The actual taxes you incur during an international assignment will differ from the amount you paid during your domestic employment. The change results from three factors. First, the amount of income on which you are taxable, in most cases, will significantly increase while you are abroad. The increase is due to the inclusion of all your allowances and differentials in your reportable income. Second, the tax rates in host jurisdictions in many cases will exceed the home country tax rates. Third, certain income items may continue to generate home-country tax during your international assignment.
Although your actual taxes may increase significantly, your out-of-pocket payments should remain fairly consistent. The majority of multinational employers have adopted tax reimbursement policies to help ensure that international assignees do not bear the incremental tax costs resulting from the above factors.
There are two main types of tax reimbursement policies: tax equalization and tax protection.
If your employer has adopted a tax equalization policy, this helps ensure that as an assignee you continue to bear approximately the same tax costs during your international assignment as you would have incurred had you stayed at home. Under tax equalization, assignees pay a hypothetical tax on those compensation items which would have been received at the home location had they not accepted the international assignment (stay-at-home income). Some employers also tax-equalize investment and other outside/personal income. (Outside/personal income generally includes all income received and losses incurred by an assignee, other than compensation received from the assignee’s employer. Typical items would include interest, dividends, capital gains and losses, rental income and losses, self-employment income and losses, spouse’s compensation, and income and losses from pass-through entities such as partnerships or trusts.)
Under a tax equalization approach, you will bear the same hypothetical tax regardless of whether the actual taxes generated during your assignment are greater or less than that amount. Accordingly, taxes should not be a factor in determining whether to accept an international assignment.
In general terms, your employer would pay all the actual taxes generated by income covered under its policy. Simultaneously, the company would retain hypothetical tax from your stay-at-home compensation. If any tax is generated by your personal/outside income, you may be required initially to pay the actual taxes. After your host and — where applicable — home country tax returns are completed, a tax reconciliation will be prepared to determine your final hypothetical tax, which is your real tax cost under tax equalization. If your payments exceed this amount, you would receive a refund from the company. If this amount exceeds your payments, you would be required to pay the shortfall to your employer.
If your employer has adopted a tax protection policy, then as an assignee you will never bear more tax during the international assignment than would have arisen at the home location. However, if the actual taxes incurred during the assignment happen to be lower than the home country hypothetical tax, you would retain the difference. Because a potential windfall may exist in low-tax jurisdictions, taxes can be a consideration in determining whether to accept one international assignment rather than another under tax protection. From an employer’s perspective, the value of an international assignment to your career generally should not be influenced by the financial windfall you might receive.
Hypothetical tax approximates the income taxes that you would have incurred if you had not accepted an international assignment. Many employers impose not only a hypothetical federal/ national tax, but also hypothetical state/province/canton and local/municipal/city taxes.
Typically, there are two elements to hypothetical tax:
In order to determine how much your employer will retain from your paycheck, depending on your employer’s tax policy, an estimate of the hypothetical tax on your stay-at-home compensation will be calculated based upon your marital status, family size, salary level, and itemized deductions, hypothetical or actual depending upon your employer’s policy.
Under tax equalization, your employer will usually pay all the host country taxes you incur. Depending upon the terms of your employer’s policy, you might be responsible for the taxes generated by your outside/personal income.
Hypothetical itemized deductions are an estimate of what your itemized deductions would have been on your income tax return had you stayed home. The reason policies address hypothetical deductions is because, as an expatriate, your actual itemized deductions would change, and may be less than those you incurred prior to accepting your assignment. In order to calculate a hypothetical tax that approximates your stay-at-home tax, an assumption must be made as to the level of itemized deductions that would have been incurred at your home location.
How a company calculates hypothetical deductions varies from policy to policy. In some cases the employer, based upon input from independent advisers, determines the amounts. Others could apply a flat percentage of base salary for all expatriates, regardless of what they had prior to the assignment. Another example is a modified hypothetical itemized deduction, which takes into account both actual and hypothetical taxes paid. Variations will depend on numerous factors such as the culture of the employer, demographics of the population, size of the population, administrative abilities, and in-house versus outsourced expertise.
Once again, each employer varies when it comes to hypothetical state tax. Examples of how your hypothetical state tax may be calculated are as follows:
While there are other variations that organizations may apply, each one will determine which method is most in line with the organization’s culture, location of the employee’s home state, administration costs, and in-house versus outsourced preparation of the calculations, as well as various other factors.
In all probability, yes. The current trend is for employers to impose hypothetical tax on outside/ personal income and to pay any actual home and host country taxes generated. However, not all employers treat this income in the same fashion. Some companies put a cap on how much outside income can be equalized. Others exclude specific types of income, such as the capital gain on the sale of a principal residence or a spouse’s compensation. In other cases, passive losses generated by rental real estate may be allowed for hypothetical tax purposes on either an actual basis as deducted on the current return or on a hypothetical basis as if only stay-at-home income was reported.