What is hypothetical tax and how to calculate hypotax for expats in 7 steps

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 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.

Contact us should you require further clarifications on what hypothetical taxes are and how to calculate them. We offer a free ½ hour consultation.