Is a detailed hypothetical tax calculation necessary?
For purposes of this discussion, a hypothetical tax calculation refers to a periodic estimate of an 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. Many employers will prepare a detailed hypothetical tax calculation 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.
In the case of significant economic events, such as stock option exercises, gain on sale of stock, etc., some employers may also provide for additional calculations during the year, to make sure sufficient amounts of hypothetical tax are withheld for the year. In other instances, instead of preparing an additional tax withholding calculation, employers may simply substitute or use the assignee's actual pre-assignment tax withholding as the hypothetical tax withholding and assess a flat rate of tax on income resulting from significant economic events.
Generally, 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.
Several other factors 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 a sufficient benefit? Will a comprehensive calculation help identify the need to increase hypothetical tax withholdings and thus reduce a large year-end tax settlement?
- The magnitude of assignee population's non-company (personal) income - Is personal income generating significant year-end tax equalization settlements due to you from your assignees?
- 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 the company?
The above list is not all-inclusive, but presents areas for review and discussion. We recommend reviewing these points with your service 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. (For this discussion, we will use "state" to stand for "state, provincial, and/or local" hypothetical tax.) Where the intent of the equalization policy is to approximate the tax an assignee would have paid had they remained in their home location, then state tax is likely to be included in the stay-at-home hypothetical tax.
The most common approaches used for state hypothetical tax withholding 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 effect 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 employee has terminated state tax residence. 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 tax service 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 hypothetical state tax" option, to one where some amount of state hypothetical tax is collected from the assignee. However, in cases where employees have taken extra steps to terminate state tax residence, employers may still support the "no hypothetical 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 salaries change. Changes in tax legislation may also warrant a revised hypothetical tax calculation. Also, 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.
Assignees should update their hypothetical tax whenever there is an increase in non-company income due to stock option exercises, employee stock purchase plan income, capital gain from the sale of stock or property, etc. A change in marital status, an increase or decrease in the number of dependents, a house purchase, a mortgage refinance or retirement, and increased charitable contributions should also elicit a review of the hypothetical tax.
We will be paying out bonuses in March. Should hypothetical tax be withheld on the bonus? If yes, at what tax rate?
In general, hypothetical tax should be withheld on the bonus. The marginal tax rate on the hypothetical tax calculation may be used. (The marginal tax rate is the percentage of tax paid on the last dollar of taxable income.) The goal of having the hypothetical tax withholding approximate the final tax equalization has a greater chance of being met if you withhold at the hypothetical tax marginal rate.
Another option is to have actual tax withheld on the bonus at the flat tax rate of 25% for supplemental wages. However, the 25% is usually lower than the assignee's hypothetical tax marginal tax rate. This option may result in the assignee having a balance due the company on the final tax equalization. Special consideration may be needed for the state tax on bonuses as some state taxes may be on an actual basis depending on the assignee's state residency.
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 and no hypothetical tax would be withheld.
In short, there are many factors to consider with regard to hypothetical tax withholding. If you have any questions or would like assistance in this process, please do not hesitate to contact Sajjad at email@example.com or +1.708.887.0275 or your GTN contact.
The information provided is for general guidance only, and should not be utilized in lieu of obtaining professional advice.
Author: Sajjad Abadin
Sajjad began his career with GTN in 2014 and currently serves as Senior Manager in GTN’s Great Lakes region. He has nearly 15 years of experience in expatriate and foreign national tax preparation and consulting. He oversees multiple companies’ mobility tax programs as well as many independent assignees. Clients rely on Sajjad to expand their understanding of complex mobility tax issues, and they put trust in his ability to coordinate and manage the intricacies of their specific mobility programs. firstname.lastname@example.org | +1.708.887.0275