What is Tax Equalization? [how it affects overseas employees in 2022]

When it comes to relocating employees overseas, there are so many factors to consider. One area that a lot of employers wish they could do without is tax obligations, and especially relocation tax. It’s not easy to understand and the penalties are significant. 

If you have employees that have relocated internationally, tax equalization is one way to ensure that both you and the employee are compliant. Plus, it’s a great benefit for the employee because it doesn’t place additional tax obligations on them, thus making the relocation more desirable overall. 

What is Tax Equalization? 

The definition of tax equalization basically says that an employer can minimize the negative financial impact of a relocation for an employee by lowering their tax liability. They’re able to do this by paying any additional tax responsibilities for the employee. Think of it as something that is baked right into the relocation policy of your company. 

Whenever an employee is forced to relocate to keep their job, they might incur higher tax obligations in their new country. As a result, you as the employer take on that added responsibility so they’re not forced to pay any more than they were in their home country. 

The ultimate goal of this is not only to make the employee happy but to ensure good citizenship by guaranteeing that expats relocated to another country maintain proper tax compliance. It also makes global mobility more realistic because it lessens the burden on behalf of the employee. 

Of course, there are cases where this makes sense and where it does not. Companies offering long-term assignments between one and five years believe that tax equalization is the way to go. Problems arise due to a lack of understanding by the company and because it results in more payroll administration and tax costs for the company. This is especially true when dealing with permanent relocations. 

The Four Elements of Tax Equalization 

There are four aspects of equalization tax that every company needs to understand. Let’s break them down: 

1. Actual Income Tax Payments 

If tax equalization does apply for your company, the employer fulfills the necessary obligation in the host country. The most common way is through foreign payroll or shadow payroll. You as the employer are then responsible for paying the tax due in the host country while the employee continues to pay the regular tax in the home country. Essentially, you’re paying the difference. 

2. Actual Social Security Tax Payments 

Many employers do not understand that FICA taxes may still apply to foreign employees even if they’re not living in the United States. When you send that employee abroad on an assignment, your company must still take FICA withholdings and that employee is also responsible for social security tax and domestic tax in the country they’re currently living in. Of course, this is not always the case but can often be so it’s important to speak with a relocation specialist when developing your relocation policy. 

3. Hypothetical Tax 

A hypo tax is often baked into the policy as well. This is when the company reduces the employee’s salary based on the amount of tax they would have paid in their home country. The employer then keeps these funds to pay the tax obligations in the home and host countries. The total tax amount due would consist of their federal, state, social security, and medicare tax. 

4. Theoretical Tax 

This is sometimes referred to as an “annual tax equalization calculation” and it’s the year end hypothetical tax based on actual income and deductions. It’s the same as a hypothetical tax from the perspective of an employee. The company is responsible for paying all the taxes due. The main difference is that the theoretical tax represents the same tax burden that the employee would have had whether they took the overseas assignment or not. But, any deductions that result from the assignees expat status are not recognized thus no one receives a tax liability windfall, should there be one. 

Employer Tax Equalization

Employer Tax Equalization 

All in all, the tax liabilities and responsibilities often fall onto the plate of the employer. While they can sometimes benefit from tax equalization and find that they have more money than they need to fulfill the responsibilities, that isn’t usually the case. It’s something that should be factored in when deciding if relocating an employee to another country is the best option or not. 

Expat Tax Equalization 

Most of the benefits fall on behalf of the employee because they’re not responsible for paying any higher taxes when they’re relocated to another country. This gives them peace of mind in knowing that they won’t encounter more challenging financial situations in their host country. In the end, it makes the prospect of relocation more desirable. 

Final Thoughts

When putting together a relocation package, be sure to keep tax equalization in mind and provide a clear explanation to your employees what compensation is being used for taxes each year and which policy you’re implementing. 

Remember that international tax is a complicated topic and no matter how much you explain it, employees still may not understand. Be sure to provide your employees with tax consulting services in their host country so they’re not left with the burden of figuring it out on their own. 

If you’re planning a business relocation and you’d like assistance with putting together a relocation strategy, be sure to schedule a free consultation with ARC Relocation. We specialize in relocating employees all over the world and we have the experience and expertise you need for a smooth and efficient relocation.