Many employers offer tax equalization to their employees as a benefit or condition of expatriate assignments. While the objective is simple- to ensure that the employee will not suffer any additional tax burden or benefit any tax windfall from the assignment, the process is slightly different from managing one's regular taxes had the employee not been on assignment.
The following process reflects the common tax equalization process. Variations to the process below exist depending on individual companies' policies, payroll system capabilities, and practices unique to or commonly adopted for specific industries or professions.
Determination of Estimated Hypothetical Tax Withholding
Similar to regular income tax withholding determined by I.R.S. and state tax withholding tables based on taxable salaries, exemptions & estimated deductions, the calculation of estimated hypothetical tax withholding is also based on the same elements, usually excluding any taxable assignment-related benefits, to initiate the tax equalization process.
Taxable personal income such as interest income, dividend income and net rental income are usually also included in the estimated hypothetical tax withholding calculation. Inclusion of estimated personal income in the tax withholding calculation helps even payment of taxes on such income over the year.
Non-periodic compensation such as bonuses, stock income and commissions will usually have additional hypothetical taxes withheld. If significant unexpected personal income is realized (e.g. capital gains from sale of stocks), the tax accountant should be advised so any additional estimated hypothetical taxes can be determined in advance to avoid surprises at year end.
Essentially, the estimated hypothetical tax liability approximates what the employee's home country income tax liability would have been had the employee not gone on assignment. This estimate is determined initially at the commencement of the assignment and updated usually annually to reflect salary adjustments and changes in expected personal income and deductions.
This estimated hypothetical tax liability is usually annualized and withheld from each pay check. The amount withheld can be used by the employer to fund any employer's costs of the employee's assignment such as taxes payable to the tax authorities and assignment benefits.
Tax Equalization Calculation
This annual calculation is also sometimes called the tax equalization settlement calculation and it usually takes place upon completion of the employee's annual tax returns when the final stay-at-home or hypothetical income (excluding taxable assignment benefits), exemptions and deduction amounts are known. A final hypothetical income tax calculation will be prepared and compared to the estimated hypothetical taxes withheld during the year. Any over or under withholding will be settled between the employer and employee.
Tax Equalization Calculation - Example 1
- The employee left the U.S. for an international assignment to Japan effective January 1, 2008.
- At the commencement of the assignment, the estimated hypo tax liability was $48,000. Payroll is monthly so $4,000 ($48,000 / 12 months) were withheld from each monthly paycheck.
- It is now April 2009 and the employee's 2008 tax returns are completed. The company pays the taxes computed the employee's 2008 Japanese tax return.. There is a refund of $1,000 due to the employee on the 2008 U.S. tax return. The 2008 final hypo tax liability is determined to be $45,000.
- The company owes the employee $2,000 ($45,000 final hypo tax liability + $1,000 refund on the 2008 U.S. tax return going to the employee from the I.R.S. - $48,000 estimated hypo taxes withheld from the employee during the year).
Tax Equalization Settlement - Example 2
Assumptions 1 and 2 stay the same as in Example 1.
- The employee left the U.S. for an international assignment to Japan effective January 1, 2008.
- At the commencement of the assignment, the estimated hypo tax liability was $48,000. Payroll is monthly so $4,000 ($48,000 / 12 months) were withheld from each monthly paycheck.
- It is now April 2009 and the employee's 2008 tax returns are completed. The company pays the taxes computed the employee's 2008 Japanese tax return.. There is a balance due of $2,000 to the I.R.S. the employee's 2008 U.S. tax return. The 2008 final hypo tax liability is determined to be $52,000.
- The employee owes the company $2,000 ($52,000 final hypo tax liability - $2,000 balance due on the 2008 U.S. tax return paid by the employee to the I.R.S. - $48,000 estimated hypo taxes withheld from the employee during the year).
Possible reasons why money is owed by the employee to the employer in Example 2:
- Under-estimate of personal income in the tax withholding calculation.
- Over-estimate of personal deductions in the tax withholding calculation.
- Changes in personal status affecting tax liability (e.g. divorce, separation, loss of dependent exemptions)
Budgeting and Accrual
Being diligent in one's own taxes does not only help minimize his / her financial surprises, it also helps his / her manager's department to be more accurate in the budgeting and accrual process for assignment costs.
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