Companies that regularly engage in international work typically attempt to account for foreign tax for their workers. However, there are two distinct systems that are often used to accomplish this same goal: tax equalization and tax protection.
While these terms sound similar and accomplish similar goals, there are important differences between them. These differences may make one version a better fit for certain businesses. Tax equalization is when a company covers an employee’s tax obligations in both countries while the employee pays back the company for their U.S. tax obligation. Tax protection is a bit different and involves employees being reimbursed by their company for their taxes up to a certain amount. Rather than calculating actual tax obligations, companies use a comprehensive list of tax assumptions to estimate a hypothetical tax rate that employees are responsible for. Tax obligations are important as they simplify an otherwise very complicated legal process and make it easier for people to work and live abroad. Exactly how and when you deal with equalization or protection depends on your situation.
US Tax Help and CPA Ted Kleinman can assist your company in weighing the relative advantages and disadvantages of each system if you call this link – get in touch and schedule an evaluation of your case.
What is Tax Equalization?
Many people who live and work overseas may worry that they will pay excessive taxes or suffer from double taxation. However, the U.S. Tax Code has accounted for the possibility that a U.S. taxpayer assigned to work in a foreign country could face either extremely favorable or extremely unfavorable tax treatment due to the interplay of the U.S. Tax Code and the laws of the nation where the taxpayer is assigned.
The intent of tax equalization is to equalize the amount of tax paid so that the taxpayer who is living and working abroad pays what they would have paid in tax domestically. That is, the goal of tax equalization is to level out the amount of taxation so that it is similar to what the taxpayer would be assessed if they stayed within the United States.
When utilized, an employer is responsible for covering the overseas employee’s or assignee’s tax costs for their assigned nation and their home country. For their part, the employee then remits payments to the company per terms of the company’s tax equalization policy.
These payments should be collected from the employee every pay cycle, and once a year, the hypothetical tax amount should be reconciled with the actual tax amount. This can lead to the employee or assignee having to remit additional payments or the company having to return a portion of the already paid funds.
What is Tax Protection?
Tax protection has similar goals to tax equalization, but it accomplishes them in a different manner. Tax protection largely puts the burden of home country and foreign tax compliance on the employee. The employee is responsible for paying all local and international taxes. An annual assessment of the taxes paid may be performed at the end of the tax year.
If the actual taxes paid are greater than the hypothetical amount that would have been paid had the worker stayed home, the company must reimburse the worker. If the amount in actual tax paid is less than the hypothetical stay-at-home amount, then the worker does not receive any remittance.
This tends to be a less popular way of organizing taxes than tax equalization. However, it tends to have similar outcomes for employees.
Are there Benefits or Drawbacks to These Methods?
The tax protection method is often favorable to businesses because the company does not have to cover taxes for the entire year until the annual assessment is performed. However, this type of system can lead to some negative consequences.
First, if the employee lives in a high-tax jurisdiction under a tax protection system, the individual may experience significant cash flow issues. Furthermore, the employee can reap a significant tax windfall if the hypothetical tax is under-calculated.
By contrast, the tax equalization method may require additional oversight and administration by the company, but it provides greater fairness, increased tax compliance rates, and flexibility. Fairness is present in tax equalization schemes because the worker assigned to a foreign country is put in a tax-neutral position. This scenario permits greater flexibility as the individual may move from country to country, as work or the project dictates, without having to account for changes in levels of taxation.
Why Are Tax Protection and Equalization Important
You might be wondering why even go through the process of tax equalization or tax protection. If you are working and living abroad as part of your job, you might assume it would be easier if you just handled your taxes on your own. The problem is that handling U.S. taxes is notoriously confusing. Dealing with tax obligations in a foreign country in addition to the United States might be a full-time job itself.
Tax protection and tax equalization allow people to work abroad while simplifying their tax situation. Instead of calculating domestic and foreign tax obligations and finding tax breaks and incentives to minimize these obligations, your employer may take care of it for you.
Often, these situations are beneficial for employees and employers. If an employee works in a foreign country with higher taxes, tax equalization or tax protection ensures they pay less money and have lower tax obligations. If they work in a country with lower tax obligations, the employer may benefit, as the amount of taxes they cover for the employee is lower.
What is a Hypothetical Tax for Tax Equalization and Protection?
People whose work takes them abroad might see something referred to as a “hypothetical tax.” This is an important element of tax equalization and tax protection. The hypothetical tax, sometimes abbreviated as hypotax, is the normal tax you would pay if you were living in the United States. This tax is hypothetical because it is not calculated by the IRS but by employers.
There are no laws that specifically dictate how the hypothetical tax is to be calculated when exercising tax equalization or protection. Instead, these figures are based on company policy rather than formal law. Because each employee might be in a unique tax situation, it could be extremely difficult for a company to accurately calculate individual hypotaxes for everyone. Instead, many companies come up with a comprehensive list of tax assumptions for their employees to determine their hypotax. Your actual tax obligations might be a bit more or a bit less.
If you use the tax equalization method, your employer would pay your taxes on your behalf, and you would cover the cost of foreign taxes up to the value of the hypothetical tax. If the foreign taxes in the country where you work are higher than the hypothetical tax, your employer would pay the difference. If they are less, your employer pays nothing.
Under the tax protection method, you would pay the actual taxes that are due. Your employer would then reimburse you based on the hypotax.
How Does Tax Protection and Tax Equalization Come Up When I Pay My Taxes?
If you work for a company that utilizes tax equalization or tax protection, you might be wondering how this comes up when it comes time to file your taxes. The answer to this question depends on which method you are using. Most companies with employees working abroad use the tax equalization method. The tax protection method is less popular, although some companies use it.
If you use the tax equalization method, your employer would cover your tax obligations for both countries. In return, you would pay your employer the value of the hypothetical tax based on your normal U.S. tax rate. Exactly how and when this money is exchanged might depend on your job. It might be taken from your pay automatically, or you might have to navigate other corporate channels.
Tax protection tends to be less popular because, while everything tends to even out in the end, it can be cumbersome for employees to keep up with. Generally, employees pay all their taxes themselves and are later reimbursed by their employer for the hypothetical tax. As mentioned above, if tax rates are high in the foreign country where you work, you might have difficulty maintaining a healthy cash flow as you cover various tax obligations before reimbursement.
Rely on My International Business Tax Experience
Ted Kleinman of US Tax Help is a CPA dedicated to using his 30 years of tax knowledge and experience to help taxpayers and their businesses maintain compliance with domestic and international tax obligations. To schedule a case review, call Ted Kleinman of US Tax Help at (541) 923-0903.