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An FAQ Guide to Understanding Hypothetical Tax Withholding


Guide for tax

If your company has tax equalized assignees, you may have heard from employees who have received unexpected tax bills, have yet to settle their tax equalization payments, or are confused about how their tax liabilities were calculated. If any of these ring a bell, now is the time to re-examine the hypothetical tax positions for your mobile employees. Let’s explore some of the most frequent questions we receive and delve into our recommendations on how you can ensure a successful mobility program.

What is a hypothetical tax calculation and how is it calculated?

In general, employees subject to tax equalization are responsible for contributing income and social taxes based on the location they worked prior to the initiation of the assignment and on income they would have been eligible to receive without regard to any assignment-related compensation. For example, consider the following scenario:

  • Jane lives and works as an employee in California
  • Her US income includes base salary and bonus
  • She takes a tax equalized assignment to Canada
  • During the assignment, she receives base salary, a bonus, and various allowances (e.g., housing, cost of living)
  • During the assignment, Jane will need to file US federal and Canadian income tax returns to consider her full assignment compensation package, and may need to file a California state tax return, unless certain criteria are met. She will also continue to be subject to US social security taxation based on her full compensation package.

Under most tax equalization policies, Jane would be held responsible for US federal income tax, California income tax, and US social security tax as if she were still working in California (referred to as her “stay-at-home” tax liability). She would only be held accountable for these taxes as calculated on her base salary and bonus income. The employer would cover the actual global tax liabilities on her worldwide income in excess of Jane’s contribution towards this liability as defined under the policy (i.e., her “hypothetical tax”).

From an IRS perspective, hypothetical tax is considered a reduction to compensation. For this reason, it helps to reduce the overall tax cost for the employer. For the employee, hypothetical tax is akin to the actual payroll withholding that the employee experienced prior to their assignment. They are given credit for this withholding when their hypothetical tax liability is trued-up through an annual tax equalization calculation.

To assist employees in setting their hypothetical withholding at a level that approximates their final tax equalization liability, many companies will work with their mobility tax provider to prepare hypothetical tax calculations. These calculations are used to provide an estimate of the assignee's annual stay-at-home tax. The computation is prepared to determine the amount of "tax" to be ratably withheld from an international assignee's wages while on assignment.

A detailed hypothetical tax calculation is typically prepared when an assignee first goes on assignment and then annually thereafter. Generally, the annual tax equalization is prepared at the end of the year, or when the Home country tax return is prepared, to reconcile the assignee's actual stay-at-home tax with the hypothetical tax withheld (and any other tax payments funded or refunds retained by the employee). As noted below, additional updates to this calculation may be warranted to address significant events that were not reflected in the initial estimate.

Is a detailed hypothetical tax calculation necessary?

In general, the more detailed a hypothetical tax withholding calculation is, the more accurate it is likely to be. This can result in fewer surprises to the assignee and reduce administrative time when the tax equalization is completed at year-end.

Other factors that may impact the decision to prepare a detailed calculation:

  • The company's equalization policy: What income is being equalized? Are there limitations on the equalization of non-company (personal) or equity income?
  • The international assignment program's administrative costs and cost constraints: Does the additional cost associated with a detailed calculation yield enough benefit? Will a comprehensive calculation help identify the need to increase hypothetical tax withholdings and thus reduce the overall cost of the assignment?
  • The magnitude of assignee’s personal income: Are year-end tax equalization settlements significantly impacted due to your assignee’s personal income?
  • Corporate culture relative to knowledge about personal income: Does the company want to delve beyond the employee's company earned income? Would assignees agree to provide non-company income information for withholding tax purposes?
  • Impact of alternative calculations: Will using a higher flat rate of hypothetical withholding on non-periodic and/or non-company income help reduce potentially large tax equalization settlements due to the company?
  • Employee experience: Will the completion of the calculation help to prevent surprise tax bills that may be hard to collect and will likely lead to employee dissatisfaction?

The above list is not all-inclusive but presents questions to consider. We recommend reviewing these points with your mobility tax services provider if you are considering adopting guidelines for more detailed hypothetical tax calculations.

Should our company withhold hypothetical state/provincial/local tax in addition to federal tax?

A company's tax equalization policy sets forth what taxes are to be covered under tax equalization, and thus which taxes will be included in the hypothetical tax calculation. Where the intent of the equalization policy is to approximate the taxes an assignee would have paid had they remained in their Home location, then hypothetical state, provincial, or local tax (“state” tax) is likely to be included in the stay-at-home hypothetical tax.

The four most common approaches used for state hypothetical tax withholding calculations are:

  • Pre-departure location state tax: Tax is withheld as if the assignee had remained a tax resident of their designated Home state.
  • Headquarters location state tax: Tax is withheld based upon the state tax rate at the employer's headquarters.
  • Average rate of state tax: Tax is withheld based upon a blended or average rate of state tax at the various employer locations.
  • No state tax: No state tax is withheld on the premise that the employee has terminated state tax residency. The company is not paying an actual state tax on behalf of the assignee, so the employee receives a state tax windfall.

