Tax trouble when working abroad

It’s increasingly common for U.S. companies to ask employees to work abroad. That usually means dealing with two tax codes. But companies recognize many employees won’t accept foreign assignments if it means higher taxes. So, most firms that move U.S.-based employees provide either tax equalization or tax protection:

• Equalization: Pay is adjusted up or down so the employee’s after-tax income is no different than it would have been had she continued working in the U.S;
• Protection: Same as equalization, except there’s no downward adjustment. This would only be an issue if tax in the foreign country is lower than the tax in the home country.

Equalization calculation

The equalization calculation is often complex because it’s hard to determine hypothetical tax, which is what the employee’s tax would’ve been at home. Once hypothetical tax has been determined, it’s compared to actual tax; the employer then pays the employee the difference. But that payment is always taxable for U.S. purposes, and often for foreign purposes. So that amount also has to be equalized.

Employers have to decide what income to equalize. Employment income is standard, but what if the employee has other sources, such as interest, dividend, rental, and capital gains? If the employee is American and starts contributing to a foreign plan, it may not be tax efficient. What if there’s no foreign company plan, but available individual plans (e.g., an equivalent to an IRA)? What if an employee’s spouse also moves? Should the spouse’s income be equalized?

Large, experienced companies typically have robust policies. But, smaller firms that are new to the employee transfer game can make expensive mistakes.

Learning the hard way

A typical scenario would be a U.S. company expanding into Canada. A mid-level or senior employee is moved, but no one considers the tax issue until Canadian withholding starts. It’s much higher than U.S. withholding, so the employee asks the firm for help. The employer typically says something like, “Don’t worry, we’ll make it the same as it would be if you were still in the U.S.”

The employer consults with us and learns the cost of equalization is considerably greater than anticipated. There’s the equalization cost itself, and the cost of doing the calculation. Sometimes the calculation must be done in advance, and not just after returns are finished. That doubles the cost.

The problem is not the absolute cost level—it’s expensive to move people around the world. Instead, unanticipated costs can be problematic. For your clients, it’s better for them to know their costs in advance. So, if you have American business-owner clients expanding abroad, have them work with their tax teams well in advance to avoid unnecessary costs.

by Kevyn Nightingale, partner, U.S., Canadian and International Tax, at MNP LLP in Toronto.