September 2010

What is Hypothetical Tax?

By Mary Lou Stockton — Managing Director, GTN Philadelphia

Phone: (484) 885-2419

The concept of hypothetical tax came along when the practice of tax equalization was developed. As many international assignees (and their HR departments) know, when an employee moves to a different country for their employer, their taxes are usually affected - either positively or negatively, but always in the direction of more complexity .

In particular, when a US person is sent out of the US for an overseas assignment, his or her taxes can quickly become much more complicated. This is because the US requires any US resident or citizen to continue to file and report worldwide income during the entire international assignment period. At the same time, reporting of income is usually required in the host country. This complexity and the added cost can have a material impact on an employees net pay as well as increase his or her level of confusion about their compensation, unless the employer provides clarification and assistance.

In order to make the move tax neutral for the employee, companies developed the concept of tax equalization: Even though the employees taxes may have increased due to the international assignment, the employee would only pay as much tax as he/she would have paid if he/she had not gone on assignment.

The resulting tax is called hypothetical tax — its the tax the employee would hypothetically have to pay if the assignment had not occurred. The company takes responsibility to fund the worldwide actual tax liability for the employee, and collects the hypothetical tax from the employee, reducing the companys net tax reimbursement cost.

Thus, the hypothetical tax is not an actual tax that is remitted to a taxing authority. Instead, it is an estimate of tax on the assignee’s earned income (excluding assignment-related income), and non-company income and deductions. Hypothetical tax approximates the federal, state, and (typically) social tax an international assignee would pay if he/she didn’t go on assignment.

It generally replaces the actual tax withholdings that would otherwise have been retained from the employees wages. In fact, in many cases, federal (and often state) income tax cease to be withheld during an international assignment.

After the hypothetical tax is calculated, a pro rata portion of the annual tax is normally deducted from the assignee’s paycheck throughout the year. The hypothetical tax is retained from the assignee’s base salary, much like actual federal and state income tax withholdings.

However, this hypothetical tax is not sent to the IRS or state taxing authorities, so it is not included in the annual federal and state withholding boxes of the Form W-2. The Company retains the deducted hypothetical tax.

Hypothetical tax should be updated at the beginning of each year and when salaries or tax rates change. Also, the hypothetical tax should be reviewed and adjusted whenever an international assignee experiences a significant economic event, such as family status changes, stock option exercises, employee stock purchase plan (ESPP) activity, or gain on the sale of stock. Actual tax withholding on stock option exercises, at the statutory rate of 25%, is often lower than the hypothetical tax rate. There is no actual tax withheld on employee stock purchase plan income or gain on the sale of stock.

The objective is to have the assignee’s estimated hypothetical tax withholding approximate, as closely as possible, the final year-end hypothetical tax.

• If the estimate is too low, the assignee must pay an additional amount to the company.
• If the estimate is too high, the company must pay an amount to the assignee.

The ideal goal of the estimated hypothetical tax is to ensure there will be no unpleasant surprises for the assignee or the company at the end of the tax year. It also helps ensure the company will not be placed in the position of having to collect additional hypothetical tax from the assignee at the end of the tax year.

In terms of the time value of money, an important point is that hypothetical tax withheld from current pay is able to be excluded from taxable income in virtually all taxing jurisdictions. The US federal income treatment was addressed in Rev Ruling 78-374. As a result of this treatment, the net effect of the tax equalization process is that only the excess of worldwide taxes (home and host) over the stay at home tax is included in income in the current year. Since this income inclusion is typically taxed on a grossed-up basis, it is worth real money to exclude the hypothetical tax from income as early as possible.

In summary, the hypothetical tax is a unique concept that was developed in order to address Treasury, Tax, individual, and HR concerns arising out of the taxation of international assignments. Treasury looks to preserve capital, Tax looks to proper compliance with applicable regulations, the assignee needs to understand what is happening with his/her paycheck, and HR needs to address all of these concepts simultaneously. If administered and communicated timely, the use of the hypothetical tax can be an effective solution on all of these levels.

If you have international assignees who pay hypothetical tax but dont understand it, or if your international assignees do not pay a hypothetical tax, but perhaps should, call us at GTN. We can help you implement a hypothetical withholding process that will make sense to you and your employees and address the need to minimize costs of an international assignment.

Should you have any questions please feel free to contact us at Help@GTN.com

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