As we approach the end of another year, it is time again to reflect on the past 12 months and take steps to prepare for a successful 2020. If your company has tax equalized assignees, you may have noticed employees with surprise tax bills, uncollected tax equalization settlements, or confusion on how their tax liabilities were calculated. If so, now is the time to revisit the hypothetical tax positions for your assignees, to allow for improved results in the upcoming year.
In this month’s newsletter, we provide answers to the most common questions relating to hypothetical tax and provide recommendations on what you can do now and over the coming months to ensure that your mobility program will truly have a happy and successful New Year.
In general, employees subject to tax equalization are responsible for contributing income and social tax based on the location they worked in prior to the initiation of the assignment and on income that they would have been eligible to receive without regard to any assignment-related compensation. For example, consider the following scenario:
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 for tax purposes (i.e., her “hypothetical tax”).
From an IRS perspective, hypothetical tax is considered a reduction to base salary. 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 tax services 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.
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. As noted below, additional updates to this calculation may be warranted to address significant events that were not reflected in the initial estimates.
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 above list is not all-inclusive but presents questions for you to consider. We recommend reviewing these points with your tax services provider if you are considering adopting guidelines for more detailed hypothetical tax calculations.
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 tax 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:
Employers should discuss state tax withholdings with their tax services 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 residence, employers may still support the "no state tax" option.
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 tax services 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:
*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, with further under-withholding potential also common for many states.
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% 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 state taxes calculated 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.
There is still some confusion and uncertainty with the tax law changes enacted at the end of 2017. This can be even more difficult for those individuals living outside of the US (i.e., global assignees). Individuals should keep the following in mind:
All these considerations may need to be reviewed when implementing hypothetical withholding in 2020.
Attention to the following steps can assist in avoiding surprise tax bills, uncollected tax equalization settlements, and employee dissatisfaction in 2020:
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.
For additional information on the unique tax situation of a US citizen going on an international assignment, please see our “Taxation of US Expatriates” booklet at http://info.gtn.com/taxation-of-us-expatriates.
We’re here to help. If you have questions regarding this, please contact me at jstein@gtn.com or +1.312.698.9864, or visit our Mobility Tax Services page to see what assistance we can provide.
The information provided in this article is for general guidance only and should not be utilized in lieu of obtaining professional tax and/or legal advice.