Tax equalization is a policy widely used by companies with mobile employees. At its core, tax equalization is a mechanism to ensure that an employee is neither better nor worse off financially, from a tax perspective, for having accepted an international assignment. However, there are many misconceptions about what exactly it means to be “tax equalized.” As one example, some companies will try to avoid the policy because they think it will automatically lead to high company costs and administration.
For companies considering the use of tax equalization, it is critical to know the pros and cons of the approach; what does it really mean to apply tax equalization and what are the impacts for both the employee and organization? By gaining a thorough understanding of the concept and implementing an appropriate policy, tax equalization can be an important tool in promoting and supporting a successful mobile workforce.
What is tax equalization?
In basic terms, tax equalization is a compensation approach used to neutralize the effect of a global assignment on an assignee’s personal tax liability. Under the tax equalization approach, the assignee should pay approximately the same level of taxes had they remained working and living in their Home country/state.
A tax equalization policy has four major objectives.
- Maintain the assignee on a comparable Home country tax basis while on foreign assignment (i.e., minimize the assignee's gain or loss as it pertains to taxes and equalize, as much as possible, the tax burden the assignee would otherwise have had, had the assignee remained in the Home country)
- Ensure good corporate citizenship regarding the assignee's tax compliance in every location in which the company operates, and eliminate the risk of noncompliance to local law, tax regulations, and exchange rate controls
- Support assignee mobility to meet the company’s international staffing needs (i.e., from a tax perspective, an assignee should have no incentive or disincentive to accept a foreign assignment, transfer from one foreign assignment to another, or to be repatriated)
- Minimize cost as far as law and practicality permit
To implement this policy and achieve these objectives, it is essential to understand tax equalization as a compensation policy. Since tax laws and tax levels vary significantly from country to country, it is necessary to concentrate on the net after tax results of tax equalization rather than pre-tax salary alone.
Generally, a tax equalization policy will provide that, if an employee would be subject to a higher tax burden worldwide due to accepting an assignment in a new Host country compared to their current tax rate, the company will pay all the increased tax obligations. Similarly, if the assignment results in a lower tax burden worldwide, then the tax windfall will be retained by the company.
But is tax equalization the best policy for all assignment types? Based on past surveys conducted by GTN, a large majority of companies will use tax equalization for long-term assignments (typically defined as assignments lasting more than one year and less than five years). Companies will also generally apply tax equalization for short-term assignments (one year or less) if there are tax complexities in the Host location. Tax equalization is not as common for transfers or scenarios without tax complexities in multiple locations, however, companies will often provide tax assistance to support compliance in both jurisdictions for limited durations (e.g., for transfers, companies generally provide tax services for the year of transfer and possibly one additional year).
Given its goal of keeping employees tax neutral, why would tax equalization not be preferred for all assignment types? The reason is the implementation of tax equalization generally results in additional payroll administration and tax compliance costs.
For example, if an employee permanently transfers to another location (i.e., will be on Host country payroll under a local contract), will your organization want to continue to hold the person accountable to Home country taxation? Here, it may be possible to simply apply tax gross-ups to certain agreed benefits, rather than pay for year-end tax equalization calculations for an indefinite period.
For companies that do want to implement tax equalization, it is critical to understand how tax equalization works for both the employee and the organization.
Tax obligations of mobile employees
In considering how tax equalization works from an employee perspective, it is important to understand the following basic elements of tax equalization:
- Actual income tax payments
- Actual social security tax payments
- Hypothetical tax
- Theoretical tax
Actual income tax payments
For international assignments where tax equalization applies, employers will generally fulfill the tax obligation in the Host country. This can be done in multiple ways. One of the most common ways is via foreign payroll. Employers will sometimes use what is known as “shadow payroll” or “parallel payroll” to comply with payroll reporting and tax withholding requirements in the Host country for their mobile employees. When a company utilizes a shadow or parallel payroll, they pay the tax due in the Host country while keeping the mobile employee on the company’s payroll in their Home country for actual pay deliverance.
Once the employee’s Home and Host tax returns are completed, any balances due are typically paid by the company with any refunds due back to the company.
Actual social security tax payments
It is critical that employers with mobile employees working abroad understand their obligations to pay employment taxes imposed under both Home and Host country laws.
For example, some employers do not realize that FICA taxes may still apply to their US employees while they are working abroad. In many cases, when a company sends an employee abroad who is a US citizen or permanent resident, the company is still responsible for FICA withholdings on the employee's income, even though they are working outside of the US. These US employees may also be subject to Host country social security tax based on the domestic laws in the countries where they are living and/or working.
Employers should consult with a mobility tax expert to determine if social tax liabilities may be due in the Home and/or Host location for the employee and company. In addition, a mobility tax expert can also assist with mitigating double social taxes by invoking totalization agreements between the Home and Host countries, if applicable.
Many company tax equalization policies include provisions for a hypothetical tax (also known as hypo tax). Under a hypo tax, a company reduces the salary of a mobile employee, based on estimates of the amount of tax the employee would have paid in their Home country if they had not been assigned abroad. The retainment of hypo tax has several benefits:
- The hypo tax is often considered a pre-tax deduction for Home and/or Host payroll reporting purposes, thereby helping to reduce the tax gross-up impact of a tax equalization policy for the company.
