Understanding Expatriate Tax: Installment 2 – The Implications and Considerations

Expatriate Tax Considerations

Written by: Eva Kolasinski, PMP CSM LSSBB
Head of Operational Excellence at Celergo LLC.

In our previous installment, Understanding Expatriate Employees Installment 1: The Basics, we learned about the differing types of expats and their distinction from locals.  In this installment, we will learn about expatriate tax implications.

The distinction between an expatriate and a local is important for purposes of benefits and taxation. In many cases, an expatriate will have both home and host country tax liabilities while on an international assignment.

If an expatriate extends his or her stay beyond five years, the host country, from a taxation perspective, may start considering the expatriate a local and therefore require him or her to pay into local social insurance programs, etc.

If the employee is in a European country, for example, Belgium, the extended change in status can significantly increase the cost to the employer in Belgium. When the employee was an expatriate, the Belgium office did not have to pay the employer’s portion of the social tax if a totalization agreement was in place with the home country. The switch to a local status will require the employer in Belgium to pay the employer’s portion of the social tax in Belgium and discontinue the employer’s match of the social tax in the home country, which will most likely be at a lower rate – as it would, for example, in the United States.

It also will be important to look at treaties between the home and host locations to avoid double taxation.  Most companies will utilize an accounting or tax firm that specializes in expatriate taxation to determine the companies tax policies for its expatriates. These firms will ensure expatriate tax programs created by the company based on the home and host combinations effectively use tax treaties and compensation techniques to reduce costs and increase compliance.

Expatriate Tax  – Hypothetical Taxes and Exemptions

A hypothetical tax, often referred to as hypo tax, is computed when an expatriate tax equalization program is implemented. Typically, an expatriate will continue to receive his or her basic compensation package, including salary, bonus, and pension deductions and employer’s pension match. From this core data, plus personal information such as the employee’s size of family and work state, if the home country is the United States, the employee’s hypo tax will be calculated. This amount is the tax the employee would have paid had he or she stayed home and not taken the expatriate assignment. The hypo tax is usually expressed as a percent of salary although in some cases, the hypo tax may appear as a flat number per pay cycle. There often is one percentage calculated for the base salary and another for bonuses. A unique property of hypo tax is that, although it is withheld from the employee, it is NOT paid to the home government.

If the employee’s home country is the United States, the employee should have waived withholding for federal taxes by completing a Form 673, Statement for Claiming Exemption from Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911. As a long-term expatriate, the employee will be paying taxes in a foreign location, and those tax credits will be utilized to offset the employee’s U.S. tax liability. In many cases, this tax credit will completely offset any U.S. tax owed by the individual. If the employee is going to a lower tax jurisdiction, like Hong Kong, a calculation near the end of the year should be performed by the U.S. tax provider to determine if any actual tax should be paid to the U.S. government since there will not be enough offsetting credit. This calculation will help ensure the employee has paid in enough U.S. tax over the year with the goal of being penalty-proof.

The hypo tax is withheld from an expatriate’s pay. It is the employee’s contribution to the taxes the employer is paying on the employee’s behalf in the host location. For example, if the expatriate is working in Germany, the company is paying the employee’s German tax liability and grossing it up at the host location. In essence, this is a benefit in kind because the company is paying it on the employee’s behalf, which requires the gross-up. So, assume the hypo tax is $2,625 for a month, this is the amount the employee would have paid to the U.S. government had he or she stayed at home. The $2,625 will be withheld from the employee each pay cycle and used to offset the German host tax – often referred to as shadow payroll calculations – paid by the company, which has a higher tax rate and is grossed up. A typical month may see a German host tax converted to USD with a cost of $5,200, assuming no benefits in kind were processed. The company will expense the differential of $2,575 which will be booked to the expatriate’s cost center and included in the company’s cost of the assignment.  Additionally, the company will process across credit to the local German entity for the hypothetical tax withheld from the employee.  In this case, it would be the $2,625 converted to EUR to offset the local taxes paid on behalf of the employee in Germany.

Expatriate Tax – Totalization Agreements

Totalization agreements exempt expatriates from having to pay into the social insurance programs at the host location as long as they continue to pay into their home social programs. Countries must have treaties in place that allow for these exemptions. The United States has 26 totalization agreements in place today, with new ones continually being negotiated. The expatriate must complete a Certificate of Coverage (COC) at time of expatriation. Typically, tax providers or relocation companies will provide this service for the expatriate as part of their outbound tax briefings. The premise behind these agreements is that the expatriate will not benefit from government-sponsored pensions, long-term disability, and unemployment programs, etc. since the expatriate is in the host location for less than five years. The European Economic Area has a similar program, which requires employees to have an A1, also known as an E101 Certificate, for working in participating countries.

In practice, if the expatriate has a COC or an A1 in place, the company will continue to withhold his home social insurance but does not have to withhold social insurance in the host location. It is best to have expatriate tax advice regarding COCs and A1s because not all social insurances are exempt. Many countries statutorily withhold benefits, including healthcare, the expatriate may need when living in the host location.

