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Global Tips

Expatriate Payroll Tips: Tax Equalization—an Overview

By David Leboff, CPA

As far as global mobility policies go, tax equalization (TEQ) seems to be the least understood by payroll professionals. A U.S. 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 regarding TEQ before being involved with expatriates and asked to deal with transactions stemming from the TEQ process. I will try to provide the rationale for TEQ policies (there actually are reasons for them!) and illustrate some of the common TEQ payroll transactions and the related payroll coding.

Before we delve into the transactions, let’s first look at the reasons TEQ exists and how policies are typically structured. Because U.S. expats transferring abroad want to remain tied to certain home country benefits (such as U.S. social security, Medicare and 401(k) plans, for example), it is common for U.S. employers to find ways to report them on a U.S. payroll to protect those benefits. However, while working in a host country, the expat is likely 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 U.S. alone. Imagine, then, your expatriate, with a U.S. Form W-2 and a similar host country document trying to figure out the income tax return filing rules of the host country. That return is likely in another language, maybe with a different tax year-end (the U.K. income tax year-end, for example, is April 5) and in a foreign currency. A U.S. tax return will have to be filed for a U.S. citizen or U.S. 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 him or her to the host location and then to maintain that person there. These benefits (housing, relocation, education, cost-of-living, for example) are likely taxable in both the host location and the United States. However, the rules of taxability of each benefit may be different in the host country and the United States.

Foreign exchange rates must be applied to calculate the appropriate amounts to report in each location (See Expatriate Payroll Tips in the November Global Payroll). Are there special laws that may be applicable to calculating tax on an expatriate’s income? For example, here in the United States we have 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 great confusion. Don’t worry. This is where TEQ policy comes into play. TEQ policy fixes the employee’s tax obligation in many cases at roughly what it would have been had he or she 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 U.S. 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 he or she remained at home with the same salary.
  • Because this amount is derived by policy, a company could instead define Theoretical Tax to be a flat percentage 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 tax, 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 United States 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 pay code called “Hypo Tax” as a taxable negative compensation item. For example, if an employee is paid an annual salary of $100,000 and his or her Theoretical Tax is determined to be $20,000 (divided by the number of pay periods in the year), then a Hypo Tax of $20,000 will be retained from the employee:

Salary: $100,000

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” his fair share to the company through the reduction of his earnings via his hypothetical tax obligation.

So let’s assume that total actual federal income tax withholdings on $80,000 is 15%. Social security and Medicare are owed but, in this example, there are no state taxes. Then, the actual tax calculation looks like this:

Federal Income Tax: $12,000 (15% x 80,000)

Social Security: $4,960 (6.2% x 80,000)

Medicare: $1,160 (1.45% x 80,000)

Total Actual Withholdings: $18,120

Because 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 social security and Medicare, the additional total tax would be $4,104. But guess what? That payment is taxable, too. So, the final gross-up (the tax plus the tax on the tax on the tax, etc.) in this case is $23,426. You can prove this as follows:

Salary: $100,000

Hypo Tax: ($20,000)

Gross-up: $23,426

Box 1 Compensation: $103,426

Federal Income Tax: (15.0% x $103,426) $15,514

Social Security: (6.2% x $103,426) $6,412

Medicare: (1.45% x $103,426) $1,500

Total Tax: $23,426

So, in addition to a Hypo Tax pay code, you also need a U.S. gross-up pay code to reflect the employer’s payment of the actual taxes. This is a positive, taxable earnings code. The amount in this pay code 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.

The reason 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 he or she is provided without a tax gross-up. And as the interplay of the second tax jurisdiction can complicate the tax calculation dramatically, it is best that the expat has an obligation he or she can understand and pay on a regular basis—hence the Hypo Tax.

Under TEQ 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 this provides you with a baseline understanding of the rationale for tax equalization policy and an initial understanding of the basic U.S. pay coding involved.