Tax Equalization Versus Tax Protection
Which Tax Reimbursement for an Expatriate Assignment is Fairer?
Sep 22, 2009
Why do companies offer tax reimbursement when they send employees on temporary assignments overseas? There a few main reasons:
- To ensure employees do not have to pay more taxes due to the assignment
- To allow global mobility of their employees when needs arise
- To maintain compensation equity among employees
- To encourage employees to comply with global income and tax reporting requirements
Differences Between Tax Equalization & Tax Protection
Regardless of the tax reimbursement policy, three income tax calculations are done when the tax year is over to determine the expatriate employee's tax responsibility:
- Hypothetical Tax- Home country tax liability based on hypothetical income* as if the employee had not taken the assignment
- Actual Home Country Tax Liability- The tax liability owing to the home country tax authority based on all income and benefits provided by the employer to the employee and taxable under the home country tax law
- Assignment Country Tax Liability- The tax liability owing to the assignment country tax authority based on all income and benefits provided by the employer to the employee and taxable under the assignment country tax law
* Hypothetical Income= The income elements that would have been received even if the expatriate had not taken the assignment. Examples include regular salary, commissions, bonuses and stock income, less pre-tax deductions such as retirement plan contributions. Assignment related benefits such as assignment country housing benefits, cost of living adjustments (or COLA) and dependent tuition fees in the assignment country are usually not included as hypothetical income for the purposes of calculating hypothetical tax.
Under tax equalization,
- the employee is always responsible for (1), and
- the employer is always responsible for (2)+(3).
Under tax protection,
- the employee is responsible for the lower of (1) and (2)+(3)
Therefore, under tax equalization, the employee will not be worse off or better off in terms of taxes because of the assignment location. Under tax protection, if (1) is lower than (2)+(3), the employee is essentially tax equalized. If (1) is higher than (2)+(3), the employee will have a tax windfall by taking the assignment because his / her new tax responsibility is lower than what (s)he was paying before the assignment.
Pros and Cons
If tax protection is seemingly more advantageous to an expatriate employee, why don't most companies adopt tax protection to encourage employees to accept international assignments? There are some broad-base reasons as follows:
- Equity among employees on expatriate assignments and employees not on assignments- If a Canadian employee is sent to work in Hong Kong and (s)he is tax protected, since Hong Kong tax rate is much lower than Canadian tax rate, the employee will likely come out ahead in terms of taxes under tax protection compared to his / her colleague back in Toronto. This is assuming the employee has broken Canadian tax residency and has no residual Canadian tax liability while living and working in Hong Kong.
- Equity among employees on expatriate assignments- Similarly, assuming the tax rate for Sweden is higher than Canada the tax rate of which is higher than that of Hong Kong, under tax protection, a Canadian expatriate employee working in Hong Kong will come out ahead in terms of taxes compared to a Canadian expatriate employee at the same salary level working in Sweden. The expatriate employee in Hong Kong is most likely paying (2)+(3) under tax protection while the expatriate employee in Sweden is probably paying (1). Again, this is assuming that both employees broke Canadian tax residency while living and working abroad.
- Global mobility- Tax equalization takes away tax advantages and disadvantages out of the assignment decision and acceptance process by the employees and allow companies to maintain a globally mobile workforce.
Business Trends
Some companies historically offered tax protection to their expatriate employees with the intention to confer any tax advantages to the employees as an enticement to accept the assignments. With changes in business environment and globalization of work force, many of them switched to tax equalization. An example is provided by KPMG LLP.
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