Congress Closes Loophole Allowing Private Security Contractors to Avoid Paying Employment Taxes

Last week, the President signed the Heroes Earnings Assistance and Relief Tax Act which, among other things, closes a loophole that has saved contractors in Iraq millions of dollars while simultaneously undercutting the Social Security and Medicare trust funds and the individual contractors. The Act requires that foreign subsidiaries of US companies doing business with the federal government pay employment taxes as if they were US employers if the parent company owns 50% or more of the foreign subsidiary.

In March of this year, The Boston Globe reported that KBR (formerly Kellogg Brown & Root, once a subsidiary of Halliburton Corp.) had managed to avoid paying employment taxes by hiring its contractors through shell companies based in the Cayman Islands. While this move has saved the Defense Department more than a pretty penny, it puts the Social Security and Medicare trust funds at a disadvantage due to the lost investable income. The Social Security and Medicare taxes in question total 15.3% of an employee’s pay, and are split between the employee and employer. The greater disadvantage, however, belongs to the employees of these overseas shell companies. Because KBR does not pay employment taxes on the contractors’ earnings, the wages are not reported to the Social Security Administration (SSA). As a result, the contractors cannot receive any future retirement benefits for their time as employees of these shell companies. This problem is magnified by the fact that the contractors are very well paid, which would have led them to put a larger portion of their paycheck into retirement savings. The Act provides these employees some relief, though nothing about the law is retroactive. The SSA will only credit the contractors for earnings that are properly taxed and reported to the appropriate federal agencies.

KBR isn’t the only contractor who took advantage of this loophole, but undoubtedly benefited the most. The company employed more than 20,000 contractors in Iraq through its offshore subsidiaries (Incidentally, the contractors also managed to avoid paying federal and state unemployment using this tactic). Subsequent Globe investigations revealed that DynCorp International and MPRI both hired their Iraq contractors through foreign subsidiaries. The practice, surprisingly, was not widely used by anyone other than Iraq contractors, but Congress still felt compelled to act.

As I said at the beginning, the foreign entities going business with the federal government will now have to comply with US employment tax laws if they are 50% or more owned by a US company.