The Expat Hypo Tax ‘Equalization,’ Calculation Example

When a person receives an employment assignment to go overseas, their income is often ‘equalized’ by the company offering the expatriate assignment. The idea behind equalization is that the company does not want the U.S. taxpayer to be in any better or worse position simply because they are taking an assignment in another country. In reality, there are many complexities involved in hypo-taxation and how to calculate it — especially since the U.S. taxes individuals on their ‘worldwide income’ regardless of where they live. This can get even more complicated in situations in which the hypo tax is based on multiple foreign countries — and especially if the taxpayer is considering one of the amnesty programs, such as the streamlined procedures or delinquency procedures. Let’s examine the basics of a hypothetical tax example.

Hypo Tax Example

Here is a common example of a hypo-tax scenario: Mark is a U.S. citizen who is excellent at his job (and probably the only person qualified to take on a new assignment in Hong Kong). The company wants to send Mark on a three-year assignment. One of the main issues becomes the fact that Hong Kong has a lower personal income tax rate than the United States. As a result, Mark will benefit greatly if he gets to pay Hong Kongese taxes instead of US taxes. Therefore, the company prepares a hypo tax calculation, along with a stay-at-home calculation for Mark to consider. The hypo-tax is deducted from his paychecks, and ultimately, the company pays the taxes for the individual in both jurisdictions. Still, Mark will be responsible for these ‘hypo-tax payments’ (deducted from each paycheck he receives) to equalize the difference between working in Hong Kong and working in the United States.

General Tax Rules

In this situation, Mark is technically responsible for paying taxes both in the United States and overseas (as well as any potential state tax implications depending on which state he resides in). But with tax equalization, Mark is taxed on the income as if he would have been had remained in the United States. In other words, Mark does not pay (usually) tax on the additional benefits derived from being on the assignment, such as housing, because if he were not on the assignment, he would not be receiving these types of benefits.

A Few Key Facts About Hypo Taxes

The hypo tax is not technically salary or wages. The amount paid (presuming the taxes are estimated properly in conjunction with U.S. Taxes and the worldwide income requirement) is used by the company to equalize the tax and pay both countries. In other words, the employer pays the taxes on behalf of Mark to both countries — Mark does not pay these taxes to either jurisdiction (this may vary based on the company and type of assignment). Until the final tax is calculated, the hypo tax is an estimate, and the employee may owe more taxes or receive a refund. Also, the hypo-tax is not withholding per se. And since the hypo-tax is not an actual withholding tax, it is not remitted to any governmental authority. Instead, the employer becomes responsible for submitting the employee’s actual tax (pays the tax on the tax remitted on the employee’s behalf) both in the United States and in the host country.

Hypo Taxes Have Several Moving Parts to It

Hypo tax analysis can be very complicated because it can involve issues such as the foreign earned income exclusion, foreign tax credits, carryforwards, and whether the company properly equalizes the income for U.S. Taxpayers working abroad (due to the U.S.’s worldwide income tax rules). Depending on whether the employee is paying the tax or not will also impact whether the employee has the credit to use in future years or if the credit was assigned to the employer.

The IRS Offshore Disclosure and Hypo-Taxes Conundrum

It is very common for taxpayers to approach us when they have been equalized but have not properly reported their foreign accounts, assets, and investments. In this example, it would not be uncommon for Mark to reach out to us to let us know that he did not file an FBAR or Form 8938 — because he was unaware that her Hong Kongese MPF is reportable as a foreign account or asset. Since the amount of income he earns is substantial, his MPF is sizeable too — even though it’s only been accumulating for three years. When it comes to how to report hypo taxes, it is not a perfect science. Especially when the taxpayer has been non-compliant; thus, the safest route is generally for the employee U.S. person with the employer to ensure the full amount of income is reported (for U.S. tax purposes), and include this in an offshore disclosure submission (such as a streamlined or delinquency procedures) to reduce the number of red flags. Timing is also important because the taxpayer does not want to be seen as willful or make a quiet disclosure.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and/or other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist Taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Late-Filing Disclosure Options

If a Taxpayer is out of compliance, there are various international offshore tax amnesty programs that they can apply to safely get into compliance. Depending on the specific facts and circumstances of the Taxpayers’ noncompliance, they can determine which program will work best for them.

*Below please find separate links to each program with extensive details about the reporting requirements and examples.

Streamlined Filing Compliance Procedures (SFCP, Non-Willful)

The Streamlined Filing Compliance Procedures is one of the most common programs used by Taxpayers who are non-willful and qualify for either the Streamlined Domestic Offshore Procedures or Streamlined Foreign Offshore Procedures.

Streamlined Domestic Offshore Procedures (SDOP, Non-Willful)

Taxpayers who are considered U.S. residents and file timely tax returns each year but fail to report foreign income and/or assets may consider the Streamlined Domestic Offshore Procedures.

Streamlined Foreign Offshore Procedures (SFOP, Non-Willful)

Taxpayers who are foreign residents may consider the Streamlined Foreign Offshore Procedures which is typically the preferred program of the two streamlined procedures. That is because under this program Taxpayers can file original returns and the 5% title 26 miscellaneous offshore penalty is waived.

Delinquent FBAR Submission Procedures (DFSP, Non-Willful/Reasonable Cause)

Taxpayers who only missed the FBAR reporting and do not have any unreported income or other international information reporting forms to file may consider the Delinquent FBAR Submission Procedures — which may include a penalty waiver.

Delinquent International Information Returns Submission Procedures (DIIRSP, Reasonable Cause)

Taxpayers who have undisclosed foreign accounts and assets beyond just the FBAR — but have no unreported income — may consider the Delinquent International Information Return Submission Procedures. Before November 2020, the IRS was more inclined to issue a penalty waiver, but since then this type of delinquency procedure submission has morphed into a reasonable cause request to waive or abate penalties.

IRS Voluntary Disclosure Procedures (VDP, Willful)

For Taxpayers who are considered willful, the IRS offers a separate program referred to as the IRS Voluntary Disclosure Program (VDP). This program is used by Taxpayers to disclose both unreported domestic and offshore assets and income (before 2018, there was a separate program that only dealt with offshore assets (OVDP), but that program merged back into the traditional voluntary disclosure program (VDP).

Quiet Disclosure

Quiet disclosure is when a Taxpayer submits information to the IRS regarding the undisclosed foreign accounts, assets, and income but they do not go through one of the approved offshore disclosure programs. This is illegal and the IRS has indicated they have every intention of investigating Taxpayers who they discover intentionally sought to file delinquent forms to avoid the penalty instead of submitting to one of the approved methods identified above.

Current Year vs. Prior Year Non-Compliance

Once a Taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, Taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties.

**Need Help Finding an Experienced Offshore Tax Attorney?**

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for Taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting.

*This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure.

Contact our firm today for assistance.