Expatriate and Foreign National Taxation
J. Allis & Co. - US Citizens

US Citizens

Hypothetical Tax

You may be covered by a tax reimbursement program while working abroad and your wages reduced by a hypothetical tax amount. These arrangements are set-up to transfer the worldwide tax risks of a foreign assignment to the employer. You pay your fair share of the worldwide liability through the hypothetical tax. The following discussion explains general tax reimbursement theory as applied in the US and does not relate to any of our clients' particular policies. Your employer's policy may apply this theory differently.

What is hypothetical tax?

Hypothetical tax is a reduction in salary which estimates the amount of tax that you would have to pay if you had not gone on assignment. This amount is only an estimate. You will still need to file your tax return and settle the final liability with your employer on a tax equalization.

Does hypothetical tax go to the government?

Hypo tax does not go to any government. It only reduces your income.

Does the IRS know about hypo tax?

Yes. The IRS has long been aware of hypothetical tax and tax equalization. In fact, this is referred to in the Sec. 911 regulations on sourcing of income for the foreign earned income exclusions.

What is stay-at-home income?

Stay-at-home income is the compensation that you would have received if you had not gone on assignment. This includes compensation such as base salary reduced for retirement contributions and medical insurance, overtime or extended workweek, performance bonuses and stock options. You are usually responsible for the amount of tax on this income while the company pays any tax on your uplifts or other assignment related benefits.

What is tax equalization?

Tax equalization is an arrangement where you pay no more, and no less, tax than if you stayed at home. Because your worldwide tax risk is transferred to the company, you know the amount of your after-tax compensation before going on assignment. Your share of the tax liability is usually estimated through hypothetical tax withholding with a final tax equalization calculation prepared after your return is filed to settle the liability with your employer.

Do I get to keep any benefits of working abroad under tax equalization?

No. Any tax benefits of working abroad reduce the employer's tax reimbursement cost for you. You do not retain any benefits such as for the foreign earned income exclusions or foreign tax credits. Usually, an employer will pay a foreign service premium which is the financial incentive to go on a foreign assignment.

How is the tax on my non-company income figured?

Under most policies, you pay the same amount of tax on your non-company income as you would have paid if you stayed at home. This means that your spouse can continue having tax withheld on his or her W-4 in the same manner. Your spouse will not suffer an increased tax liability even though you have significantly more income reported due to your assignment.

Will I owe money even if hypo tax is withheld? What are the common causes of this?

You may owe your company after the tax equalization is prepared. When the amount owed the company is a few thousand dollars or less, the balance due is often caused by hypothetical tax being withheld at too low of a rate. For example, the hypo tax may have been based on your previously completed Form W-4. However, that may have reflected itemized deductions, such as mortgage interest and real estate tax that you no longer have while living abroad.

When employees owe the company many thousands of dollars, we often see performance bonuses or commissions paid in the host country with no hypothetical tax withheld . Sometimes, income from stock options was withheld at a lower flat rate although the employee pays tax on the options at his or top rate (often 35%).

What is tax protection?

While tax protection policies vary widely, this arrangement usually lets the employee keep any net tax benefit of being on assignment. If the worldwide tax liability (foreign plus US taxes) exceeds the amount of stay-at-home liability, then the company pays the difference. Difficult situations arise when the foreign taxes are paid in a different tax year from the US taxes.

Many employers with a tax equalization policy use tax protection to settle any state tax liability.