Employers should discuss state tax withholdings with their mobility tax provider when deciding which, if any, of these alternatives is appropriate for their company's policy. It should be noted that with the increased attention to controlling international assignment costs, there has been a movement away from the "no state tax" option to one where some amount of state hypothetical tax is collected from the assignee. However, in cases where assignees have taken extra steps to terminate state tax residency, employers may still support the "no state tax" option.

When should we update an assignee's hypothetical tax?

Generally, an assignee's hypothetical tax is adjusted at the beginning of each tax year and whenever there is a salary adjustment. Changes in tax legislation may also warrant a revised hypothetical tax calculation. Each year the program administrator should compare the assignee's final tax equalization to the estimated hypothetical tax. If there are major differences, a review of the current year's hypothetical tax with the assignee could help to minimize surprises at year-end. It is often helpful to discuss hypothetical tax during the tax counseling session conducted by your mobility tax provider to educate the assignee on how this works.

Assignees should review their hypothetical tax position whenever there is an event that may increase or significantly change their taxable income. Common examples include:

  • Stock option exercises or other taxable equity events*
  • Receipt of bonus or other supplemental income*
  • Capital gain from the sale of stock or property
  • A change in marital status
  • Changes that significantly impact credits or deductions on the individual’s Home country  income tax return

*It is especially important to review the hypothetical tax position for these events if the income is not subject to withholding at the employee’s true marginal tax rate (i.e., the marginal tax rate is the percentage of tax paid on the last dollar of taxable income). Supplemental income is often subject to special withholding rates that may result in under-withholding of up to 15% for US federal purposes alone, and many states may also have their own under-withholding rules.

Should hypothetical tax be withheld on a bonus? If yes, at what tax rate?

In general, hypothetical tax should be withheld on a bonus. If possible, it is typically best to withhold at the employee’s hypothetical marginal tax rate. By using the marginal rate, it is more likely that enough tax will be withheld to satisfy the final tax liability that will be incurred on the bonus income at the time the tax equalization is prepared.

Another option is to have actual tax withheld on the bonus at the flat tax rate of 22% for supplemental wages. However, the 22% may be lower than the assignee's hypothetical marginal tax rate. This option may result in the assignee having a balance due to the company on the final tax equalization. Special consideration may be needed for state taxes calculated on bonuses as some state taxes may require actual withholding instead of hypothetical withholding.

If the bonus is an assignment acceptance, relocation, or completion bonus, a review of the company's international assignment policy is required to determine if the bonus is considered an assignment allowance or employment income. Assignment allowances are generally "tax free" to the assignee under a tax equalization policy and no hypothetical tax would be withheld.

What steps can be taken now to avoid hypothetical tax surprises for your international assignees?

Attention to the following steps can assist in avoiding surprise tax bills, uncollected tax equalization settlements, and employee dissatisfaction:

  • As appropriate, consider a review of your employee's hypothetical tax position. Offering a year-end projection to executives, for example, will provide advance notice if a balance is due and can offer peace of mind for the assignee as they complete their own year-end financial planning process.
  • Complete hypothetical tax calculations to reset withholding levels for the start of a new year. As possible, allow your assignees the opportunity to include new estimates of their personal income and deductions.
  • Proactively review the level of hypothetical withholding applied to supplemental payments, such as bonus and equity income. Your mobility tax provider can assist in identifying appropriate marginal tax rates for hypothetical withholding that may limit any under-withholding. If supplemental withholding rates cannot be adjusted, you can still proactively communicate with your assignees so that they set aside funds for potential future tax equalization settlements.
  • Communication is key. Make sure your assignees understand your tax equalization policy and process. Many companies will enlist assistance from their mobility tax provider to provide education during a pre-departure tax counseling session. Provision of annual webinars can also assist in highlighting changes to policy and tax laws that may impact an assignee’s hypothetical tax liability or experience.

Your mobility tax provider can help you to determine the appropriate policy and process for implementing hypothetical tax withholding for your specific mobile employees and assignment locations. Through ongoing review and communication, it is possible to improve your assignee’s experience as it relates to hypothetical taxes and minimize surprises and collection issues. Contact GTN to find out ways we can help manage and simplify your mobility program.

Download the Foundational Steps to Establishing a Mobility Tax Program Infographic

Author: Jennifer Stein

Jen has over 25 years of experience in expatriate and foreign national tax preparation and consulting. She joined GTN in 2011 and serves as Managing Director. While clients' projects may look similar on paper, she understands that every employee situation is unique. She coaches clients to understand the complexities of sending employees overseas and helps them work through the many requirements of Home and Host reporting. | +1.312.698.9864
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