The fundamental principle behind tax equalisation is that an expatriate should be no better off or no worse off as a result of being assigned abroad. This, presumably, is in place to encourage expatriates to work for their employers wherever they may be sent, sure in the knowledge that they are not disadvantaged tax-wise and their tax affairs are taken care of by the company's appointed tax advisers. Indeed, it is very common for the employer to enlist the assistance of a firm of tax advisers to oversee the preparation of both home and host country tax affairs, and, crucially, the payment of any local tax and social security which may be due as a result of the assignment to the host country.
How Does Tax Equalisation Work?
A calculation is made of what the home country tax liability would have been on the non expatriate components of an individual's remuneration package – in other words, salary, standard benefits in kind, bonuses, stock options etc. No account is taken of cost of living allowances, and other expatriate benefits such as disturbance allowance, school fees, home leave and local accommodation etc. Therefore, an individual seconded from (say) the UK to the United States would have an amount of "hypothetical tax" withheld from their earnings each month in line with what they would have paid on the non expatriate parts of their salary package if they had remained in the UK.
It follows that the individual therefore suffers no personal tax burden as a result of the expatriate aspects of the assignment such as cost of living allowance, disturbance allowance and accommodation in the host country. The only "tax" that the individual pays is the "hypothetical tax" withheld at source to reflect home country tax and social security liabilities.
Of course, if someone becomes non resident in their home country, it is unlikely that any great liability to tax would have existed there anyway, however we must remember the aim of tax equalisation is to ensure that the individual is no better or no worse off as a result of the assignment. Therefore, the individual is required to bear the cost in terms of tax and social security that they would have borne on the non expatriate parts of their salary package, as if they had simply not gone on assignment.
Conversely, it is the employer's responsibility to bear the cost and discharge any personal tax and social security liabilities resulting in the host country. Therefore, in the example just cited, the employer would be responsible to pay US federal, state and city tax and social security on the individual's entire salary package as a result of their assignment to the US. Note that it is the entire remuneration package which is subject to tax in the host country (subject to whatever the local tax laws are), and not just the non expatriate elements.
The payment of tax on behalf of an individual is, normally seen as a benefit in kind itself which adds to the taxable part of salary. Therefore, an additional liability to tax arises on the amount of tax paid by the employer and so on. In order to calculate final liability to host country tax to be borne by the employer it is necessary to undertake a process known as "grossing up". I will not explain this in detail, however suffice to say that the company often needs to bear a far greater level of tax to that which the individual would have paid if they had simply stayed at home or been responsible for meeting their own tax obligations in the host country.
Two Key Implications
Of course, the theory is all well and good. An individual bears tax to the same level they would have borne on the non expatriate elements of their salary as if they had stayed at home. The employer bears the actual cost of the tax in the host country, whatever that might be.
The "rub" is often when an individual moves from a high tax country to a low tax country – i.e. from, for example, the UK to Hong Kong, or Holland to Hong Kong – an individual continues to pay a level of hypothetical tax equivalent to what he would have paid in the home country (the higher tax country) whereas the company actually has a burden to tax at a lower rate in the host country. Under these circumstances, the company can be better off than the individual as a result of this arrangement.
However, the reverse is also true. If an individual is seconded from a low tax country to a high tax country (such as from Hong Kong to the US or from the UK to Norway, for example), the individual retains the liability to tax equal to what they would have paid in the home country, whereas the employer faces a much more significant burden to tax in the host country.
By agreeing to enter into a tax equalisation scheme, the expat effectively removes themselves from any entitlement to an actual tax refund i.e. if more than sufficient local tax was withheld through the payroll to cover the actual tax liability. By the same token they are not responsible for paying any additional tax demands in the host country. At the end of the year, the company should engage a tax adviser to make a calculation of the amount of home country tax and social security which would have been paid on the non expatriate elements of the salary, and compare this to the level of hypothetical tax actually withheld from the individual's salary. This can sometimes result in discrepancies, either in favour of the individual or in favour of the company.
If it is calculated that an individual has had too much hypothetical tax withheld through the payroll, they will be due a refund from the company. Alternatively, if too little hypothetical tax has been withheld through the payroll a further settlement would be due to the company.
Is it fair?
I suppose that this depends on whether you are seconded to a low tax or a high tax country. In my experience, a country will operate a "global policy" either to apply tax equalisation to every assignment (regardless of from where or to where the individual is assigned) or they will simply do nothing and leave responsibility for the payment of tax and filing of tax returns to the individual in their host country.
A company can, of course, operate whichever policy it wishes. In theory, it can also be selective about where it operates tax equalisation and where it does not.
If an individual is tax equalised I think it is also important not to forget the added benefit that the individual's tax affairs would normally be dealt with by competent professionals both in the home and host country. The value of this should not be underestimated as issues of residence, global mobility and international remuneration packages are constantly changing. Frankly, it would be almost impossible for an individual to be reasonably expected to manage their tax affairs in both jurisdictions to cover the correct taxation treatment of, for example, phantom stock options, long term productivity bonuses, capital gains tax etc. Can you imagine how difficult it would be to grapple with the international tax regime of, say, Japan, not to mention having to deal with the Japanese authorities personally – if it were not for the team of professionals that the company had employed to attend to this on your behalf?
So am I arguing for tax equalisation? No – not particularly. It is true that tax equalisation can confer some fairly significant benefits on an expatriate but, as we have seen, there can also be downsides.
It simply comes down to understanding the expatriation process relevant to your employer and the terms governing your assignment. I suppose that the million dollar question is whether an individual employer will allow individual assignees to opt out of tax equalisation if it is in their best interests to do so. That is a matter for negotiation on a personal basis with the employer.
Source: The Fry Group