The Role of Human Resources in Expatriate Tax Matters

As expatriate tax matters have become increasingly complex, with home and host locations expanding into developing countries, human resources professionals face a difficult task. The role of human resources and related departments revolves around the following actions when it comes to tax:

• Determine overall policy strategy and treatment (tax equalization, tax protection, laissez-faire, ad hoc). 
• Establish what income the policy should cover (company source, personal). 
• Establish hypothetical tax formulas and ensure appropriate tax withholdings. 
• Manage the services of the external tax provider. 
• Ensure compliance with home and host tax regulations.

The following discussion provides an overview of each aspect and issues to consider when making policy decisions.

Overall Tax Policy and Treatment

International assignments are complicated by tax regulations both at home and abroad. Home-country and foreign tax laws, as well as a company’s policy, determine how the employer will treat the assignee’s spouse or partner’s income, the assignee’s income from investments and other sources not related to the company, any property ownership, and other such matters. In general, however, the majority of multinational companies attempt to focus their expatriate compensation programs, including the treatment of income tax, around the following principles: 

• The assignee will neither gain a windfall nor suffer undue financial burden as a result of the special circumstances and complexity of compensation and tax matters while on an international assignment. 
• The assignee and employer must comply fully with the tax laws and fi ling requirements of both home and host governments. 
• Tax policies are fair and reasonable, equitable to all employees, cost-effective, easy to administer, and easy to understand.

From the host-country perspective, most governments require that an expatriate pay taxes on income attributed to working in that country, irrespective of where the income is actually paid. Expatriates’ ongoing home-country tax obligations vary. Although most countries do not require nonresidents to report (or be taxed on) income earned outside the country, many expatriates still have continuing home-country tax obligations from non-employment income, such as investments. For US assignees, tax issues are particularly complex. The United States is an example of a country that requires its citizens and permanent residents to be subject to US taxation on total income – even if the individual is no longer resident in the United States.

Tax liability is likely to be higher on assignment due to higher foreign tax rates and payment of additional expatriate allowances.

• In many countries, expatriate taxes are higher when compared to the home-country tax system because the individual does not have the same opportunities to reduce local tax liability as do local-national employees. While there may be special concessions available for expatriates, such as advantageous tax rates and deductions or credits, individual circumstances do not always allow assignees to claim the same deductions as their local counterparts. For example, the assignee will probably rent a home while abroad, thus preventing the assignee from deducting mortgage interest. Another possible reason is that the assignee is likely to make charitable and pension contributions in the home country, again prohibiting the use of deductions. On the other hand, there will always be situations where the host-country taxes are lower, resulting in a windfall that would revert either to the assignee or company, depending on how the company handles taxes. 
• Many companies provide a number of diverse allowances on a tax-free basis to help assignees pay for additional expenses related to the assignment – relocation, housing, car, hardship, goods and services, children’s schooling, and so on. Although these allowances and premiums are often paid on a tax-free basis, they are considered by many countries as taxable income, thereby raising overall income and resulting in a higher tax liability.

Employer practice runs the gamut from heavy involvement (complex calculations) to little or none (the employee is responsible). Although there are four common methods of treating expatriate tax – equalization, protection, ad hoc treatment, and laissez faire – the latter two are rarely used:

