After a successful summer school on mobility tax with Global Tax Network now is the perfect time to revisit the fundamental principles of tax equalization and hypothetical tax.
Tax equalization is a compensation approach utilized by multinational companies designed to ensure that an employee is no better nor worse off from a tax perspective as a result of accepting an international assignment.
Tax equalization is a cornerstone of the Home-based ‘balance sheet’ approach, designed to achieve multiple goals:
With tax equalization, the company covers actual taxes on employment income (including taxable allowances such as housing, COLA, education, etc.), and the employee contributes to tax at a stay-at-home rate (on employment income only).
When an individual accepts an international assignment, income tax (and possibly social security) will most likely be due in the Host location during the assignment period. Under tax equalization the employer commits to funding all Host tax due on employment income on behalf of the employee. The employee is responsible for working with a designated tax provider to facilitate timely and accurate tax compliance (filing tax returns)
When a company pays tax on behalf of an employee, it is typically considered a taxable benefit, and therefore the company must pay tax-on-tax, more commonly known as a gross-up. For example, if an employee nets $100,000 and the tax rate is 50%, in order to cover the ‘tax-on-tax’, the employer would need to pay $100,000 in tax ($200,000 x 50% = $100,000 net). The costly nature of gross-ups make tax equalization one of the most expensive options for compensating expatriates.
Prior to an assignment, an employee would earn a Home country salary and typically have actual income taxes and social security withheld from their pay each pay period.
During an assignment, the employee still earns a Home country salary but, instead of actual taxes, a ‘Hypothetical Tax’ is withheld. Hypothetical tax is the estimated amount of tax the employee would have paid had they not gone on assignment. The company withholds the hypothetical tax from employee and uses to fund tax obligations in the Home and Host locations.
The reason Hypothetical tax is implemented is because it is not necessary to pay actual tax on the same income in two different jurisdictions. As a result of the assignment, Home tax residency may be broken, or if not, the Home country will almost certainly provide for double tax relief, usually via foreign tax credits. If the employee had stayed on actual withholdings, there would be a large refund due on the Home tax return, which may prove difficult to collect. Tax authorities tend to scrutinize a return that requests a $30,000 (interest-free) refund, for example.
Under many tax equalization policies, the designated tax provider will prepare an annual tax equalization settlement intended to ‘true-up’ the amount of hypothetical tax withheld versus the final calculated hypothetical tax to ensure the employee’s tax neutral position. Similar to how many countries’ tax returns determine the final balance due or refund payable, a final calculated hypothetical tax reconciles the hypothetical tax withheld compared to a calculated final hypothetical tax. This calculation typically results in either a balance due from the company to the employee, or vice versa. Interested in learning more about the balance sheet approach to expatriate compensation, download our introduction to the balance sheet.
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