for U.S. persons to take advantage of treaties with foreign countries, the foreign company will ask for documentary proof that the endorser is a U.S. taxpayer. None of the typical means of proving residence (e.g., passport, driver's license, certified articles of incorporation, etc.) suffice as proof. The only acceptable proof is an IRS letter of U.S. residency certification on Form 6166, which is obtained by submitting Form 8802 to the Internal Revenue Service. Foreign companies will typically not make full payment until they receive a Form 6166, even if they are absolutely convinced that the endorser is a U.S. person. If you have advance warning that a foreign endorsement deal is in the works, it is good practice to submit the Form 8802 right away, because it can take six weeks for the Form 6166 to be issued.