Crown Relocations

Tax Advice 0

By Tim Lenneman, CPA

"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.

About the Author

AS Tim LennemanTim Lenneman is the managing partner of Global Tax Network and is located in the Denver office where he focuses on providing Expatriate and Foreign National tax services to corporate and individual clients. Tim also has a strong background in corporate international tax matters.

Crown Relocations

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Comments about this Article

Apr 18, 2011 11:10

Very good article.I got to know an overview of tax equalization. Thanks Tim.

Mar 12, 2012 08:06

My employer has told me that if I buy a house, then any profits from it when selling in the future will be payable to company. Is this correct? This would mean there is no point in buying a house because any capital gains will be for the company. My 'solution' is to put the house on my wife's name, however I don't know if this helps...

Apr 9, 2012 02:52

Tim, I wonder if you will get this? My company CH2MHill, has included a single footnote in it's hiring package, that allows them to recoup a significant portion of the salary paid to us, when they send us to expat assignments with no taxation, whatsoever. I'm refusing to pay the $16,000 difference, and need some support. Can they use TAX EQUIBRATION to take back some of the income they paid me? Thanks for any information you can provide, Steve.

May 7, 2012 23:27

Hi Tim , this is a very informative article . I have a French expat working for me in the philippines and was would like to know what the tax equalization rate would be for him . thanks, Bob

Oct 3, 2012 13:58

HI, thanks for the Article, I am investigating if my company can deduct Hypo tax even though I am in a tax free country UAE on a permanent assignment (classed as an expiate), and I am not a USA citizen? I am out of my home country for 360 days and might return every 5 years? Is this legal?

May 20, 2013 17:01

What if our home country taxation rules mention that an expatriate commuter residing in the home country's salary is not taxable if the source of income comes from outside the home country ? Means all the hypotetical deduction is returned back to the employee?

Feb 3, 2016 05:38

Our company recently decided to change to this policy...its a huge screwing to the employee. My bigger concern is that once my W2 is completed and my income reported to the IRS and Social security the company then has me give them the equivalent of the Social Security FICA and Claim the Foreign tax credit against my income. If I pay all of this back to the company (around 20 grand) then the company has now filed a fraudulent W2 on my behalf by over reporting my income, since it isn't my income. Do they have to do an amended return to correct the payments to SS and Medicare since the income that isn't income has not been legally reported, and when I claim SS it is on a falsely reported income. So now I have committed fraud by not reporting the correct income. Same with the fals claim of a foreign tax credit. Since the company has already subtracted my pay including the foreign tax paid from their income and now they will recover from me (20K) then they will have over stated what was paid to me in their taxes. With thousands of employees this is Millions and maybe close to a billion dollars of falsely reported payments and income. So my confusion to the legal implications is huge. I talked to one of the Auditors I know and she wasn't sure this is a legal transaction...she suggested I get the process in writing from our company chosen accounting firm and talk to someone at the IRS so I don't end up in Jail...when I called the IRS they couldn't find an agent who understood what my company was doing. They have told us they are working to find a Tax specialist to explain it to us, but we haven't heard from them yet. Can you tell me where this is an allowable transaction in the IRS code?

First Published: Jul 15, 2002

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