Tax Equalization on Expatriate Assignments
Understand the International Assignment Policy & Expat Tax
Sep 18, 2009
An employee is presented with an opportunity to take an international assignment with his / her employer. While it is an exciting milestone in the employee's career, there are many steps in the preparation process such as negotiating and understanding the new compensation package, the moving process, finding a new home, renting or selling the current home and locating international schools for the children. If the employer offers tax equalization, it is particularly important to understand what it means and the associated tax impacts.
Understanding an Employer's International Assignment Policy
Many people hire tax accountants or use tax return preparation software programs to prepare their returns without really knowing how the source information affects their taxes. If a tax consultation with a tax accountant is offered, take advantage of it. Do not dismiss the importance of the meeting even though the employee has been preparing his / her own tax returns. One may consider asking a spouse or own accountant to attend the consultation as well. A typical individual will likely be surprised by how different the process is from what (s)he has been doing in the past. However, the policy is put in place to ensure equity and fairness.
Tax Reimbursement Provision in an International Assignment Policy
When an individual takes on an international assignment, (s)he will likely be subject to income taxes in the new country due to the physical work location. The effective tax rate in the new country may be higher or lower than the individual's home country rate. Depending on personal circumstances, the individual may continue to incur home country taxes.
Many expatriate packages offer benefits such as housing, tuition allowances and cost of living adjustments that are taxable in many countries. For most expatriate employees, unfortunately, these benefits are not free money but are necessary expenditures.
A tax reimbursement provision is usually introduced in an international assignment policy to ensure that an employee on international assignment will not incur more taxes had (s)he not taken the assignment. The common tax reimbursement policies are:
- Tax Protection
- Tax Equalization
Each policy has its own merits for different circumstances. This article discusses the more common policy - tax equalization.
Tax Equalization on International Assignments
The objective of tax equalization is to ensure that employee is paying approximately the same amount of income taxes had (s)he not taken the assignment. There may be variations from one company to another on the scope and mechanics of tax equalization. At the end of the day, regardless of the cash flow arrangement between the employee and the employer, the results are generally as follows:
- The employee is responsible, to the employer, for a hypothetical tax (see below).
- The employer is responsible for any amounts owing on the employee's personal tax returns to the tax authorities (in the new and home countries).
- The employee and the employer are jointly responsible for providing correct information timely to the tax accountant to prepare your taxes.
Hypothetical Tax & Tax Equalization Settlement
The processes described below reflect the common practice.
Before the international assignment begins, the tax accountant will assist the employee to determine what the employee's income tax responsibility will likely to be if (s)he were to stay home. This is the estimated hypothetical (or hypo as commonly called) income tax liability based on expected income and deductions. It is called hypothetical because it is based on a hypothetical situation and it is not the actual amount owing to any tax authorities. This estimated hypo tax will be spread over the year and deducted from the employee's paychecks.
If there are any changes to the assumptions used in the calculation (e.g. a significant unexpected amount of capital gains or loss, a new baby or a change of marital status), the tax accountant should be advised to determine if any change to the withholding amount is necessary.
After the end of the year when all the income and deduction amounts are known, the tax accountant will prepare the employee's tax returns based on the final income and deduction information provided by both the employee and the employer. The employer will be responsible for the tax liabilities owed to the tax authorities.
The tax accountant will also calculate the employee's final hypo tax liability based on the employee's final income and deduction amounts for the year pursuant to the employer's tax equalization policy. If the final hypo tax liability is lower than the estimated tax amounts withheld from pay plus any other taxes the employee paid towards his / her final hypo tax liability, the company owes the employee the difference and vice versa. This is usually called the tax equalization settlement process.
A Few Things to Remember Before Taking an Expatriate Assignment
- Tax equalization is not the law. It is merely an HR policy adopted by a company reflecting its corporate HR philosophy.
- Understand the mechanics of tax equalization and the final settlement process.
- Understand the information used in the calculations and it is an individual's responsibility to advise his / her tax accountant / employer of any life events that may affect the tax bottom line.
- Take the opportunity to understand one's own taxes. It is an individual's civic responsibility. This responsibility is well exemplified by a recent decision of the U.S. Court of Appeals for the Fifth Circuit published by Deloitte Tax LLP Tax Controversy Services group's September 2009 edition of I.R.S. Insights.
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