Mobility Basics – What are tax equalisation and tax protection?
We look at the advantages and disadvantages of tax equalisation and tax protection to help you decide what approach is best for your organisation.
In today’s cost-conscious world companies sending assignees to work abroad need to have tax management policies in place. It needs to be clear from the outset who will bear the burden or enjoy the gains of the international tax differentials – the employee or the employer.
Life would be very simple if tax rates were the same around the world, but in reality they vary from country to country. Also, when an employee goes on assignment, their tax liability usually changes. If the assignee becomes tax resident in the host country, their income will be subject to income tax there, regardless of where they are paid. At the same time, there may be continuing tax and/or social security liabilities in the home country if they remain tax resident there during the assignment. Remember that fiscal law determines tax residence, not the employee’s or employer’s choice.
An effective tax management policy can help promote mobility by ensuring that the generous or punitive tax regime of the destination country is not the deciding factor for accepting or refusing an assignment. Generally, companies will use either tax equalisation or tax protection, but some use a laisséz-faire approach which leaves the assignee to take responsibility for their own tax affairs.
In simple terms, tax equalisation means that the employee pays no more and no less tax while on assignment than they would have paid had they remained in their home country. Tax equalisation remains the most common approach to tax management, used by 80% of companies according to our latest Expatriate Salary Management Survey.
The company bears all the actual home and host country tax due. The employee’s contribution to the tax burden is the hypothetical tax they would have paid had they not gone on assignment. This amount is deducted from notional home salary in the calculation of the assignment salary using the build-up or balance sheet approach.
If the actual tax due is higher than the hypothetical tax (or hypotax) withheld, the employer pays the difference.
If the actual tax due is lower than the hypotax, the employer keeps the difference.
We also need to keep in mind that payment of tax on behalf of the employee is normally considered a taxable benefit itself and therefore attracts an additional tax liability. ECA’s assignment management system, ECAEnterprise, automatically takes this “tax-on-tax” into account in salary calculations and cost projections.
How do you calculate hypothetical tax?
As it is by definition hypothetical, the way to calculate hypothetical tax is not enshrined in tax law and must instead be determined by company policy.
58% of companies applying tax equalisation use a set of standard assumptions to calculate the hypotax, rather than trying to replicate an individual’s exact tax position. In doing this, they strike a balance between accurately estimating an individual’s home country tax and social security liability and keeping the process simple by using a standard calculation methodology for all assignees.
This approach also promotes employee equity by avoiding the scenario where employees with the same home gross salary could receive very different assignment salaries for the same posting.
Most companies therefore calculate hypotax using a country’s standard rates of tax and social security contributions, including the deductions and credits that are available to all taxpayers. The assumptions are usually varied according to family size, which raises the question of whether or not to include family allowance (child benefit) payments in the calculation.
In several countries (the UK for example) family allowance is paid as a cash allowance. In other countries such as Germany, taxpayers with children may receive either a deduction from taxable income or a family allowance payment, whichever is most beneficial to the taxpayer. Therefore, if you have an employee from the UK and an employee from Germany and your policy is not to include family allowance in hypotax calculations, the UK employee would be at a disadvantage compared to the German employee who receives the tax deduction.
Advantages and disadvantages of tax equalisation
Makes assignments tax neutral
Can be expensive to administer
No financial surprises for the assignee
Onus on the company to be compliant
Encourages tax compliance
Potential assignee resistance unless policy well explained
Potential windfall for companies generated by assignments
An alternative to tax equalisation is tax protection. In this approach, the employee will pay no more tax while on assignment than they would have done in the home country, but could end up paying less if the host country tax burden is lower than in the home country.
The company will reimburse the employee for any excess tax resulting from higher tax rates in the host country but will not benefit from the situation where the tax is lower in the host.
Unlike tax equalisation, the employee bears the responsibility for paying home and host country taxes.
According to the Expatriate Salary Management Survey, 5% of companies apply a tax protection policy.
Advantages and disadvantages of tax protection
The assignee can benefit from lower tax rates, which may be an incentive to undertake an assignment
May impede mobility and/or repatriation to higher-tax countries
The employer loses out on potential cost-savings by allowing the assignee to keep the windfall
The assignee may experience cash flow difficulties
Potential compliance risk as the assignee may under-report the taxable income
Which approach should you use?
You may wish to consider the following when contemplating your company’s tax management policy options:
How many employees will be affected?
If you are only managing a few assignees, it may be practical to deal with tax on a case-by-case basis. If you have hundreds of assignees, a simple, standard procedure for managing tax differentials is essential for a smooth-running mobility programme.
Are host country taxes higher or lower than home country taxes?
The bigger the differences, the more important an effective tax management policy will be. This can help to give an indication of the tax burden the company might bear or the windfall they might receive.
Do you have the tools and resources to undertake complex hypotax calculations?
If not, then a simple, standard calculation methodology would be beneficial to the administrative process.
How high is the risk to your reputation should there be any compliance issues?
Any compliance failures by the assignee could reflect negatively on your company’s reputation. More importantly, failure to comply with the local tax law could result in expensive financial penalties being levied and being barred from doing business in that country.
Both tax equalisation and protection are advantageous to assignees as they ensure they will not be at a disadvantage due to tax differentials on assignment. Under tax protection, they could even receive a cash windfall.
Whichever tax management policy you choose to apply will impact the total costs of the assignment, particularly when factoring in that any tax reimbursement is likely to result in a further tax burden itself. Depending on the countries you operate in, the tax equalisation approach at least offers the potential of cost savings to the company. This, in addition to removing tax as a barrier to mobility, is why it is used by so many companies.
Find out more
Clear and comprehensive tax reports are available for more than 100 countries as part of a subscription to ECA data and can also be bought on demand.
ECA’s hypothetical tax data is built into our various assignment calculators and cost projections, including our assignment management system ECAEnterprise.