The pains and gains of tax equalization

By Geraldine C. Esguerra-Longa, 5 September 2013

To keep up with the rapid pace of globalization, companies are realizing the value of human capital as a source of competitive advantage. And so, in the past years, we have seen a paradigm shift in how companies have reengineered the recruitment process from the traditional domestic in-sourcing to cross-border outsourcing, foreign work reassignment, and overseas employment where employees are sourced from any part of the world. Thus, getting the right people to the right places at the right time is now the rule of the game for global businesses.

While global mobility has clear economic benefits for the organization, its employees, and the economy at large, it also comes with cost exposures -- from travel and relocation expenses, daily cost of living, and legal charges, among others. Yet, what is often understated, if not left out of the economic equation, is the tax cost, which is one of the highest costs of international assignments for the employer.On the part of the employees, mobility also affects their tax position, either positively or negatively. Therefore, the issue of taxes can be the deal-clincher or deal-breaker in deciding whether or not to accept a foreign post. For instance, between a secondment in a low-tax country like Hong Kong and a high-tax country like Australia, a Filipino employee falling under the maximum tax bracket of 32% would opt to go to Hong Kong, as he is likely to pay tax at a lower rate of 17% compared with 45% (maximum rate) in Australia.

By and large, foreign assignment is dictated by business needs rather than the employee’s discretion. Thus, to make taxes a neutral factor in the employee’s decision to accept or decline a foreign assignment and soften the impact of potential higher taxes, companies strategically resort to tax equalization.

Tax equalization is a process that ensures that employees continue to incur a tax burden approximate to what they would have incurred if they remained in their home country; hence, it ensures that employees neither suffer a financial burden nor realize a financial windfall as a result of the international assignment.

Under tax equalization, the company takes responsibility for funding the employees’ actual worldwide (home and host) tax liability, but in exchange, collects hypothetical tax from the employees.

Hypothetical tax is a key element in tax equalization as it is the amount of tax that employees would have paid if the assignment had not occurred. The computation is typically based on “stay-at-home” income and deductions only, i.e., the income and deductions that employees will ordinarily be entitled to when filing an income tax return if they remained working in the home country. The computation therefore excludes additional benefits or compensation brought about specifically by the foreign assignment (assignment-related income).The hypothetical tax replaces the actual withholding taxes that would otherwise have been retained from the employees’ compensation. By yearend, the total estimated hypothetical tax withholdings of the employees are reconciled with their final or the “should-be” hypothetical tax. This reconciliation could result in either a refund to the employees (in case of overpayment of hypothetical taxes), or reimbursement to the company (in case of underpayment). By collecting hypothetical taxes from the employees, the net tax reimbursement cost of the employer is also reduced.

While tax equalization uses but one general principle, it is not a one-size-fits-all model. Due to the complexities and subjectivities involved in its implementation, a tax equalization policy should be formulated based on the attendant circumstances and cost appetite of the company, i.e., what items of income and losses the company is willing to tax-equalize, as well as the process and timing for the settlement of any under or over withheld hypothetical taxes.

Thus, in practice, tax equalization policies differ by company and even by industry. Policies can be so diverse that anyone who attempts to design one will discover it to be more of an art than a science. This is made evident especially when considering different assignment scenarios or various compensation packages the company may provide in the future.

The challenge, however, does not stop at the design stage -- for what good is a well-drafted policy if not implemented properly? For program administrators, the implementation stage is where the heart of the problem usually lies.

Since tax equalization may pose a sensitive issue for employers and employees alike, open and candid communication is a foremost consideration during this stage to ensure that both parties understand the policy and commit to their responsibilities under the program. Specifically, the employees need to understand that tax equalization is not synonymous to tax exemption, as what most employees are likely to presume.

Thus, it is in the best interest of both parties to have a pre-assignment consultation that provides an opportunity for the parties to take stock of relevant accountability clauses, including the tax equalization policy, incorporated in the employees’ assignment contract.

Another important consideration during the implementation stage is to avoid undesirable surprises for the employees during the yearend settlement, such as ensuring that the employees’ estimated hypothetical tax withholdings approximate, as close as possible, their final hypothetical taxes. Some employers even design a proactive policy to ensure that the settlement would result in the company owing a balance to the employees rather than the other way around -- since chasing employees for repayments can be downright difficult and frustrating.All things considered, the key to reaching a reasonable compromise between the parties on any issue that may arise would be having a sufficient level of understanding of the rudiments and mechanics of the policy.

Despite the challenges, however, tax equalization offers intangible benefits that far exceed its complexities, such as:- facilitates mobility of employees by making any assignment location (whether a high-tax or low-tax country) tax-neutral, i.e., producing no tax benefit or detriment to the employee;- provides equitable tax treatment to employees, thereby avoiding or at least minimizing individual negotiations in terms of assignment package;- provides employees with manageable cash flow through regular payment of hypothetical taxes;

  • reduces the risk of non-compliance in both home and host countries, with the employer paying the employee’s tax liabilities in the home and the host countries as they fall due;
  • regulates the overall employer cost of the international assignment since savings from employees posted in low-tax countries will offset the additional costs incurred for employees posted in high-tax countries.

On a personal note, it would seem that tax equalization continues to be the popular choice of tax reimbursement among a number of global companies because of the perceived fairness of the program. However, in reality, its benefit almost always tilts in favor of one party. An assignment to a high-tax country will generate a tax windfall to the employee (as the employer pays the tax difference between his home and host countries) while an assignment in a low-tax country will generate a tax windfall to the employer (as the employee is expected to contribute a higher amount of hypothetical tax).

Perhaps, fairness is not the standard by which the success of any tax equalization policy should be measured. Rather, its optimal advantage lies in the forging of a comfortable compromise towards a “win-win” relationship between the employer and the employee. For, in the end, what matters is that parties part on a firm handshake, mutually satisfied and benefited by their agreement.

The author is a director at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network. 

Views or opinions presented in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The firm will not accept any liability arising from such article; the author will be personally liable for any consequent damages or other liabilities.