The taxation of international and expatriate assignments

For someone on an expatriate assignment, understanding the tax impact of such an assignment is just as relevant, or even more crucial, as knowing the location of the new home or the strengths of the children’s new school. Further, when the employer puts in place a tax equalization (TEQ) arrangement for the international assignment, it is equally important to understand its meaning and objective, the mechanics, and the related tax implications thereof.

This article focuses on an expatriate’s international assignment in the Philippines. For Filipinos assigned overseas, employer-global companies similarly adopt the same policy to ensure that employees pay approximately the same amount of income taxes as if employed locally. For both inbound or outbound assignments, note that the key principles and logic of tax equalization are the same.

TAX REIMBURSEMENT IN INTERNATIONAL ASSIGNMENTS

When expatriates take on an international assignment, the employer ordinarily provides them with packages or benefits and additional compensation to augment their base salary and bonus. These items are intended to balance the increased cost of living in the foreign country and to reimburse them for expenses associated with the relocation. Such benefits may include any or all of the following: cost of living allowance (COLA), moving expense reimbursement, hardship premium, automobile allowance, family assistance, resettlement allowance, housing differential, tuition allowance, home leave assistance, foreign service premium, goods and services differential, and appliances/utilities allowance.

These additional benefits are taxable to the expatriate not just in the home country, but in the host country as well since many other countries treat these packages as taxable. For most expatriates, these allowances or benefits are not “free” money but are necessary expenditures related to their foreign assignment.

To ensure that expatriates on international assignment will not incur more taxes than what they would ordinarily pay in their home country, a tax reimbursement provision is usually introduced and offered in an international assignment policy. A Tax Equalization Policy is a common form of tax reimbursement.

TAX EQUALIZATION POLICY

A TEQ is meant to ensure objectivity and fairness. Tax equalization offsets any taxation differences between two jurisdictions as a way of balancing additional taxes faced by employees so that they will be in a tax neutral position while working abroad. The employees are assured that, while on foreign assignment, they will pay neither more nor less taxes because of the additional compensation due to relocation. The company/ employer will carry the responsibility for paying all related worldwide effective taxes for the assignees and the assignees will only be responsible for paying their usual home country taxes. The company paying the taxes will ensure that the employees are in no better or worse position — from a tax perspective — in accepting the foreign assignment.

Although TEQ policies may vary from one company to another in terms of scope and mechanics, the results are generally as follows:

* The employer is responsible for any amounts owed on the employees’ personal income tax returns to the tax authorities, both in the new (foreign or host) and home countries.

* The employees are responsible for hypothetical tax that is paid to the employer.

HYPOTHETICAL TAX DEDUCTION

A hypothetical or “hypo” tax is an estimate of the tax due from the employees given the set of circumstances pertaining to their assignment. Thus, it is not the actual amount payable by an expatriate which is due to be settled with the tax authorities.

In order to implement tax equalization procedures, the company will have to withhold a hypo tax from the assignees when the international assignment begins. The computed hypo tax pertains to the normal tax obligations of the assignees in their home countries, without taking into account foreign assignments.

The hypo tax is computed on the expatriates’ regular “home country” compensation and may include as well hypothetical state/ local income taxes (in the case of US expatriates) and social security taxes. Current year income tax legislation, personal exemptions and allowances, and tax rates in effect for the assignees’ home countries are used in computing this liability.

Once the hypothetical home country tax has been calculated, the actual timing of deductions from the employees’ pay normally will correspond to the periodic payroll cycle, in lieu of the regular tax withholdings. Hypo tax will be spread over the year and will be deducted from the employees’ paychecks. It will not be remitted to tax authorities but will be kept by the employer.

If there are changes to the personal circumstances used in the calculations (e.g. a significant change in the amount of capital gains or losses, change of marital status or the arrival of an additional dependent), the withholding amount will be changed accordingly.

STATE TAXATION

An individual’s residence does not change until he or she demonstrates that such residence has been abandoned and that a new residence has been established. As such, some expatriates (for example, US citizens) may continue to be liable for state income taxes even if they are living overseas. Depending on the applicable rule in each state, generally, individuals retain a permanent home in their state and may continue to be subject to state taxation. Thus, state taxation will still be properly evaluated in the tax reimbursement scheme or TEQ.

In order not to pay state taxes on income earned after leaving the home state, taxpayers must be able to show proof that residence has been terminated in that state. Primary factors establishing termination of residence may include change in employment location, acquisition of residence in the new work location and sale of the old residence, significant time spent in the new location, items that have significant sentimental value are in the work location and some minor factors, such as closing of bank and brokerage accounts, abstaining from voting in state elections or allowing driver’s licenses to expire.

In next week’s article, we will continue to discuss some of the other areas that will have an impact on taxation for expatriates, such as social security tax and foreign country taxation. We will also cover some of the common problems that arise in TEQs.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the

views of EY or SGV & Co.