• Laissez faire places the entire responsibility on the assignee for calculating and paying income taxes related to both home and host countries. Among possible results are potential windfalls when host taxes are lower, an extra liability burden when taxes are higher, and noncompliance with government requirements. 
• Ad hoc simply means that there is no formal tax policy, and the company handles each expatriate’s tax situation on a case-by-case basis. The possibility exists for inequitable and inconsistent treatment of expatriate tax. 
• Under tax protection, the employer is responsible for the assignee’s tax liability if income taxes are higher than what the assignee would have paid at home. The individual keeps any windfall when taxes are lower, but this result may raise an issue of inequity with colleagues in other locations. Further, tax protection focuses on actual tax payments, so the assignee does not know what to expect regarding reimbursement until the tax return has been fi led, taxes are paid, and differences reconciled between what the assignee would have paid at home and what was paid as a result of the assignment. As a result, the assignee might suffer a negative cash flow until the company reimburses the amount owed. 
• Tax equalization is consistent with the balance sheet approach to international compensation; the expatriate is no better or worse off financially as a result of the assignment. The employer withholds a hypothetical income tax assessed against compensation at the same level as that assessed for home-country peers. In turn, the employer is responsible for tax assessed on company-earned income (e.g., base salary, bonus). If taxes are higher on assignment, the employer reimburses the difference; if they are lower, the company keeps the savings.

Some employers might find themselves debating whether to follow tax equalization or protection. In these situations, the following considerations are helpful:

• Complexity of the process (e.g., tax protection involves accessing assignee financial records). 
•  Sources of information for hypothetical taxes (e.g., external data suppliers). 
•  Administrative costs (e.g., additional time needed to process assignee tax information). 
•  Cultural changes (e.g., resistance to intrusion in personal finances). 
•  Equality (e.g., consistency with overall expatriate program). 
•  Competitive practice (e.g., multinationals follow a tax equalization policy, but in some tax-free countries, such as Saudi Arabia or the United Arab Emirates, tax protection is relatively common. In these situations, companies have to weigh the pros and cons of providing an exception to their normal tax equalization policy for those countries.).

Income Included in Tax Equalization

What income items an employer might equalize vary by company policy. Complicating the issue is the fact that home and host tax authorities may (or may not) assess taxes on company-source income, outside income (e.g., interest, dividends), and spouse or partner employment. Although many employers limit their coverage to income directly related to the assignee’s job, a growing number include a portion of outside income. When they do, their equalization of outside income is generally similar to that regarding company-source income.

When deciding how to treat personal income, these factors come into play:

• Complexity of administration and additional cost (e.g., tracking different income components). 
•  Cultural changes (e.g., resistance to intrusion in personal finances. 
•  Whether the expatriate should be exposed to higher tax liability on outside income. 
•  Whether the company should “equalize” family income. 
•  The cost impact to the assignee and company.

Details of Hypothetical Tax

Hypothetical tax, which is subtracted from base salary and retained by the employer, approximates the amount that would be paid by home-country peers at a comparable salary level and family size. For practical purposes, making a hypothetical deduction is easier than calculating the assignee’s actual tax liability, which requires details of the family’s financial circumstances. Imagine that same task multiplied by hundreds of assignees, each with a different home-host combination and tax-related situation.

The employer uses hypothetical tax to pay home- and host-country taxes. If foreign authorities prohibit an employer from paying assignees’ foreign taxes directly, assignees are then responsible for payment (with reimbursement by the employer). The expatriate may also be responsible for home-country tax payments on non-company-source income (such as investments).

Methods for calculating federal hypothetical tax vary, typically based on the following common approaches:

• Deductions taken by the assignee’s average home-country counterpart. 
• Deductions calculated with a fixed percent of salary (based on studies of average home-country peers) that is applied to all income levels. 
• An average of the assignee’s actual deductions several years prior to the assignment.

You can apply any of these approaches, including an estimated itemized deduction model based on analysis from US Internal Revenue Service data, using the calculator in Mercer’s Personal IncomeTax Solution.

Calculating hypothetical US state taxes involves using the expatriate’s state of employment or residence prior to the assignment, deductions based on the company’s HQ state tax, or not applying the state tax deduction.

Once the appropriate deduction choice has been made, the calculations follow the general pattern listed below:

• Income (salary only) and family size are determined. 
•  Allowable deductions are subtracted from income. 
•  Allowable exemptions are subtracted from income. 
•  The appropriate gross tax rate is determined from the net income amount. 
•  Applicable surcharges or excise taxes are added. 
•  Any applicable credits, which reflect the amounts deducted from potential taxes in relation to specific items, are subtracted, resulting in a final figure representing the hypothetical tax. See Chart, “Hypothetical Tax Issues for US and Non-US Expatriates.

