Hypothetical tax / hypotax is a concept we have already briefly touched upon in our previous article on shadow payrolls.
However, from feedback received, we have decided to write a more in-depth article to explain in greater details what “hypo taxes” (aka “hypos” or “hypotax”) are and how they work.
Hypothetical tax (“hypotax”) definition
As mentioned in our global mobility guide:
Hypothetical taxes (or “hypotax”) are the taxes an individual would have paid, had they remained at home and never gone on assignment.
Hypos usually cover personal income tax and social security but not assignment specific compensation items such as COLA, housing allowances, school fees and relocation payments.
Crucially though, hypothetical taxes are yes withheld in the same way actual income taxes are from the employee’s gross salary but they are not remitted to the home country’s tax authorities.
Instead, they are “kept” by the employer in anticipation of the taxes due in the host country which become due via the shadow payroll and/ or once the foreign country’s tax return is filed.
In other words, one can think of hypothetical taxes as a substitute for actual income taxes which are normally deducted from an employee’s gross salary.
It is important to remember however that from the moment hypothetical taxes are deducted, actual income taxes withholding needs to be either “switched off” or reduced.
Another aspect also worth noting is that the hypo taxes withheld will never equal the exact amount of income taxes due in the host location.
This means that the concept of hypothetical taxes goes hand in hand with the chosen tax equalization policy (see an example here from the SEC TEQ Policy).
Last but not least, it is the home country’s payroll that continues to deliver the net pay to the individual whereas the shadow payroll is used to calculate and report the taxes due in the host location only.
How to calculate hypotaxes
Whilst there is no official legislation that regulates what hypothetical taxes ought to include and how they should be calculated, the below process explains the logic applied for calculating hypotaxes for someone who is tax equalized.
1: establish the reference gross salary during the assignment.
2: calculate the income taxes that would normally be due on the gross salary from Step 1 using the parameters applicable to the individual (relevant progressive rates, single vs married personal allowances, etc).
3: (applicable only to countries with State / Local income taxes in addition to Federal ones): calculate the State / Local taxes that would normally be due on the gross salary from Step 1 using the parameters relevant to the individual (mainly, the correct State / Local tax rates).
4: to get the total hypothetical taxes add step 2 + step 3.
Once the hypotaxes are known, there are a couple of additional steps required to arrive at the guaranteed net salary the individual will receive no matter what level of taxes are due in the host location.
5: deduct from the reference gross salary, federal (step 2) plus state (step 3) hypothetical taxes AND actual social security (for example FICA and Medicare in the US) and pension contributions.
6: add assignment specific allowances such as cost of living (COLA), housing, relocation assistance
The given total is net compensation payable to the individual in order to ensure that the employee is neither better nor worse off as a result of higher or lower host country taxes under a tax equalisation arrangement.
7: reconcile at year-end to work out if the hypothetical taxes withheld from the individual are actually those that they would have paid at home.
This final step, also known as annual tax equalization settlement calculation, is intended to ‘true-up’ the amount of hypotax deducted versus the hypothetical taxes which would actually have been deducted.
It is needed because sometimes:
- there can be changes in the middle of the tax year or at year end to the applicable income tax rates; or
- perhaps at the time the hypotaxes were calculated, some supplemental pay items such as bonus and commissions were not known and thus not included in the initial hypothetical taxes calculations.
The annual tax equalization settlement calculation usually results in a balance due either by the individual to the company or vice versa.
FAQ on hypothetical taxes
What is hypo tax?
Hypo tax (short for hypothetical tax) is an estimated tax deduction representing the income taxes an employee would have paid if they had remained in their home country and never gone on assignment.
It is usually part of a tax equalization policy to keep the employee tax‑neutral, ensuring they pay roughly the same tax as if they had stayed at home.
What is the practical meaning of hypothetical tax?
In practical terms, under a tax equalization scenario, the hypothetical home‑country tax replaces actual home‑country withholdings and is used to ensure the employee is neither better nor worse off from a tax perspective as a result of the assignment.
What is expat hypo tax?
Expat hypo tax is essentially the same as hypo tax, namely, the hypothetical home‑country tax that is withheld from an expatriate’s pay under a tax equalization arrangement.
Instead of having actual home‑country tax withheld and remitted, the employer withholds this hypothetical amount and then takes responsibility for the real tax liabilities in the home and host countries.
What is typically included in the hypotax calculations?
Bearing in mind there are no hard and fast rules, it really depends on the employer’s tax equalization / protection policy, the bargaining power of the employee and industry best practices.
In addition to standard salary, bonus and commissions, some hypothetical tax calculations may also include personal investment income, share-based compensation and spousal income.
On the other hand, compensation items such as COLA, housing allowances and relocation assistance are typically excluded from hypotax calculations as considered assignment-specific.
These items are however typically covered by the tax equalisation / protection policy thus ensuring they are offered to the employee on a net-of-tax basis.
Nonetheless, no two expats going on assignment are the same.
It is therefore recommendable to engage the expertise of a niche expat tax and global mobility specialist to advise on the best approach to follow when it comes to hypo taxes for each individual circumstances.
What is a hypothetical tax calculator?
A hypothetical tax calculator is a tool or model used to estimate the home‑country taxes an assignee would have owed had they not gone on assignment.
In practice, most employers or tax providers use internal calculation templates rather than a public “one‑size‑fits‑all” online calculator, because hypotax assumptions (income included, filing status, deductions, treatment of bonuses, etc.) are policy‑specific.
What is hypo tax withholding?
Hypo tax withholding is the process of deducting hypothetical home‑country taxes from an assignee’s compensation each payroll period.
Those amounts are not paid to the tax authorities; they are retained by the employer to help fund the actual tax liabilities arising in the host and, where relevant, home jurisdiction under tax equalization.
Is hypo tax a pre‑tax deduction?
Yes, hypo tax is typically treated as a pre‑tax deduction from the employee’s gross home‑country–reference salary under a tax equalization policy.
It functions much like normal tax withholding from the employee’s perspective, but instead of being remitted as actual tax, the employer holds it internally and then runs a year‑end equalization to “true up” against the final hypothetical tax.
IRS guidance, such as in private letter rulings and memoranda (e.g., PLR 202202010), describes hypotax as a reduction to compensation—not income the employee ever receives—under tax equalization policies.
This aligns with Rev. Rul. 78-374, where similar employer-paid tax amounts are excluded from wages, effectively making the employee’s taxable salary the “net” after hypotax deduction.
What is a hypothetical tax settlement?
A hypothetical tax settlement (or tax equalization settlement) is the year‑end reconciliation comparing the hypotax withheld during the year with the final hypothetical tax calculated on the employee’s actual full‑year income and personal circumstances.
The settlement determines whether the company owes the employee a refund of over‑withheld hypo tax or whether additional hypo tax needs to be collected from the employee.
