"Tax equalization" is a policy that is followed by many employers of expatriate employees. The underlying theory of tax equalization is to ensure that the expatriate assignment is "tax neutral" to the expatriate employee. In other words, while the expatriate employee is on foreign assignment, the employee will pay approximately the same amount of income and social security taxes (referred to as "stay-at-home" or "hypothetical" tax liability) as they would have paid had they remained in the U.S., or their home country, and only earned the items of compensation that they would normally earn such as base wages and bonuses. The company pays any taxes that exceed the expatriate's hypothetical tax liability. Companies also implement tax equalization policies so that expatriate employees are treated fairly and consistently throughout the world (an expatriate in Saudi Arabia is treated the same as an expatriate in the U.K. although the tax laws in these countries are vastly different). Further, tax equalization policies allow large expatriate employers to standardize and streamline administrative processes.
Expatriate employees are subject to a worldwide tax burden during their foreign assignment that is either higher or lower than what they would have paid had they not left their home country. The reasons for their worldwide tax burden being higher or lower include:
- Higher Tax Base Employers typically provide additional compensation to the expatriate to cover increased housing, tax, and cost of living expenses. In many cases, these additional compensation items are subject to tax in the home and host locations.
- Tax Rates - Depending on the host country, foreign tax rates may be significantly higher or sometimes lower than the U.S.
- U.S. Foreign Earned Income Exclusion The foreign earned income and housing exclusions reduce the U.S. tax base (regardless of whether the foreign country taxes the expatriate's income).
Most of the time, the expatriate employee is subject to higher taxes, so tax equalization provides for great comfort and piece of mind for the employee.
Tax equalization policies generally provide that the expatriate employee pay to their employer his or her an estimated hypothetical tax liability during the tax year through hypothetical withholding from each paycheck. In return, the company will pay all the actual home and host country taxes owed during the foreign assignment. After the expatriate employees tax returns are completed, an annual tax equalization settlement is prepared, which determines the expatriate's hypothetical tax liability for the tax year, and that is compared to the hypothetical withholding to see if the hypothetical withholding was too much or too little. Depending on this comparison, the expatriate may be due money back from the company, or the expatriate may owe the company additional money towards his or her hypothetical tax liability for the year.
Although tax equalization policies and procedures are very similar among companies, the key differences are usually related to the treatment of the following items when calculating the tax equalization settlement calculation:
- What items of income are subject to tax equalization? Some will tax equalize company compensation only, while others will tax equalize some income from other sources including investment income and spousal income. Also, companies may, or may not, tax equalize stock option income.
- What deductions are allowed when computing the hypothetical income taxes? Companies generally have special methodologies for determining itemized deductions.
- Will the expatriate be tax equalized to their former state of residence or some other state (an expatriate's hypothetical tax liability for the tax year generally includes, when looking at U.S. expatriates, federal and state income taxes, as well as FICA taxes)?
- Tax equalization policies may or may not address items such as the sale of a principal residence or rental properties.
- If you receive a hardship allowance or foreign service premium, are these amounts subject to tax equalization?
Note that there are also policies referred to as "Tax Protection" policies that generally provide for the same outcome for the employee when the worldwide taxation is greater than his or her hypothetical tax liability (the company pays the additional tax). However, under a tax protection policy, if the employee saves on taxes while on assignment, then the employee keeps the tax savings. Tax protection policies are less common than tax equalization policies. Tax protection policies tend to be used more often by small expatriate programs or companies with many expatriate employees that are in low tax countries. The procedures for a tax protection policy are usually quite different from a tax equalization policy.
If you are new to tax equalization or tax protection policies, I suggest that you spend some time with a qualified expatriate tax advisor to understand your tax equalization policy or to help your company implement a policy. Usually, under both types of policies, the employer will provide for home and host country tax return preparation and consulting to ensure that the worldwide tax costs are kept to the minimum allowable by law, and that filing requirements are properly met.