Example: If an expatriate is from the U.S., is working in the UK, is on a tax equalization program, and has completed a COC:

*The expatriate would remain on U.S. payroll, and the company would withhold Social Security, Medicare, and FUTA.

*The company would calculate PAYE (UK wage tax, which is similar in concept to US Federal tax) on a shadow payroll for the expatriate, but would exempt the employee from National Insurance (NI) in the UK.

You can find a list of totalization agreements here.

U.S. Medicare and Social Security

There are special considerations for U.S. Medicare and Social Security taxes for expatriates. If the company is using the concept of hypo tax for federal and state tax purposes, the company may elect to use a hypo tax calculation for Medicare and Social Security taxes.

Expatriate Compensation Package

In the above example, the employee is bearing the Medicare and Social Security on his or her base salary, just as the employee would have if he or she stayed home – without any allowances, norms, or COLA as a local. This would be considered a hypo tax, the approximation of the real taxes on his or her home compensation. Though, the U.S. government will require companies to increase Medicare and Social Security by the allowances and decrease the calculation by the hypo tax and norms. Therefore, companies handle this calculation in one of three ways:

  1. Employee Bears the Additional Tax on Full Assignment Costs:
    In this case, the employer calculates the Medicare and Social Security on the salary plus the COLA, allowances, and benefits in kind, minus the hypo taxes and norms. The employee then pays the additional tax calculated on the allowances, assuming the allowances plus the benefits in kind are greater than the norms, thereby creating additional positive income. For example, COLA of $4,000 plus transportation allowance of $1,000 (plus hypo taxes of $3,000) would create an income of $2,000. The employee would bear the cost of the FICA on the $2,000. In general, companies see this calculation method as unfair because the employee is paying additional Medicare and Social Security taxes because he or she took the assignment at the request of his or her employer.
  2. Employee Bears the Additional Tax (But Not for Benefits in Kind):
    In this scenario, the employee will pay actual Social Security and Medicare taxes on his or her total base compensation package (salary plus allowances and COLA, minus hypo taxes and norms). Benefits in kind are run on off-cycles and grossed up and so do not affect the employee. At the end of the year, most expatriates will max out Social Security, and companies will true up the employee for the extra Medicare taxes he or she paid throughout the year. Therefore, the employee has no increased tax burden while on assignment.
  3. Employee Pays Hypo Tax and Employer Pay Actual Tax:
    In this case, the employee will receive the net pay as illustrated in the example above. The employer then performs a separate calculation for actual Social Security and Medicare tax to pay to the U.S. government for both the base compensation package and benefits in kind. In some cases, companies will divide out Medicare and Social Security withholding evenly through-out the year. Others will mimic US payroll calculations and max out social security during the year similar to what would occur with actual FICA calculations.

Expatriate Tax on Benefits in Kind

Payments for benefits in kind must be included in the expatriate tax calculation at the host country and at the home country if the home country taxes worldwide income for social insurance purposes, e.g., United States, South Africa, and Switzerland. Benefits in kind are often included through off-cycle processing, as they need to be grossed up; otherwise, the employee will end up bearing the increased cost of these taxes.

Because the determination of taxability is different in each country and is also determined based on the expatriate program (short-term, long-term, commuters, rotators, local plus, etc.), the best practice is to create a taxability grid for each payroll of all compensation elements. This ensures that the payroll team at the host and home (if applicable) knows how to tax each element. A basic excel sheet with multiple columns is sufficient if it details the taxability for each program (and by each tax) for each compensation element.

Tax providers can help a company refine the matrix, which will ultimately support how they calculate the taxes on the tax return. If done properly, adhering to an expatriate tax matrix should also reduce costs of ensuring that all benefits were included in each payroll cycle, as it details what should be included and what is taxable. Additionally, a tax matrix will increase the accuracy of withholdings each pay cycle, thus reducing the probability of overpayment and underpayment of taxes at year end. In some countries, overpaid taxes are difficult to reclaim (in China, for example), while the underpayment of taxes can lead to a penalty in most countries.

An example of how to create an expatriate tax matrix is provided below based on a long-term expatriate policy.

Expatriate Tax Matrix

Note: This is an example for educational purposes only. Each company has its own relocation policy and internal risk tolerance related to expatriate tax policies. Some companies are more aggressive and others more conservative on the interpretation of tax law in the host location.

We hope you found these articles on expatriates and their processing helpful. If you would like to learn more about how to ensure your expatriates are paid accurately and timely, please contact a member of our team today. Celergo has the knowledge base to cover your expatriate process!


*This article references “Global Payroll” Chapter 13 of the Payroll Answer Book published by Wolters Kluwer. Chapter 13 is written by Michele Honomichl Founder & Chief Strategy Officer of Celergo LLC.  

**This article is for informational purposes only. It is not intended to constitute legal advice.

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