Hypothetical Tax Issues for US and Non-US Expatriates

For US expatriates, one should consider the following points when using US federal itemized deduction estimate:

• If the company assists expatriates to sell their homes, whether they lose their itemized deductions. 
•  If the company guarantees a minimum level of itemized deductions, whether it should apply to previous renters. 
•  The cost impact to the company of itemized deduction guarantees.

Considerations for US hypothetical state deduction estimate:

• “Keep the employee whole” principle. 
•  Complexity of administration. 
•  Disputes over relevance of prior state. 
•  Cost impact to company.

For non-US expatriates, employers should consider its tax-reimbursement policy on company-source income:

• Full tax equalization, including year-end reconciliation of hypothetical tax deductions. 
•  Deduction of hypothetical taxes without carrying out year-end reconciliation of hypothetical tax deductions. 
•  Tax protection, whereby the company reimburses expatriates for any taxes in excess of the normal home-country tax liability. 
•  Laissez-faire – expatriates responsible for own taxes. 
•  Of those companies that do year-end reconciliation, how are the reconciliations carried out? All income or only company income? Is it worth it?

Manage the Services of the External Tax Provider

The organization’s role is to help prepare the expatriate for the upcoming issues related to tax matters, often through assistance from in-house or external experts. If the company determines that an outside vendor is necessary, human resources is often responsible for identifying knowledgeable and reliable providers and researching the specific services these providers will offer to expatriate families. It is important to monitor delivery of these services and assess employee satisfaction with them. Ongoing communication with both the expatriate and the provider – before, during, and after the assignment – will help ensure that the process is going as smoothly as possible.

Ensure Compliance with Tax Regulations

Any company sending employees abroad, either formally through assignment packages or informally (frequent business travelers), will probably incur additional tax liability on employees’ global compensation. (See Chart, “Challenges Posed by Business Travelers.”) Being ill-prepared or ignoring various country reporting requirements can be very costly for the company in terms of fines, fees, and administration costs. In addition, many countries can and will impose criminal penalties on company representatives for misreporting employee compensation, whether or not the employees are country residents.

Therefore, it is critical that both the organization and the employees who fall into these categories understand the level of risk associated with working in a global environment. The fact that every country has its own set of compliance requirements (some of which can be quite stringent) further complicates the level of risk.

An assignee’s income may be subject to tax in both home and host locations regardless of where earned, paid, or received. This income includes typical assignment allowances and expenses for items such as cost-of-living, housing, foreign tax, education, automobiles, gross ups, hypothetical withholding, and relocation. Similarly, equity plans, executive compensation, and other such plans may be subject to host-country taxes even if paid after the assignee returns home. These factors explain why the company needs to capture all income and possibly report it in both home and host locations to avoid problems with tax regulators.

Challenges Posed by Business Travelers

The compliance environment is changing, bringing more focus on capturing income and collecting tax on business travelers. To this end, immigration and tax authorities are partnering. The 183-day rule only applies between countries with treaties under certain conditions and often does not apply at all if the employee’s expenses are being charged to the foreign company. The types of services that the employee is performing in the foreign country also need to be carefully reviewed, as they may be regarded by local tax authorities as directly benefiting the local company and, therefore, immediately taxable. Getting expert tax advice is essential.

Employers should consider the option of establishing processes to identify business travelers and capture/report data. In general, extended travelers (short-term assignees) fall under relocation policies/processes, but frequent business travelers are not supported by the company relocation department.

Employers should also consider taking action to ensure tax and visa compliance of extended business travelers and short-term assignees. Many companies rely on external tax and immigration service providers to monitor and advise them on potential compliance issues. Some companies implement a system requiring all employees to report international travel days or use an external provider (e.g., company travel agent) to track and report employee travel.