Tax

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Education Knowledge Base

What is Hypothetical Tax?

Prior to an assignment, an employee would earn a Home-country salary and typically have actual income taxes and social security withheld from their pay each pay period.

During an assignment, the employee still earns a Home-country salary but, instead of actual taxes, a ‘Hypothetical Tax’ is withheld. Hypothetical tax is the estimated amount of tax the employee would have paid had they not gone on assignment. The company withholds the hypothetical tax from the employee and uses it to fund tax obligations in the Home and Host locations.

Hypothetical tax is implemented because it is not necessary to pay actual tax on the same income in two different jurisdictions. As a result of the assignment, Home tax residency may be broken; if not, the Home country will almost certainly provide for double tax relief, usually via foreign tax credits. If the employee had stayed on actual withholdings, there would be a large refund due on the Home tax return, which may prove difficult to collect. Tax authorities tend to scrutinize a return that requests a $30,000 (interest-free) refund, for example.

Under many tax equalization policies, the designated tax provider will prepare an annual tax equalization settlement intended to ‘true-up’ the amount of hypothetical tax withheld versus the final calculated hypothetical tax, to ensure the employee’s tax neutral position. Similarly to how many countries’ tax returns determine the final balance due or refund payable, a reconciliation compares the hypothetical tax withheld against the final hypothetical tax calculation. This reconciliation typically results in either a balance due from the company to the employee, or vice versa.

What is tax equalization?

Multinational companies use tax equalization as a compensation approach to ensure that an employee is no better or worse off — from a tax perspective — as a result of accepting an international assignment.

Tax equalization is a cornerstone of the Home-based balance sheet approach, designed to achieve multiple goals:

Preserve – protect an employee’s stay-at-home income and net purchasing power
Universal – can be used for any Home and Host country combination
Flexible – easily modified to meet corporate objectives and policy preferences
Consistent – links employee to Home benefits, encouraging repatriation and tax compliance
Fit-for-purpose – serves as the foundation for determining cost of living and housing support

With tax equalization, the company covers actual taxes on employment income (including taxable allowances such as housing, COLA, education, etc.), and the employee contributes to tax at a stay-at-home rate (on employment income only).

When an individual accepts an international assignment, income tax (and possibly social security) will most likely be due in the Host location during the assignment period. Under tax equalization, the employer commits to funding all Host tax due on employment income on behalf of the employee. The employee is responsible for working with a designated tax provider to facilitate timely and accurate tax compliance (filing tax returns).

When a company pays tax on behalf of an employee, it is typically considered a taxable benefit, and therefore the company must pay tax-on-tax, more commonly known as a gross-up. For example, if an employee nets $100,000 and the tax rate is 50%, in order to cover the ‘tax-on-tax’, the employer would need to pay $100,000 in tax ($200,000 x 50% = $100,000 net). The costly nature of gross-ups makes tax equalization one of the most expensive options for compensating expatriates.

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