What Is Tax Equalization?
Moving abroad for work is exciting, but you might wonder how your taxes will change, especially if you move to a country with higher rates than the US.
Companies recognize that relocating employees overseas can be quite stressful and frustrating, particularly because these employees must file and pay taxes both in the US and the foreign country. To mitigate this stress and financial impact, employers often provide tax equalization services.
Essentially, tax equalization involves comparing the amount of tax an employee would pay while living in the US with the amount they pay in the host country. Based on this comparison, companies adjust the employee’s pay either upward or downward to ensure they are paying the same total tax as they would if they were living in the US. This is a benefit in some cases, but if you live in a low-tax country, opting out and using the foreign-earned income exclusion or foreign tax credit for yourself could be beneficial.
Expats still have to file taxes with the US, even if they don’t owe any money. It can be tricky to learn which documents to file; for help, reach out to the Greenback Expat Tax Services team. Since the company was founded in 2009, we have focused exclusively on expat taxes. Many of our CPAs and Enrolled Agents are expats themselves, and because they live in 14 time zones, they have experienced firsthand the challenges of living abroad.
Why Is Tax Equalization Important?
As part of our commitment to understanding and better serving our clients, we conduct an Annual Survey of US Expats. This year’s results, linked here, revealed several reasons why tax equalization matters.
- Double Taxation. When you work abroad, you’re responsible for filing taxes in the US and where you live. To eliminate double taxation, the government offers tax benefits. For example, the US has entered into tax treaties with over 60 different countries, which can provide additional tax savings opportunities.
- Moving Abroad Is Complicated. Competing for talented employees isn’t easy, especially when their assignment is outside the US. Hiring is easier when employees aren’t disincentivized by host countries with high taxes.
- Financial and Banking Challenges: With 38% reducing their use of financial products and 28% simplifying portfolios due to foreign banking laws, tax equalization helps alleviate the challenges of relocating overseas. By offering a more straightforward process that encourages financial engagement without fear of regulatory repercussions.
- Considering Renouncing Citizenship: Nearly 1 in 3 expats are considering it. About half feel they’ve built stronger ties in their host country than at home, while others are critical of where the US government is heading. However, 75% want to renounce simply because of the tax headaches of being abroad.
- Dissatisfaction. With 3 in 4 expats frustrated with the tax filing process and 1 in 4 lacking confidence that they’re doing so correctly, tax equalization provides support, reduces frustration, and ensures compliance.
How Does Tax Equalization Work?
Companies like Deloitte and PwC, as do many tech giants, have quite a few international employees. For example, if you were hired and sent to Japan, where the tax rate is higher, the company would use tax equalization to ensure you pay a familiar rate.
The key takeaway for you, as an employee, is that tax equalization ensures ‘no gain, no loss.’ You won’t pay extra because you’re abroad, but you won’t get a windfall from living in a low-tax country.
The administrative details are complicated, but again, they’re handled by your employer. One of the main benefits of tax equalization is that it simplifies the local tax process for expat employees. Here’s the basic gist:
- When you meet country-specific residency requirements, you must pay local taxes.
- Your employer will calculate a “hypothetical tax” representing what you would owe living in the US. It’s “hypothetical” because it’s figured by your company rather by you or your accountant. They’ll consider your likely deductions against federal, state, Social Security, and Medicare taxes when deciding how much to withhold from your paycheck. Other taxes, such as interest, dividends, and capital gains, remain your responsibility.
- Your company will pay you through its US payroll system while operating a parallel payroll to track and pay for local taxes.
- At the end of the year, the hypothetical tax will be reconciled against your actual income. If they collected more than you’d owe in the US, they’ll reimburse you. If they collected less than your host country’s tax rates specify, they’ll pay the difference on your behalf. If they collected the correct US tax amount but owed less to your host country, they would keep the savings for themselves.
Tax Equalization vs. Tax Protection
A related idea is tax protection. While tax equalization aims to make sure your tax stays the same as at home, tax protection only ensures you won’t pay more than your home tax. Under this policy, you keep the savings if your foreign taxes are lower than at home.
Tax equalization is considerably more common than tax protection.
Real-World Tax Equalization Agreement
Let’s look at a real example: SEC exhibit 10.10. Aside from identifying information, this agreement is authentic. When evaluating agreements like this, we look for a few key items:
Defined Roles
Who’s responsible for what?
In the SEC agreement, the company will pay home and host country taxes on company-sourced income associated with base pay, bonus and incentive compensation, overtime, holiday, and a variety of other standard provisions.
However, equity compensation is excluded from the company’s responsibility. If shares vest or you exercise them while on assignment, this would result in a potentially significant tax bill for the employee.
Hypothetical Tax Rate
How is it calculated?
The company will first consider marital status, filing status, and dependents to estimate hypothetical tax. Then, they will calculate appropriate federal, state, local, and social taxes.
However, one potential issue with this agreement is that state income tax will continue to be withheld, even if you may no longer be a resident. This could be refunded at the end of the year, but it does result in lower take-home pay in the interim.
Adjustment Timing
When does the company check if the taxes paid align with the hypothetical amount they deduct?
Per the agreement, estimated taxes will be calculated at the beginning of your assignment and revised once per year or upon a salary adjustment. End-of-year reconciliations will be completed within 30 days of when taxes are filed.
However, one potential issue is that the policy allows the company to charge interest for unpaid tax after the 30-day grace period. If there are discrepancies or disputes, this could result in an unwanted bill.
Tax Equalization Considerations for Expats
Tax equalization can be helpful up to a point. However, if you become a non-resident of your home country and move to a low-tax country, chances are you’ll owe less than if you stayed at home. Under an equalization agreement, you won’t benefit from these tax savings.
Additionally, no two agreements are the same. While it’s simpler to let your employer take care of paying foreign taxes for you, some policies will be more or less advantageous to you.
Most companies will provide you with resources to help facilitate your move, including tax documents and explanations. However, it’s a good idea to consult with an unbiased expat tax professional to better understand the full implications of such a move. For help, reach out to one of our expat tax services experts. We’ve prepared 60k+ returns for 18k+ expats and would be delighted to provide you with the service that has earned us a 4.9-star rating across 1,200 Trust Pilot reviews.
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