This article is the third in a series of four examining the Canadian and U.S. income tax implications of the temporary assignment of an employee from Canada to the U.S. Specifically, these articles address the situation of an employee remaining employed by a Canadian entity, but temporarily assigned to work in the U.S. Our previous two articles (Winter 2015 U.S. Tax Alert and Spring 2015 U.S. Tax Alert) examined the importance of the determination of "residency" for personal income tax purposes, and the Canadian and U.S. personal tax liabilities based on different residency scenarios. This article examines the concept of tax equalization. Our Fall 2015 U.S. Tax Alert will have a discussion of select corporate payroll and income tax matters.
Due to the complexities inherent with a temporary foreign assignment, many companies will provide some form of tax relief to employees. The most common approach to ensure equitable tax treatment of employees on foreign assignment is to implement a "tax equalization" policy. The primary objective of such a policy is to ensure the employee is no better off and no worse off, from a tax perspective, due to the foreign assignment. In other words, the policy seeks to ensure the amount of income tax paid by the employee on their "stay at home" compensation during a year of assignment is no less and no more than the amount of income tax the employee would have paid had the employee remained working in their home country. The intended goal is to neutralize the impact taxation may have on the employee's decision-making process related to an international assignment.
Implementing a tax equalization policy usually means the employer accepts responsibility for any additional personal income tax costs resulting from the assignment. These costs can result from many factors, including different income tax rates between the home and host countries, or from additional income tax that is levied on assignment-specific benefits, such as housing allowances. On the other hand, such a policy ensures the employer – not the employee – benefits when an employee is assigned to a lower-taxed jurisdiction.
In order to implement a tax equalization policy effectively from a cash flow perspective, it is often advisable for the corporation to withhold hypothetical home country taxes. This is an estimate of the income tax for which the employee would be liable had the employee remained working in the home country. The amount is usually based on an estimate of the tax on the salary, bonus, and other taxable benefits the employee would normally receive when not on a foreign assignment. Most tax equalization policies exclude assignment-specific benefits from hypothetical tax, as the corporation usually assumes responsibility for any income tax on such benefits. The hypothetical tax withheld from the employee during the year represents an estimate of the employee's home country tax liability for the year. The actual income tax cost at tax filing time generally becomes the responsibility of the employer.
Hypothetical tax is not an actual withholding tax, which in normal circumstances is remitted to the government. Rather, the hypothetical tax withheld is used by the employer to fund all or a portion of the actual personal income taxes due for the year in the home and host countries. Where a Canadian employee remains a Canadian resident while on a foreign assignment in the U.S., the employer may not cease withholding actual Canadian tax without obtaining a tax withholding waiver from the CRA.
In order to ensure the employee has paid the appropriate amount of income tax for the year, it is necessary to do a reconciliation of the hypothetical taxes withheld to the actual amount of hypothetical tax for which the employee should be responsible. This reconciliation takes place after the year and requires a determination of each of the employer's and employee's portions of the actual tax liability for the year in both the home and host country. At this point, all actual compensation elements are known. The reconciliation identifies changes to the employee's tax liability due to changes in compensation, bonus or other benefits received during the year, and normally results in a settlement or "true-up" between the employer and the employee.
Where there is an incremental tax cost related to the benefits received on assignment, the employee will also receive an income tax "gross-up." The gross-up ensures the employee receives the same benefit or allowance on an after-tax basis. In effect, the employer pays an additional amount to cover the tax on the benefit. There are various tax gross-up methods that directly affect the cost of the assignment to the employer. These methods should be considered carefully when estimating the overall cost of a foreign assignment. Further, in many jurisdictions, including Canada, the payment of an employee's personal tax liability creates a taxable benefit to the employee, resulting in additional cost in the form of tax on that benefit.
A tax equalization policy also must clearly spell out which party is responsible for any incremental tax on income from sources other than employment. This issue could be significant for employees seconded to countries where the tax rate on non-employment type income is higher than the home country. On the other hand, a policy that excludes other sources of income from tax equalization may make countries with lower tax rates on such income more attractive to employees, provided they are not also subject to home country tax on such amounts.
See our Fall 2015 U.S. Tax Alert for the final article in this series, drawing attention to a selection of corporate income tax matters associated with a temporary assignment.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.