CA Shrutika Shedshale
With increase in global mobility, there is an increase in international assignees and resultant tax complications. Hypothetical Tax (commonly referred as Hypo Tax) is a topic which arises normally in case of International assignees. Hypo tax comes up in cases where the international assignee and his/ her employer have entered into Tax Equalization agreements.
An individual is usually accustomed to the tax rates and tax structure of his/her home country. Tax rates are different in different countries. If an employee is deputed from his home country to another country certainly his net income will be impacted because of difference in tax rates. e. g. If an Indian employee (effective tax rate is about 25%) is deputed to Saudi Arabia (zero tax) he will be very happy because his net take home will increase by 25%. But the same employee will be unhappy if he is deputed to some of the European countries where tax rates are very high. The concept of tax equalization came up so that the employee is “neither better off nor worse off” because of deputation to another country.
A Tax Equalization agreement is entered between an employee and his home country employer. The agreement lays down that, employee’s tax deduction will remain as per his home country tax structure and any extra taxes/ savings as a result of the assignment will be borne/ enjoyed by the employer. Thus, tax equalization aims to remove tax as a relevant factor in international assignment decision process. Tax equalization is purely an internal understanding between employer and employee and is not governed by any law.
From an employee standpoint, tax equalization policy brings certainty of net income. Also in most of these cases, the employer takes care of employee’s tax compliances in home and host country and thus employee is saved from the tax hassles.
Again not all companies go for tax equalization. Some companies adopt a tax protection policy, where employer reimburses the employee only if the host country tax is in excess of amount which would be due in home country. Some companies do nothing and let the employees handle their taxation.
Hypothetical Tax (Hypo Tax) vs Actual tax
In any typical international assignment, the employee is paid his home country salary and plus specific assignment related allowances / perquisites. The employer deducts tax on the employee’s home country salary as per home country tax structure. This tax is called Hypothetical tax. This tax is not actual tax and is therefore not remitted to Govt. exchequer.
The tax liability in host country is calculated on aggregate of home salary (after deducting hypo tax), assignment allowances and perquisites. This amount needs to be remitted to Host country’s Govt. exchequer. This amount will be partially funded by the Hypo tax recovered by the employer from the employee. In some cases the actual tax amount will be lower than Hypo tax. The benefit will be enjoyed by the employer.
In most countries (including India) tax liability of employee borne by employer will be treated as employee’s income. This calls for grossing up while calculating host country tax liability.
There is no clear guidance on tax equalization or hypo tax in the Income Tax Act. This issue appeared before the Bombay High Court in case of Mr. Jaydev H. Raja. The assesse was employee of Coco Cola Inc., USA and was deputed to India. He received salary of Rs. 77 lakh after tax of Rs. 50 lakh. The assesse offered salary income of Rs. 77 lakh plusRs. 35 lakh of tax as taxable income. He did not offer entire Rs. 50 lacs of tax as income on the premise that Rs.15 lakh was hypo tax which was paid by him. The revenue contention was that Rs. 15 lakh was an application of income after income has accrued. The High court gave its judgment in favor of the assesse and upheld that, Hypo tax will be deducted while calculating taxable salary offered to tax in India.
Computation under tax equalization and without tax equalization
Now let us see how this tax equalization scenario compares with another employee who has not entered into a tax equalization agreement.
|Sr. No.||Particulars||Tax Equalization Scenario||Employee handles taxes on his own|
|Rs. lakh||Rs. lakh|
|A||Gross Salary in Home Country||50.00||50.00|
|B||Hypothetical tax @ 25%||12.50|
|C||Net Home Country Income (A-B)||37.50||50.00|
|E||Net Income received by Employee (C+D)||47.50||60.00|
|F||Indian Incremental Tax paid by employer ((E*30%-B)/70%)||2.50|
|G||Total Taxable Income in India (E+F)||50.00||60.00|
|H||Revenue for Govt. of India (F*30%)||15.00||18.00|
In effect Govt. of India is losing tax on the amount of hypothetical tax that was deducted by the employer. Had there been no tax equalization agreement, Govt. of India would have earned additionaltax of Rs. 3 lakh.
Hypo tax is a deduction made by employer from employees salary and is used to fund the employee’s final tax liability in host country. It is fair to include only the incremental tax paid by employer to the income of the employee. But, is reducing hypo tax amount from the salary of the employeefair? Should an internal tax equalization agreement result in reduced revenue for the host country?