A primer of expatriate tax issues

In one of my previous posts, I gave an overview of the most commonly used expatriate compensation packages, focusing on their gross income. However, expatriate compensation topics also include taxation issues, which is why a separate review of expatriate tax is worthwhile. When speaking about expatriate tax, we can differentiate between two main approaches: tax equalization and tax protection.

Tax equalization aims to maintain an expatriate’s lifestyle at the same level as it used to be at his/her home country by offsetting any tax differences that can occur while working abroad. To do so, the employer withholds the so-called hypothetical tax, which is calculated to be approximately the same amount of income and social security taxes as the employee would have paid at home. Thus, the employee is charged with a hypothetical tax, and the employer is responsible for paying the actual amount of tax at the end of the tax period. Consequently, if the actual taxes during the assignment are higher than the withheld hypothetical tax, the employer pays the difference; if taxes are lower, the employer keeps all savings. In other words, in the end equalizing taxes makes the international experience tax neutral for the assignee, and all gains or losses from tax differences are carried by the company.

In contrast, the tax protection policy benefits only the employee. As with the tax equalization approach, the employee is responsible for paying a hypothetical tax and the company pays the difference in case the actual tax liability is higher than the hypothetical tax. However, unlike the equalization approach, in case the employee’s hypothetical tax is higher than the actual tax liability, the employee (and not the employer) gets to keep the savings. In other words, if the expatriate is sent to a low-tax country, s/he will have a tax windfall, as the tax liabilities in the host country will be lower than those at home.

Latta and Danielsen (2003) argue that there is also a third type of handling taxation. Specifically, some companies that are less experienced in the global market follow what can be termed a laissez-faire approach. This method places all responsibility for expatriate taxes on the assignee, which means that the employee calculates and pays the personal taxes on his/her own and, hence, also experiences tax windfalls or extra liabilities compared to the previous tax burden in the home country. This method may lead to incompliance with governmental legislation if the employee is unfamiliar with host country rules and regulations.

Comparing the three approaches, it seems that the tax protection method is the most beneficial for the employee. However, there are also several limitations and problems inherent in this methodology. For example, as the KPMG booklet on U.S. taxation notes, tax protection may restrict employee mobility. This is because expatriates may be unwilling to move from a low-tax country to a high-tax country because of losing the ‘tax benefit’. Similarly, if the host country’s tax increases during the assignment, the expatriate may experience financial difficulties and experience the loss of a previously held ‘benefit’, which in turn can create motivational problems. Latta and Danielsen (2003) suggest that country differences in taxation rules may raise issues of inequity because expatriates in certain locations may have higher tax windfalls than expatriates in other locations. Moreover, the process of taxes being reconciled and reimbursed to the expatriate takes time, and thus creates a period of uncertainty during which the expatriate does not know what to expect financially. Also, this may lead to a temporary negative cash flow until the amount the employee is owed is reimbursed.

Therefore, the tax protection policy has its drawbacks and does not dominate the other approaches. In fact, based on their 2003 survey of tax policies in the US, the UK, and Canada, Latta and Danielsen (2003) report that the usage of tax equalization far surpasses both the tax protection and laissez-faire approaches. The 2011 Brookfield Global Relocation Trends survey echoes this finding, indicating that tax equalization outranks tax protection for host country liabilities (69% vs. 13%).

As the tax equalization approach is in line with main ideas of the balance sheet approach (see my earlier post), and with the latter being the most widely used compensation approach by multinationals, the predominance of tax equalization is not surprising. Referring to this predominance of the balance sheet and tax equalization approaches, Latta and Danielsen (2003) conclude that ‘many employers continue to believe that, in most typical assignee situations, [maintaining] the expatriate’s purchasing power and lifestyle – and tax liability – while abroad is still the approach that works best for all parties’ (p. 59).

References:

Latta, G. W., & Danielsen, T. A. (2003). Treatment of Expatriate Tax: A Look at U.S., U.K. and Canadian Practices. Compensation and Benefits Review, 54-59.