The Hindu Business Line : The expat problem

HYPOTHETICAL tax obtains significance in the case of employees who are deputed by their company from the home location to a host location (the country to where one is deputed) on international assignments. Where the employer-company assigns the service of an employee to its affiliates in international locations it has the additional responsibility of ensuring that the employee does not pay more tax than he would have paid had he continued at the home location.

In case of an assignment to a host location, the employee might find, much to his dissatisfaction, that his cash flow and purchasing power are severely depleted by living in the host country than at home owing to tax disparity.

Broadly, two methods are used for achieving tax-neutrality. Some employers give their employees an additional allowance to compensate them for the additional tax burden, while others undertake to bear the employee's tax liability either in whole or in part. This necessitates the employer to devise an international tax equalisation policy.

The basic principle of a tax equalisation policy is that the employee should suffer neither a financial hardship or realise a windfall as a result of the tax consequences of an international assignment.

This policy ensures that the employee is tax neutral and that both the domestic and international tax laws are complied with. To implement the equalisation process, the company withholds a hypothetical tax from the assignee when the international assignment begins and the same will be revised at the beginning of each year and when salaries change.

Also, the hypothetical tax would be reviewed and adjusted whenever an international assignee experiences a significant economic event, such as exercise of stock option.

Hypothetical tax approximates the home country taxes, such as the federal, state, and social security tax an international assignee would pay at home location in the absence of the international assignment. The hypothetical tax is not an actual tax. It is an estimate of tax on the assignee's earned income and deductions. It replaces the actual tax withholdings. After the hypothetical tax is estimated, a pro rata portion of the tax is normally deducted from the assignee's pay-check throughout the year.

The hypothetical tax is retained from the assignee's base salary, much like withholding taxes.

However, it is not sent to the revenue authorities. The employer holds the deducted hypothetical tax. Under a tax equalisation policy, the employer is responsible for paying all the international assignee's actual home and host country taxes. The assignee is responsible for paying the hypothetical tax to the employer.

For an US assignee, the hypothetical tax means federal, state and social tax liability. The calculation of a federal hypothetical tax normally mirrors the calculation of the federal tax return, using the appropriate filing status and number of exemptions.

The calculation of the state hypothetical tax usually follows one of the following approaches, that is, based on the state tax as though the assignee was still resident in that state prior to assignment, calculate state tax as though the assignee was a tax resident in the state where the company is headquartered or calculate state tax at an average rate for all states in the US.

The most popular approach is to use the state where the assignee resided prior to his assignment. However, each company must determine what taxes will be included in the hypothetical tax.

This concept is relatively new to the Indian tax authorities. They fail to appreciate the fact that hypothetical tax is neither due to the employee nor does he receive it and, as such, is not income in the hands of the employee.

In order to limit the possibility of disputes with the tax authorities, it is advisable that the agreements with the employees clearly bring out the fact that the salary has been fixed after reducing the hypothetical tax.

The Central Board of Direct Taxes could issue a clarification on this point to the effect that hypothetical tax is not to be treated as taxable income, unless it is either due to the assessee or is received by him, thus, avoiding any litigation on a clear point of law and put to rest the concerns of expatriate employees.

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