Tax Equalization and Hypothetical Tax Calculations for Expats

Tax Equalization is offered by most US multinational companies to offset the additional taxes faced by their employees working overseas. Under a tax equalization policy, the employee is assured that he or she will pay neither more nor less taxes on foreign assignment than what would have been paid had the employee remained in the US.

Hypothetical Tax (Hypo Tax)

A hypothetical tax calculation is completed which represents the tax the expat would have paid had he or she remained in the US.  The hypo tax is computed on the expat’s regular “stay at home” compensation, and may include hypothetical state income tax as well.  Hypo tax is what is withheld from the employee’s wages.  The US company actually pays the taxes, both US and foreign.  This ensures that the employee is in no better or worse position (for tax purposes) by taking the foreign assignment.

Additional Amounts Included in Taxable Income

Companies that transfer employees outside their home country typically provide additional compensation to supplement base salary and bonus.  These items are intended to offset the increased cost of living abroad and to reimburse the employee for expenses associated with the relocation.  Typical payments may include any or all of the following:

·        Cost of living differential (COLA)

·        Housing differential

·        Moving expense reimbursement

·        Education assistance

·        Hardship allowance

·        Home leave assistance

·        Automobile

·        Foreign service premium

·        Family assistance

·        US home assistance

Social Security Taxes and Totalization Agreements

US Citizens working outside the US are generally not subject to US social security (FICA) tax UNLESS they are performing services for a US employer.  If they are performing services for a US employer, FICA contributions continue to be withheld from compensation, including overseas allowances and tax reimbursements, even if some or all of the compensation is excluded for US income tax purposes under the Foreign Earned Income Exclusion

US Citizens working abroad may be subject to both US and foreign social security taxes.  The US has entered into “totalization” agreements with a number of foreign countries providing for limited coordination of the US social security system with systems of the other countries. 

Exemption from Double Social Security Taxation

To establish exemption from compulsory coverage under a social security totalization agreement, an employer must apply for a certificate of coverage from the country with which the employee will remain covered.  If requested, this certificate is presented to the appropriate officials of the country in which the employee seeks exemption to prove there is coverage under the social security system of the other country.

State Taxation

Some expatriates may continue to be liable for state income taxes even though they are living abroad. Depending on the state, if an individual retains a permanent home in that state, he or she may continue to be subject to state taxation.

To prevent state taxation of income earned after leaving the state, the taxpayer must be able to support the contention that residence has been terminated in the state. Actions pointing to a termination of residence include closing bank accounts and brokerage accounts; resigning from church, social and business club memberships; closing all safety deposit boxes and department store charge accounts; allowing driver's licenses to expire; and abstaining from voting in any state elections.

Note that termination of state residence may subject dependent children to the more costly nonresident tuition rates at state colleges and universities.

Taxation in Foreign Country

Most countries impose income taxes on individuals either working in or deriving income from within their borders.  To minimize double taxation, the US has entered into Tax Treaties with 58 countries, at present.  Most US Tax Treaties include a provision that exempts a US citizen’s income from taxation provided he or she spends less than 183 days in the foreign country and the compensation is not paid or borne by an employer in the foreign country.  For those spending more than 183 days, or where compensation is paid or borne by an employer in the foreign country the US taxing system provides for a Foreign Earned Income Exclusion, a Foreign Tax Credit and as mentioned above, most US multinational companies provide tax equalization.