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The Role of Hypothetical Tax in Expatriate Assignment Pay

Tax rates differ throughout the world. When an individual goes on an expatriate assignment they may move to a higher or lower tax regime. In some cases home country tax obligations may remain. If differences in tax are not taken into account by multi-national organizations, it becomes difficult to move individual expatriates to high tax countries, as they will all prefer working in low tax countries.

Hypothetical Tax (Hypotax) is a concept that was developed as part of a tax equalization approach to expatriate pay. The idea is to ensure that individuals effectively pay the same amount of tax they would hypothetically have paid at home.

As its name implies, Hypothetical tax is a method of tax calculation in terms of company policy rather than tax legislation. It is an administrative tool used to calculate taxes consistently and equitably between individuals in different countries as part of the calculation of expatriate assignment pay.

The basis of Hypothetical Tax is a set of assumptions (hypothesis) relating to the Basic Salary, Allowances and Benefits typical for individuals in the home country company. The assumptions include the amount of salary, and the type and amount of each allowance and benefit. Benefits that are provided by the host country company such as housing, transport, medical and education, are usually excluded. Additional personal income and spousal income are also typically excluded, as are allowances relating to the assignment such as cost of living and hardship allowances. The selected hypothetical Gross Home Basic Salary, Allowances and Benefits are used to determine the applicable (hypothetical) tax applicable using the home country tax and social security contributions. The Home Net Salary is determined by deducting the Hypothetical Tax from the Gross Home Salary.

For example Hypothetical Tax could be used to calculate the Home Net Salary as follows:

1) Calculate the Gross Home Salary: E.g. Basic Salary (100,000) + Allowances (12,000) + Benefits (6,000) = Gross Home Salary (118,000)

2) Using the home tax regulations, calculate the amount of Hypothetical Tax payable on the Gross Home Salary: E.g. Basic Salary Tax (20,000) + Allowances Tax (1,200) + Benefits Tax (60) = Hypothetical Tax (21,260)

Hypothetical tax is used to calculate the individuals Home Net Salary (i.e. after tax salary). 

3) Calculate the Home Net Salary: E.g. Gross Home Salary (118,000) less Hypothetical Tax (21,260) = Home Net Salary (96,740)

The Home Net Salary is the basis for the calculation of the Net Assignment Salary.

Assignment allowances such as cost of living and hardship are added to the Home Net Salary. These amounts differ depending on the cost of living and hardship differences between the home and host country. The Net Assignment Salary is amount the expatriate assignee will receive after host country tax and social security contributions have been deducted. The host country company will typically add the amount of tax and social security payable to arrive at the Host Gross Salary. This guarantees the individual will be paid an Assignment Salary net of their home country Hypothetical Tax i.e. regardless of the actual tax rate in the host country.

Hypothetical Tax is therefore a powerful tool in ensuring consistent and equitable treatment of all employees. It also facilitates mobility of individuals between high and low tax countries because individual's neither gain nor loose due to differing tax regimes.

Steven Coleman is Chief Instigator at Xpatulator.com a website that provides cost of living index information and calculates what you need to earn in a different location to compensate for cost of living, hardship, and exchange rate differences. The complete cost of living rank for all 300 locations for all 13 baskets is available here