[Editor’s Note: We are happy to welcome Jen Stein as a Guest Author. Jen is the Managing Director of the Global Tax Network Chicago office. She has more than 15 years of experience in expat and foreign national tax preparation and consulting, starting her career with Arthur Andersen, and then Ernst & Young, where she served for over 14 years.]
Taxes are one of the most complicated and expensive aspects of an international assignment. To control these costs, most companies utilize a tax policy as part of their international assignment process. The two most common approaches are tax equalization and tax protection. How do you decide if one of them is right for your company? Let’s start with some definitions.
Tax equalization is a process that ensures that the tax costs incurred by an assignee on an international assignment approximates what the tax costs would have been had (s)he remained at home (i.e., had (s)he not gone on international assignment or received any assignment related allowances or compensation items). The intent of tax equalization is that the assignee neither suffers significant financial hardship nor realizes a financial windfall from the tax consequences of an international assignment.
When tax equalization is utilized, the employer generally bears the responsibility for paying the assignee’s actual home and host country tax costs. In exchange, the assignee pays to the employer a “stay-at-home” or “hypothetical” tax as determined under the company’s tax equalization policy.
The estimated stay-at-home hypothetical tax should be collected from the employee each pay period (i.e., through a payroll deduction) and there should be an annual tax balancing to reconcile this estimated withholding amount to the final hypothetical tax liability for the year. As a result of this final tax balancing, the employee may owe the company additional stay-at-home tax, or the company may need to return part of the stay-at-home tax to the employee.
Tax protection is a process that reimburses an assignee the excess taxes (s)he incurs while on an international assignment. The employee is generally responsible for the payment of all actual home and host country taxes. The annual tax protection calculation then compares the stay-at-home hypothetical tax to the actual worldwide taxes paid by the employee. If the actual worldwide taxes exceed the stay-at-home tax amount (as determined under the company’s policy) the company reimburses the excess to the employee. If the actual worldwide taxes are less than the stay-at-home tax, the employee retains the tax benefit (and accordingly, receives no reimbursement from the company). Tax protection generally puts the burden of filing and paying home and host country taxes on the assignee.
The assignee’s cash flow may be seriously impaired under tax protection if (s)he is in a high tax rate country. The assignee must first pay both his actual home and host country taxes, then request a stay-at-home tax calculation, and finally be reimbursed for excess taxes. Compliance with the host and home country tax laws is sometimes “overlooked” since the assignee is solely responsible for filing and paying his home and host country taxes. In addition the assignee has a financial incentive to minimize his actual tax. Cash flow and compliance problems are exacerbated in high tax countries. If the assignee fails to comply with the host country tax rules and the failure is exposed, the company may be the target of unexpected and unfavorable publicity.
When tax protection is utilized, the assignee may reap a significant financial windfall if his/her assignment location country has no tax or a very low tax.
Why would a company utilize tax equalization instead of tax protection?
Tax equalization supports equity, mobility, compliance, and partnership.
- Equity is achieved because the assignee is in a tax neutral position during the assignment.
- Mobility is enhanced because changes in assignment countries produce no significant tax benefit or disadvantage for the assignee.
- Compliance with both home and host country tax laws is encouraged because there is no benefit to non-compliance.
- A partnership is formed between the company and the employee, with the company paying all worldwide actual taxes and the employee paying his hypothetical tax.
The perceived fairness of the tax equalization program provides intangible benefits since the assignee is not significantly impacted by the tax consequences of his international assignment. The use of tax equalization assists the company in being able to move employees based on business needs. It helps avoid situations where it is easy to fill a position in a country with a low tax rate while having difficulty filling a post in a high tax rate location.
By keeping the tax windfall generated by transfer years or low tax rate locations at the company level, assignment related tax costs associated with the international assignment program are controlled.
However, there are some disadvantages to using a tax equalization policy as well, including:
- Administration needs may increase due to implementation of hypothetical withholding and tracking of year-end balancing calculations and payments.
- A well defined policy may be needed to handle the variety of situations that can occur.
When deciding which, if any, tax policy is right for your organization consider the goal of the international mobility program, the business needs of the company as well as the ability of the organization to administer the policy.
More About Jen
About Global Tax Network
Global Tax Network provides international assignment tax compliance and consulting services for corporate global mobility programs, including program development, ongoing tax management, and special projects. The firm is recognized as a leader in consulting for emerging to mid-sized global mobility programs. GTN has six U.S. offices, with allied partners and resources in more than 100 countries to support assignee home and host tax requirements. For more information please contact us.