Katie Davies: Hypothetical tax and calculating fair compensation for expatriate employees
Many UK employers and employees do not realise that staff sent abroad may have to pay taxes and file personal tax returns in both the UK and the host country.
These multiple tax obligations are, of course, inconvenient for expatriate employees. More importantly, though, these obligations may result in significant employee financial losses, or sometimes even gains.
Many multinationals have tax-equalisation policies to account for these tax differentials. These policies seek to remove any tax-related advantage or disadvantage that could affect an employee’s decision to take an international position. Without such a policy, an organisation may find that its employees are eager to be assigned to work in one country because of its low income tax rates, while declining to work in a higher-tax-regime country.
Hypothetical tax, or ‘hypo tax’, is a critical element of tax equalisation policies. The employer calculates the hypothetical tax based on the taxes the employee would have paid had he or she stayed home, excluding any assignment-related compensation.
The employer then withholds that amount from the employee’s pay check and ‘overrides’ the actual payroll tax withholding. Meanwhile, the employer takes responsibility for the payment of actual tax liabilities in both the home and host countries. In tax terms, the employee then neither benefits nor loses by relocating to the different tax jurisdiction.
Depending on employer policy, different sources of income may be included in the hypo-tax calculation. The calculation may include not only stay-at-home employment-related income such as salary and bonuses, but personal investment income, share-based compensation and spousal income. Assignment-specific compensation, such as housing allowances, are generally excluded from hypo-tax calculations but are covered by the tax equalisation programme, ensuring they are provided on a net-of-tax basis.
Depending on the countries involved, tax equalisation may not be appropriate. As always, when operating in multiple countries, it pays for businesses to plan well in advance and seek expert advice to understand all their options.
Katie Davies is senior director at Radius