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Hypo-tax is the amount actually deducted by the employer. Although most of the taxable benefits associated with a transfer are not included in the calculations for the initial tax settlement, hypothetical taxation often applies to the following types of payments:

  • Basic salary
  • Bonuses + commissions (if applicable)
  • Housing allowance
  • Travel allowance
  • Stock options
  • equity compensation
  • Foreign taxes

What Influences The Calculation of Hypo Tax?

In general, the more detailed the hypothetical calculation of the tax deduction, the more likely it is to be accurate. This can lead to fewer surprises for the assignee/ex-pat and a reduction in administrative time after the conclusion of the tax settlement at the end of the year.

Other factors that can influence the decision to prepare a detailed calculation:

  1. Size of the transferee’s personal income: Is the settlement of tax adjustments at the end of the year significantly affected by the personal income of your transferee?
  2. Company Compensation Policy: What Income Is Compensated? Are there any restrictions on the remuneration of income outside the company (personal) or capital?
  3. Administrative costs and cost constraints of the international award program: Are the additional costs associated with the detailed calculation a sufficient advantage? Will an inclusive calculation help recognize the need to increase hypothetical tax deductions and thereby reduce large tax settlements at the end of the year?
  4. Impact of alternative calculations: Will applying a higher flat rate of hypothetical deductions to non-recurring and/ or non-professional income help reduce potentially large tax adjustments owed to the company?
  5. Corporate culture in relation to personal income knowledge: Does the company want to go beyond the corporate earnings of employees? Would the assignees agree to provide information on external income to the company for withholding tax purposes?

The above list is not thorough, but it does present questions you should consider. If you are making an allowance for adopting recommendations for more detailed hypothetical tax calculations, please check with your tax service provider.

Adjustment of hypo-tax deductions

Tax equalization calculations are performed annually when final income and deductions are known. This is then compared with the hypo-deduction that the company holds. At that moment, the ex-pat smoothens out the real difference with his employer. Hypo tax is adjusted each year accordingly. The ultimate goal means that the ex-pat pays the same amount of taxes as if all the work was done in the country of origin.

Companies with overseas duties should not use tax settlement agreements. The same company may also have fiscal equalization policies that are adopted in some jobs but not applied in other territories.

Common Approaches of Calculating Hypo Tax

The four most common approaches used for calculating the hypothetical state withholding tax are:

  1. State Tax before Departure: Tax is deducted as if the transferee remained fiscally resident in his or her designated home state.
  2. State Tax from Place of Residence: Tax is deducted based on the state tax rate at the employer’s registered office.
  3. Average State Tax Rate: Tax is deducted based on a mixed or average state tax rate across multiple employer locations.
  4. No State Tax: No state tax is deducted as long as the employee has settled a state tax residency. The company does not pay actual state tax on behalf of the transferee, so the employee receives an unexpected state tax.

Implications of Hypo Tax

When hypo taxes are computed, the following need to be taken into consideration:

  1. The employer is accountable for supervising both hypothetical tax deductions and all payments due in the host country.
  2. The ex-pat will have the identical tax rate and payments as if they were never assigned and will not be affected by the host country tax rates.
  3. The employer avoids any unexpected tax payments at the end of the year in the country of origin and can manage the withholding taxes of ex-pats based on their income bracket.
  4. Actual tax payments from the country of origin can be counterbalanced or reduced based on foreign tax credits or tax agreements between the two countries.

Conclusion

Yes, hypo tax is the pre-tax deduction made on an ex-pat’s gross income. It is deducted before the salary is disbursed to the employee. If the actual tax would be lower or greater than the hypo tax is dealt likewise, later.

It is particularly important to assess the hypothetical tax position for these proceedings if the income is not deducted from the employee’s effective marginal tax rate (that is, the marginal tax rate is the percentage of tax paid on the last dollar of taxable income).

Salman Rundhawa
Salman Rundhawa
Salman Rundhawa is the founder of Filing Taxes. Salman provides valuable tax planning, accounting, and income tax preparation services in Toronto, Mississauga, Oakville, and Hamilton.

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