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Let''s start by defining tax equalization and tax protection.
Tax equalization is a process that ensures that the tax costs incurred by an assignee on an international assignment approximates what the tax costs would have been had he remained at home. The intent of tax equalization is that the assignee neither suffers significant financial hardship nor realizes a financial windfall from the tax consequences of an international assignment.
When tax equalization is utilized, the employer bears the responsibility for paying the assignee ¡ ¦s actual home and host country tax costs. In exchange, the assignee pays to the employer a stay-at-home hypothetical tax as determined under the company''s tax equalization policy.
The estimated stay-at-home hypothetical tax should be collected from the employee each pay period and there should be an annual tax balancing to reconcile this estimate to the final hypothetical tax for the year. As a result of this final tax balancing, the employee may owe the company additional stay-at-home tax, or the company may need to return part of the stay-at-home tax to the employee.
Tax protection is a process that reimburses an assignee the excess taxes he incurs while on an international assignment. The employee is responsible for the payment of all actual home and host country taxes. The annual tax protection calculation then compares the stay-at-home hypothetical tax to the actual worldwide taxes paid by the employee. If the actual worldwide taxes exceed the stay-at-home tax amount (as determined under the company''s policy) the company reimburses the excess to the employee. If the actual worldwide taxes are less than the stay-at-home tax, the employee receives no reimbursement from the company. Tax protection generally puts the burden of filing and paying home and host country taxes on the assignee.
The assignee''s cash flow may be seriously impaired under tax protection if he is in a high tax rate country. The assignee must first pay both his actual home and host country taxes, then request a stay-at-home tax calculation, and finally be reimbursed for excess taxes. Compliance with the host and home country tax laws is sometimes overlooked since the assignee is solely responsible for filing and paying his home and host country taxes. In addition the assignee has a financial incentive to minimize his actual tax. Cash flow and compliance problems are exacerbated in high tax countries. If the assignee fails to comply with the host country tax rules and the failure is exposed, the company may be the target of unexpected and unfavorable publicity.
When tax protection is utilized, it is possible that the assignee will reap a financial windfall if his assignment location country has no tax or a very low tax. When tax protection is utilized, the company will always pick up the excess tax incurred during a year, but any year the actual worldwide taxes are less than the final stay-at-home tax, the employee gets to keep the windfall. This can result in a situation where the assignee is loath to move to a high tax country.
Why would a company utilize tax equalization instead of tax protection? Tax equalization supports equity, mobility, compliance, and partnership.
*Equity is achieved because the assignee is in a tax neutral position during the assignment.
*Mobility is enhanced because changes in assignment countries produce no tax benefit or disadvantage for the assignee.
*Compliance with both home and host country tax laws is encouraged because there is no benefit to non-compliance.
*A partnership is formed between the company and the employee, with the company paying all worldwide actual taxes and the employee paying his hypothetical tax.
Under tax equalization, the employee cannot lose.
The perceived fairness of the tax equalization program provides intangible benefits since the assignee is not concerned about tax issues and the consequences of his international assignment. The use of tax equalization assists the company in being able to move employees based on business needs. It helps avoid situations where it is easy to fill a position in a country with a low tax rate while having difficulty filling a post in a high tax rate location.
By keeping the tax windfall generated by transfer years or low tax rate locations at the company level, assignment related tax costs associated with the international assignment program are controlled. Thus, under tax equalization, the company can win.