- It is often possible to reduce or cease actual Home country income and/or social tax withholding for employees on long-term assignments. Retainment of hypo tax allows the employer to obtain an estimate of the employee’s tax burden under the policy even if actual withholding is not required. Via tax equalization, a true-up is prepared to reconcile the estimated hypo tax.
- If withholding can be reduced in the Home Country, continuation of actual withholding can result in large refunds due back to the employee upon completion of a Home country tax filing. Retainment of hypo tax eliminates these types of timing and cash flow issues.
Under most tax equalization agreements, when the employee being sent abroad is a US citizen or permanent resident, they will be responsible for the federal, state, social security, and Medicare taxes the employee would pay on their base salary, bonuses, equity compensation, and personal income from such things as interest, dividends, capital gains, rental income, etc. The total amount of tax due would be the hypo tax for that employee.
The theoretical tax (sometimes called the “final hypothetical tax” or the annual tax equalization calculation) is the calculation at year-end of the definitive hypothetical tax, based on company-recognized actual income and deductions. The theoretical tax bears the same relationship to the hypothetical tax that an individual's actual tax on their tax return bears to their withholding during the year.
From the employee's standpoint, the hypothetical tax represents a pay-period deduction against the final theoretical tax, which as closely as possible approximates the stay-at-home tax burden had the assignee not taken the assignment. The company then pays all taxes due, Home and Host, in as cost-effective manner as possible, whether the actual taxes paid are higher or lower than the theoretical tax.
Tax deductions that result from the assignee's expatriate status (e.g., US law permits an exclusion of foreign source earned income as defined) are not recognized in tax equalization since they would not be available to the assignee's domestic counterpart. Just as the assignee bears no extra burden from either higher tax rates abroad or taxes due on allowances provided, so the assignee does not reap a windfall should the tax liability be lower instead of higher.
The impact of tax equalization on the employer
Though there are times when a company will end up receiving more money back via hypo tax than it spends via actual taxes, tax equalization agreements often result in real costs to the company that should be part of the cost-benefit calculations used in deciding whether to send an employee abroad.
Given the complexities of international tax law, it can be difficult to calculate in advance how much a company will spend on tax equalization for an individual employee. However, it is important to at least have an estimate of the equalization costs of sending an employee on assignment for budgeting purposes.
Your mobility tax provider should be able to complete tax cost projections to help your organization accrue for the Home and Host income and incremental social security costs of tax equalization. It is important to revisit these accruals regularly to make sure the accruals are adjusted based on changes to assumptions such as tax laws and employee compensation.
Tips for creating a tax equalization policy
If your company is adding a tax equalization policy to your mobility tax program, you should work closely with a mobility tax services provider to ensure the necessary tax ramifications are addressed on behalf of the company and mobile employee. In addition, any policy would be a direct reflection of company’s core value and philosophy, so a holistic approach should be taken to come up with a good policy.
Because of their complexity, most tax equalization policies are drafted by a company’s mobility tax services provider. A policy should include the following provisions:
- An explanation as to what compensation will be used to calculate the mobile employee’s equalization payment for each year
- Specific guidance on how personal income and deductions will be handled on a hypothetical basis
- Specific guidance on the types of tax burdens covered under the policy. For example, tax equalized assignees from the US may be held to hypothetical state income tax based on their most recent work or residence location, regardless of whether state residency will continue to apply while on assignment. Additionally, leaving the policy open-ended could result in claims for equalization of other types of tax, such as estate or gift tax.
- A statement that it is the employee’s responsibility to fully comply with all the tax laws of the Home and Host country
- A provision requiring the mobile employee to work with the company’s tax provider to ensure that all tax filing deadlines are met and that they will be personally responsible for any additional taxes, interest, or penalties resulting from failing to provide information in a timely manner
- The timetable for completing any cash settlements following equalization calculations and an explanation of how it will be reported
- A statement that the company will be responsible for paying any taxes (as covered under the policy) arising from the compensation paid to a mobile employee while they are on assignment
- A statement to comply with requirements of local laws as applicable
- An explanation of how tax equalization payments will be calculated in the year that the mobile employee is repatriated to their Home country and in subsequent years
With respect to the last point, as a general rule, a tax equalization policy will apply to mobile employees while they are on assignment in a Host country and continue until the end of the tax year in which the employee returns to their Home country. After a mobile employee returns from an assignment, an employer may choose to extend tax equalization treatment to cover any assignment-related income that becomes reportable in later tax years or when company-paid foreign tax credits are used to reduce the tax liability of a current or former employee. As a best practice, such an intention to extend tax equalization beyond the year of repatriation to cover any assignment related trailing items should be specifically spelled out in the company’s tax equalization policy.
Finally, companies that are establishing tax equalization policies need to remember that international taxation is a complex topic that their mobile employees may not clearly understand. A tax equalization policy will not be reassuring to a mobile employee who has been assigned abroad if they cannot see its benefits. Therefore, it is critical that employers provide their mobile employees with tax preparation and consulting services from the company’s mobility tax services provider, both to help the employees understand the complexities of their new tax situation and to let them know who to contact when they have questions or concerns.
By understanding what it means to tax equalize, you can create a policy and apply it to the most appropriate segments of your mobility program.
If you would like assistance in developing a tax equalization policy, or if you would like a review of your current tax equalization policy, we are here to help. Schedule a call with our team to talk through your specific situation and ask any additional questions you may have.