Expat Taxes: Balancing the books
Companies that post employees abroad should consider tax equalisation policies to offset employee tax burdens associated with expat assignments. Businesses should decide when to tax-equalise based on factors that include company culture and host-country tax triggers. Tax equalisation can be costly for the employer but helps to provide transparency, and attract and retain top talent while minimising “assignment cherry-picking”.
Organisations that provide tax assistance to expats must decide whether to offer tax equalisation or tax protection, along with the types of income that will be eligible. The company must determine the different types of withholdings it must make based on host-country laws, tax treaties and other factors. It must also know its options for paying the expat and making withholdings. One solution involves keeping the employee on a UK payroll while establishing a “shadow payroll” in the host country.
If your company sends staff abroad, there are advantages to having a tax equalisation policy. It will offset employee tax burdens associated with overseas assignments while ensuring employer tax compliance in home and host countries. Many of these policies are shaped more by company philosophy than legal requirements. But making the right decisions about what to include in the policy is critical to achieving a balance between attracting and retaining top talent, maximising tax advantages, and streamlining expatriate tax reimbursement processes and payroll administration.
When equalisation is suitable
An employee who is posted overseas may trigger host-country income or social tax obligations or both, even if they stay on a UK payroll. If this is the case, their tax burdens will be different from those in the UK. Companies implement tax equalisation policies to address these discrepancies. In short, a company agrees to provide its expats with additional compensation so that they do not pay more in taxes while on assignment than if they had remained in the UK. The provision of such additional compensation is in itself a taxable benefit that must be accounted for.
Depending on host-country tax laws, some assignments – typically those of fewer than 183 days and where the costs are not recharged to the host country – may not trigger host-country tax obligations.
In some cases, a company may decide not to offer tax equalisation. Different factors will contribute to this, including the potential cost. However, those that do not offer tax equalisation should implement a policy that clearly explains to expatriate employees that they will be responsible for meeting home- and host-country tax and filing obligations.
The UK has income and social tax treaties with some countries to reduce or eliminate employee double tax burdens. However, even if you send staff only to these countries, equalisation may be appropriate because some taxes are not exempted under the treaties.
Many companies will decide to tax-equalise their expat employees. Although this places financial and administrative burdens on the employer, it provides consistency and transparency. It also helps to ensure that employees will not be deterred from accepting assignments in high-tax jurisdictions and minimises the impact of “assignment cherry-picking”, driven by personal tax motives.
Tax equalisation policies
If assistance is provided to expats it will be necessary to make several decisions about your approach. For example, will your policy enable expats who go to a low-tax jurisdiction to retain any tax advantage that they may make from the assignment or will the company look to “internalise” this saving? Here the employer needs to make the decision between a tax equalisation or a tax protection arrangement. Tax equalisation ensures the expat is no worse or better off by taking the assignment, whereas tax protection ensures they are no worse off.
Most companies prefer to implement policies that ensure expats make no tax loss or gain. These have the added benefit of making each destination equally attractive.
The organisation must also decide what types of income will be covered. An employee’s salary and variable compensation will be included, but it is possible to include non-regular compensation or specific assignment-based income such as housing, relocation assistance or school fees. Typically, assignment-related payments are excluded from tax equalisation programmes, and the company would bear any tax liabilities arising from them since these are wholly attributable to the assignment. Elements that are not tax-equalised should be articulated to ensure that the expat understands the impact of taking the assignment. Finally, when deciding what items are eligible, keep in mind that tax regulations are constantly changing, which can affect the business’s bottom line.
Each country has its own laws dictating when a foreign employer must apply tax withholdings through a local payroll and remit them to local tax authorities. An employer must by law withhold certain amounts from its employees’ income earned in-country, and forward these to host-country tax and social security authorities. In some countries, once an expat employee has been there for 183 days in a 12-month period, the employer must apply withholdings through a local payroll. These obligations may involve complying with national and regional laws, for example in the US, where federal withholding obligations and those that are state-mandated will need to be respected.
The different types of withholdings need to be established. In a country without a reciprocal agreement for social security with the UK, the employer may need to withhold host-country social taxes as well as income taxes.
Running a “shadow payroll”
There are three primary options for paying the employee and making withholdings in the host country: use a host-country payroll; establish a “split payroll” (paying some compensation portions through home- and host-country payrolls); or keep the employee on a UK payroll while establishing a “shadow payroll” in the host country.
The last of these options is often the default mechanism for tax equalisation.
First, a provider should be hired to establish a shadow payroll in the host country. Next, the employee’s hypothetical tax (hypo tax) must be calculated. This is derived from estimating the taxes the expat would have paid had they remained in the UK. These are deducted from the monthly UK payroll but in most cases not remitted to UK authorities. The employer will keep the monthly Income Tax withholdings from the UK payroll and use these to pay authorities in the host country.
Meanwhile, in the host country, the shadow payroll will be used to track withholdings based on earnings. Under the tax equalisation policy, the employer will be responsible for paying differences if host-country taxes exceed home-country taxes. The shadow payroll will be run on a “net to gross” basis. That is, since the expat is paid a salary “net of hypothetical UK taxes”, the shadow payroll amounts must be grossed up to reflect the benefits of the company paying the host-country taxes on the employee’s behalf.
Although the shadow payroll will not be used to pay the employee, money must be sent to the expat. In this scenario, the company may consider different options for delivering the compensation. These could include wiring the money from the UK payroll to the expat or using a local legal entity to issue a cash disbursement. A tax equalisation policy should clarify whether the employee will be reimbursed for exchange rate losses when paying in host-country currency or reimbursed for wire transfer fees.
At the end of the tax year, the employer will prepare a final hypo tax calculation that accounts for salary changes or additional variable pay that might not have been captured. Almost certainly the monthly recurring hypo tax deductions will have led to an overpayment or underpayment by the employee, based on all compensation subject to hypo withholding and on what the employee would have owed in UK taxes had they remained at home. As a result, the employee may owe money to the employer or the employer may owe money to the employee. This is known as the tax balancing calculation.
Developing and implementing a tax equalisation policy is complicated, but if a company wants to compete in the global marketplace it’s essential and may require expert advice. Tax equalisation policies not only help employers to manage risks, they help to set clear expectations and promote global mobility across the workforce.