The so called Tax Reduction Act of 2006 effectively increased the U.S. Federal individual income tax for U.S. citizens residing in Bermuda. Many individual employees are wondering whether they would be better off if their employer’s had a tax equalization policy. This column explores that question.
What Is Tax Equalization?
Tax equalization is a corporate policy utilized in the relocation of employees outside their home country. The underlying concept of the policy is that an individual employee will pay no more, nor no less, taxes on an annual basis than they would have paid had they not relocated. While the concept is simple, the mechanics as to how this policy works are not.
In practice, tax equalization policies differ by company and industry. In the course of our career in international human resources and tax we have probably written over 100 policies for multinational companies, and all differ in some respect.
A tax equalization policy must initially take into account what income will be covered. By intuition, salary and bonuses will be taken into account, but will stock option exercises, restricted stock vesting, interest, dividends, capital gains and the spouse’s income?
Deductions and personal exemptions are taken into account, but once you have relocated they tend to differ from what you had at home. For example, you may have owned a home in the U.S. and taken a deduction for mortgage interest and real estate taxes. However, suppose you sold your home because of the relocation and no longer pay mortgage interest and real estate taxes. How does the policy account for the fact that you would have paid mortgage interest and real estate taxes had you stayed at home, but do not now?
A tax equalization policy is usually lengthy, as it must account for every situation that could be encountered in the future. And because of all the nuances involved in attempting to ascertain what you would have paid, it tends to be more of an art than a science.
How Does A Tax Equalization Policy Work?
At the beginning of the assignment an outside consultant will compute the amount of tax an individual would have paid had they not relocated. This is usually referred to as the hypothetical tax.
Our example is a married couple, no children, who have briefly lived and work in Boston, Massachusetts. They rent an apartment in downtown Boston at a cost of $2,000 a month. The working spouse’s current compensation is $250,000, and the employer has asked them to relocate to Bermuda on January 1, 2006. The hypothetical tax would be:
United States
Federal income tax $58,100
State income tax 12,900
Social Security tax 5,700
Medicare tax 3,600
Total $80,300
The employer will now treat the $80,300 as negative compensation and the employee will receive compensation of $169,700 plus allowances such as housing, cost of living, home leave, etc. relating to the overseas assignment.
The employer is now responsible for the payment of all United States and foreign income and social taxes.
Will the Employee Pay More or Less Taxes Under Tax Equalization?
If we assume that the employee received an annual $72,000 housing allowance when they moved to Bermuda, we can then compare the taxes that they paid under tax equalization with what they would have paid if their employer did not have a tax reimbursement policy.
Tax Equalization No Policy
Federal income tax $58,100 $55,200
State income tax 12,900 0
Social Security tax 5,700
Medicare tax 3,600
Bermuda payroll tax 11,100
Bermuda social insurance 1,350
Total $80,300 $67,600
In the above example the employee pays $12,700 more under tax equalization than they would have had their employer not had a tax reimbursement policy in place.
What Would the Employer Pay Under Tax Equalization?
Under tax equalization the employer would have realized a greater savings than the employee. Why? The starting point for computing the tax would be $169,700 plus the $72,000 housing allowance. The tax on this amount would be:
Federal income tax $30,750
State income tax 0
Bermuda payroll tax 11,100
Bermuda social insurance 1,350
Total $43,200
In this example, the employer paid $80,300 less to the employee, and only had $43,200 as out of pocket tax cost. Thus, the net benefit to the employer under tax equalization would be $37,100.
Conclusion
Is there any circumstance in which tax equalization would be beneficial to the employee? Definitely. If we ran enough hypothetical examples we could clearly come up with an example that would benefit the employee. But you need to remember that from an employer’s perspective tax equalization is a “one size fits all” concept. Some individuals will benefit from it and others will not.
So before you campaign for the adoption of tax equalization at your place of employment, you need to identify which of your co-workers will be injured by it.
The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own U.S. tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances. |