As far as global mobility policies go, Tax Equalization (“TEQ”) seems to be the least understood by payroll professionals. A US Certified Payroll Professional (“CPP”) has had training on all sorts of federal and state laws and how they need to be applied to deliver compliant payroll transactions. However, TEQ is company policy and not law.
It is unlikely that even the most experienced CPP has had training re: TEQ before being involved with expatriates and asked to deal with transactions that stem from the TEQ process. In the hope of reducing much of the confusion concerning tax equalization and the payroll setup to properly reflect the related transactions, I am dedicating the next Expatriate Payroll Tips to Tax Equalization. Here, I will try to provide the rationale for tax equalization policies (there actually are reasons for them!) and then I will illustrate some of the common tax equalization payroll transactions and the related payroll coding.
Before we begin to delve into the transactions, let’s first look at the reasons TEQ exists and how policies are typically structured. Because US expats transferring abroad want to remain tied to certain home country benefits (like US social security, Medicare and 401(k) for example) it is common for US employers to find ways to keep them reported on a US payroll to protect those benefits. However, while working in a host country, the expat is likely going to be reported on the host country payroll at the same time. We all know that it is complicated enough to file a tax return in the US alone. Imagine, then, your expatriate, with a US W-2 and similar host country document trying to figure out the income tax return filing rules of the host country, likely in another language, maybe with a different tax year end (the UK income tax year end, for example, is April 5th) and in a foreign currency. A US tax return will have to be filed for a US citizen or US resident alien as well.
Remember, your expat is already a very expensive employee. Beyond salary, it is likely that your organization has committed a significant amount of additional financial assistance to move her/him to the host location and then to maintain them there. These benefits (think housing, relocation, education, cost of living for example) are likely taxable in both the host location and the US. However, the rules of taxability of each benefit may be different in the host country and the US. Foreign exchange rates must be applied to calculate the appropriate amounts to report in each location (See Expatriate Payroll Tips #3). Are there special laws that may be applicable to calculating tax on an expatriate’s income? For example, in the US we have very complex laws to determine how much, if any, foreign earned income and foreign housing payments can be excluded from income. And tax credits for foreign taxes paid or accrued by the expatriate are available as well.
Facing this complexity without assistance may cause your expatriate’s head to spin. Don’t worry. This is where tax equalization policy comes into play. TEQ policy fixes the employee’s tax obligation in many cases at roughly what it would have been had s/he remained at home. In its most basic form, TEQ policy is a deal between the company and the employee that says:
- We, the employer, will pay all of the employee’s ACTUAL taxes at home and abroad in return for the employee agreeing to a reduction in net pay equal to a TEQ policy-derived “tax” obligation.
- The policy-derived amount is often referred to as the estimated “Theoretical Tax”.
- Many US expatriate policies define the Theoretical Tax as the total amount of federal, state, social security and Medicare tax that the employee would have paid had they remained at home with the same salary.
- Because this amount is derived by policy, a company could instead define Theoretical Tax to be, let’s say, a flat 16% of salary, or some other amount. Remember, the computation of Theoretical Tax is based on a policy.
- For payroll purposes, the employee “pays” the estimated Theoretical Tax obligation to the employer through a salary reduction referred to as “Hypothetical Tax” or “Hypo Tax”. For clarity, if Theoretical Tax for an employee on an annual basis is estimated to be $12,000, a Hypo Tax of $1,000 ($12,000/12 months) will be retained from pay each month.
- Hypo Tax is not an actual tax. Again, it is a reduction of taxable earnings to be set up in payroll as negative earnings. It is retained from salary and, because it reduces net pay that the employee receives (like regular withholding), Hypo Tax “feels” like tax withholding to the employee.
- Because Hypo Tax is not an actual withholding, it is not remitted to any governmental authority.
- In return for the retained “Hypo Tax”, the employer “grosses up” and remits all of the employee’s ACTUAL tax (pays the tax on the tax remitted on the employee’s behalf) both in the US and in the host country.
If you are operating a payroll for a tax-equalized expatriate, then, as mentioned above, you should set up a paycode called “Hypo Tax” as a taxable negative compensation item. For example, if an employee is paid a salary of $100,000 and his/her Theoretical Tax is determined to be $20,000 for the year, then a Hypo Tax of $20,000 will be retained during each pay period from the employee as per below:
|Hypo Tax Example|
|Hypo Tax (Employees Policy-derived tax)||($20,000)|
|Box 1 Compensation:||$80,000|
Under TEQ policy, the employer is responsible for ACTUAL tax since the employee has already “paid” their fair share to the company through the reduction of their earnings via their hypothetical tax obligation.
So let’s assume that total ACTUAL federal income tax withholdings on $80,000 are 15%. FICA and Medicare are owed but, in this example, there are no state taxes. Then, the ACTUAL tax calculation looks like this:
|Federal Income Tax:||(15% x 80,000)||$12,000|
|FICA:||(6.2% x 80,000)||$4,960|
|Medicare:||(1.45% x 80,000)||$1,160|
|TOTAL ACTUAL WITHHOLDINGS:||$18,120|
Since the employer is funding all of the ACTUAL tax ($18,120) on behalf of the employee, the ACTUAL tax is considered compensation to the employee and must be taxed as well. In this case, at the same 15% income tax rate plus FICA and Medicare, the additional total tax would be $4,104. But guess what? That payment is taxable too. So the final grossup (the tax plus the tax on the tax on the tax, etc.) in this case is $23,426. You can prove this as follows:
|Box 1 Compensation||$103,426|
|Federal Income Tax||(15.0% x $103,426)||$15,514|
|FICA||( 6.2% x $103,426)||$6,412|
|Medicare||( 1.5% x $103,426)||$1,500|
So in addition to a Hypo Tax paycode, you also need a US grossup paycode to reflect the employer’s payment of the actual taxes. This is a positive, taxable earnings code. The amount in this paycode should always equal the sum of actual taxes remitted as per above. And you will want to set up a separate code for foreign taxes paid by the employer as well (but we will get to this in the next Expatriate Payroll Tips for Tax Equalization).
The reason that employers go through this gyration is because the additional benefits and allowances that typically go along with an international assignment are mostly taxable, and the employee will not have the tax to pay on the benefits if they are provided without a tax grossup. And as the interplay of the 2nd tax jurisdiction can complicate the tax calculation dramatically, it is best that the expat has an obligation that they can understand and pay on a regular basis – hence the Hypo Tax.
Under tax equalization programs, the employer often provides the employee with the services of a tax preparer who specializes in international income tax. In this way, the employee does not have to spend time or effort learning how to deal with all the home/host permutations and complexities. The employee, again, remains responsible for only his/her share of tax (in this example $20,000) and the employer bears the ACTUAL cost that results in both jurisdictions.
I hope that this provides you with a baseline understanding of the rationale for tax equalization policy and an initial understanding of the basic US paycoding involved. The second summary in this series will dig deeper into some of the more likely payroll transactions you can expect to see as part of the tax equalization process. Feel free to reach out to me if you have any questions about tax equalization or expatriate programs and policies in the meantime.
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More tips from Dave Leboff:
Expatriate Payroll Tips #1 – Skills and Competencies Required
Expatriate Payroll Tips #2 – A Review of the Balance Sheet Model
Expatriate Payroll Tips #3 – Foreign Exchange for Expatriate Payroll Transactions