Hypothetical Tax: What is it and Why it Matters in Global Mobility
Determining accurate “hypo” tax for transferees can be a recurring challenge for any global mobility policy – but it doesn’t need to be that way.
Death and taxation are commonly referred to as the only two certainties in life. While taxation is a familiar theme across societies worldwide, taxation strategies can widely vary from country to country. As a result, globally mobile businesses face many challenges in managing taxation rates across international borders.
International assignments require compliance with various taxation laws, regulations, and rates. Failure to do so can significantly impact employers’ and employees’ financial liability, causing widespread differences in tax levels and rates and possible unexpected expenditures.
Recognizing these differences and applying proper taxation levels is necessary when managing the financial ramifications of employees on international assignments. But how can a business ensure their transferees are protected from the potential tax pitfalls of working abroad?
What is tax equalization?
Changing locations from home to host country can impact an employee’s tax liability. Tax equalization is a tax management approach designed to balance the amount of taxes paid by a transferee working abroad.
Under tax equalization, the employee’s level of taxation is similar to what they would have paid if they’d remained at home. This method of tax management intends to prevent tax payment dislocations for the transferee.
In tax equalization, the expat worker pays a tax rate similar to their home location rate, regardless of the tax rate of their host country. This rate is also known as a “stay at home” tax rate. The employer then assumes responsibility for covering the transferee’s actual tax costs for home and host countries. In turn, the employee remits payments (i.e., the hypo tax) to their employer per the company’s tax equalization policy.
The result of tax equalization should leave employees in a financial position that’s neither favorable nor worse than remaining in their original country of residence.
What is a hypothetical tax?
Hypothetical tax, or “hypo tax,” is initially an estimated level of withholding to deduct from international transferees to ensure tax equalization. This figure is the amount deducted from the employee’s wages which the company can use to pay actual costs of the assignment, usually domestic and foreign tax expenses.
As the name implies, hypothetical tax isn’t an exact science but rather a method the employer can use to apply taxation based on the company’s individual policy.
How is hypothetical tax calculated?
Hypothetical tax is typically calculated by taking the transferee’s base compensation and netting down to the applicable taxes based on the home location’s laws, regulations, and rates. Note that social security contributions are often included in the estimated hypo tax calculation and deduction from the transferee.
Once tax returns are completed for a tax year, a final hypo tax is calculated and compared to the estimated hypo tax deducted from the transferee throughout that tax year. Any difference results in a refund of any overpayment of estimated hypothetical taxes to the transferee or an additional payment from the transferee to the company.
What income is hypothetically taxed?
Hypothetical tax is calculated by determining an initial, estimated reduction to base salaries. Aside from base salaries, other forms of stay-at-home compensation such as bonuses and equity compensation should be considered. To ensure sufficient tax is withheld, many organizations include items such as non-guaranteed bonuses in the hypo tax calculations.
Note that relocation/assignment-related compensatory figures such as cost of living amounts and per-diem allowances usually are not included in hypo tax calculations.
How can your mobility program avoid hypothetical tax surprises for international transferees?
Organizations should practice their due diligence to minimize tax surprises for themselves and their transferees. Planning can reduce unforeseen tax bills, help avoid uncollected tax equalization settlements, and limit the frustrations of both employees and employers.
It’s also essential that your global mobility policy considers facilitating a financial position/cash flow scenario that lies in the best interest of their employees. Taxation strategies should focus on monitoring budgets while balancing the interests of both the employer and employee.
Reviewing prior-year tax positions and applying realistic forward projections can offer both the employer and transferees peace of mind. If possible, prepare transferees for future taxes by including new estimates related to personal income and deductions that may change year-to-year.
The easiest way to ensure your hypothetical tax calculations are correct is to use reliable global mobility assignment software. Dedicated global mobility software helps companies manage the intricacies of hypothetical tax situations while ensuring accuracy and compliance.
Let Ineo Support Your Company with Hypothetical Taxes
Domestic and international assignments can be frustrating when managing the ins and outs of taxes. Ineo can help organizations determine hypothetical taxes and taxation rates by providing specific tools to help manage the nuances of global mobility assignments.
Learn more about how Ineo’s global mobility tax services and solutions can provide the tools and knowledge necessary to manage your organization’s relocation strategies and minimize any tax surprises associated with your mobility program.
Find more information like this in our 2022 Tax Book