When hypothetical taxes are real: Compensation policies for expat employees

Benjamin Franklin once wrote, "In this world nothing can be said to be certain, except death and taxes." He was mostly right. But in the world of expats, in addition to certain taxes, you will come across hypothetical taxes.

No, the hypothetical, or hypo, tax isn’t a genius new defense for IRS delinquents (“But your honor, let’s say my client did pay his taxes hypothetically…”). Instead, it’s a part of a tax equalization policy — a way of ensuring that your expats do not incur a tax penalty or tax bonus by working in another country. And it is something you should be aware of if you are sending employees overseas. A business can implement a tax equalization policy to remove incentives that could cloud employee decision-making about posting abroad. Without one, you might find all of your employees clamoring to secure an assignment to Bermuda and refusing to work in Belgium simply because of how it would affect their personal tax burdens (and, well, there’s also the weather).

Under a tax equalization arrangement, an expat employee has their hypothetical tax burden withheld from their paycheck — that is, the taxes they would have paid had they stayed home. Meanwhile, their employer is on the hook for taxes the employee is liable for, both at home and in their host country. An employee will not lose out from an international move that increases their tax burden, and similarly, they will not benefit from moving to a lower-tax jurisdiction.

It is a simple enough policy, but with anything that includes tax considerations across borders, there are endless complications. To start, employers have a lot of questions to ask themselves in formulating their tax equalization policies. Will you include only salary income, or also account for tax differences on investment and spousal income? And will an employee’s hardship allowance (which they wouldn’t have earned if they had stayed home) be eligible for tax equalization?

Multinationals should also be aware of when a hypothetical tax becomes truly nonexistent. Some countries — including Switzerland, Mexico and the Netherlands —let you off the hook for withholding tax on expat compensation if you are only working there temporarily and your firm has no official presence in their country. And if an expat’s home country has a tax treaty with their host country, it may eliminate some or all of the need to go through the tax equalization exercise. 

Being up on your tax equalization Ps and Qs is just another one of those HR and accounting wrinkles that comes with the territory of an international expansion. Now, if only all tax were this hypothetical.