Uncollectible Tax Equalizations: Protecting Your Company and the Assignee
by John Swilling and Evgenia Karpenko, KPMG LLP, Houston
(KPMG LLP in the United States is a KPMG International member firm)
Administering tax equalization programs can be cumbersome and practically difficult when faced with having to collect outstanding tax equalization settlement balances "("TEQ receivables") due to the company. The process of collecting TEQ receivables can be time-consuming and sensitive, especially if the international assignee has separated from the company. Furthermore, many company international assignment administrators are uncomfortable in the role of bill collector.
Several sensible strategies exist that permit employers to reduce the occurrences of unpaid TEQ receivables. However, no matter how sophisticated the international assignment program, and the technology used, many companies still have uncollectible balances related to their tax equalization settlements. Given this, it is important that the international assignment program administrator understand the withholding and reporting obligations, among other things.
Under a tax equalization policy, a company typically charges an international assignee a "stay-at-home" hypothetical income tax, collected through a payroll deduction during the year. The hypothetical tax is an estimate of what the assignee's tax liability would have been had he or she not gone on the international assignment. In exchange, the company typically funds the employee's actual foreign and U.S. tax liabilities. Once the assignee's actual liabilities are determined, upon the completion of the tax return, a reconciliation of the actual liabilities against the hypothetical tax withheld is prepared. Since the hypothetical tax was only an estimate of the "stay-at-home" liability, a result of the reconciliation is usually a settlement due either to or from the assignee.
When the company owes the assignee, the process is generally straightforward; however, when the assignee owes the company, the collection process can be quite cumbersome.
Avoid the Assignee Owing the Company
Based on our experience and interaction with company administrators, typically companies try to avoid having TEQ receivables due from assignees. Companies may use a number of strategies to reduce or eliminate the number of assignees that owe the company at year-end. While not an exhaustive list, some strategies include:
- Regular review of the hypothetical withholding amount, including revisions for changes in salary, marital status, and family size
- Withholding hypothetical taxes on supplemental income (bonuses, stock options, etc.) at the assignee's highest marginal rate
- In the case of U.S. inbound assignees, review of tax gross-ups or advances (if applicable) prior to year-end
- Increase the hypothetical tax withheld by a small percentage, e.g., 5 percent.
Best Practices for Collecting
Companies use a number of strategies to collect outstanding TEQ balances. To begin, having clear and concise policies surrounding the tax equalization process is a good way to avoid collection problems. The more "educated" the assignee is regarding the company's tax equalization policy, the more likely he or she is to pay settlements when due back to the company. Based on conversations we have had with numerous assignees, it is not hard to see how misunderstandings regarding the policy typically delay assignees' willingness to pay the balances of their tax equalization settlements.
Listed below are a few suggestions on how to effectively manage the collection process.
- Conduct an assignment briefing session prior to the assignment to cover the tax equalization policy and explain the assignee's responsibility to repay outstanding balances due to the company in a timely manner.
- Ideally, the program administrator, after having checked with the company's legal department, should request that the assignee, in writing, acknowledge the parties' responsibilities vis-à-vis tax equalization and authorize the collection by the company of TEQ settlements. If such an agreement has not been secured prior to the assignee's departure, when (and if) the assignee leaves the company or completes the assignment, the program administrator should obtain a signed agreement from the assignee stating he or she understands the continued coverage by the company's tax equalization policy. If an assignee is let go, or upon repatriating, during the appropriate exit interview or repatriation session, the company should get the signed document.
- Enter into an agreement with the assignee authorizing the collection of outstanding TEQ balances from current wages (the written agreement should be drafted and approved by the company's legal department).
- Consider referring outstanding settlements to a collection agency if not timely paid and inform the assignee if such a step is taken.
- Charge a stated interest rate on all settlements provided they are not paid within a reasonable timeframe.
There are a number of options and methods employers can use to more effectively collect settlements. It largely depends on the company's culture, structure, and systems in determining what method fits right.
Uncollectible TEQ Receivables
Even the most sophisticated programs have situations where a TEQ receivable cannot be collected from a current or former employee. And when collection efforts are exhausted and the TEQ receivable has been determined uncollectible, the question often arises as to how to report the uncollectible amount. The reporting and withholding requirements depend largely on the underlying nature of the balance due to the company.
The administrator must first answer a few key questions:
- Did the balance due the company result from an under-withholding of hypothetical taxes?
- Did the balance due the company result from an income tax advance that was not reported in compensation?
- Or was the balance due from a combination of under-withholding of hypothetical taxes and advances not reported in compensation?
Depending on the answer, the reporting and withholding requirements vary. The examples provided below 'walk through' each question to determine the appropriate treatment.
Did Balance Due to Company Result from Under-withholding of Hypothetical Taxes?
On January 1, 2003, Joe Expat, an employee of Company X, accepts a two-year international assignment under the company's tax equalization program. He receives base wages of $100,000, which are reduced by $20,000 of hypothetical tax withholding. Joe also receives various foreign allowances that add up to $40,000. Joe's compensation reported on the 2003 Form W-2 is $120,000 ($100,000 - $20,000 + $40,000).
The 2003 tax equalization reconciliation, prepared following the completion of Joe's 2003 return, shows a $3,000 balance due from Joe to Company X, due to insufficient hypothetical tax withholding during the year. Joe resigns without paying X the $3,000, and at the end of 2004, the company determined that it would not be able to collect the TEQ receivable.
Joe's taxable compensation for the year was $120,000. Had the right amount of hypothetical tax been withheld, the taxable compensation for 2003 would have been $117,000 ($100,000 - $23,000 + $40,000). Since the company did not withhold from Joe's wages the additional hypothetical tax in 2003, Company X overpaid Joe by $3,000. Therefore, the uncollectible TEQ receivable of $3,000, was already included in Joe's wages in 2003.
Determining that the TEQ balance due is uncollectible does not constitute additional compensation to the employee. The amount was correctly reported in 2003 as compensation and all federal and employment tax-withholding obligations were met at that time.
Did Balance Due to Company Result from an Income Tax Advance Not Reported in Compensation?
Companies, for various reasons, may provide federal or social income tax advances to international assignees. If properly structured as loans, the advances, unlike gross-ups, are not included in the W-2 as compensation. Typically, the advance is reconciled in conjunction with the tax equalization settlement process.
It is important to distinguish between a tax equalization settlement due back from the employee related to underpaid hypothetical tax and one due back from the assignee for a tax advance.
On January 1, 2003, Joe Expat, an employee of Company X, accepts a two-year international assignment under the company's tax equalization program. He receives base wages of $100,000, which are reduced by $23,000 of hypothetical tax withholding. Joe also receives various foreign allowances that add up to $40,000. Joe's compensation reported on the 2003 Form W-2 is $117,000 ($100,000 - $23,000 + $40,000). In addition, Joe receives a federal income tax advance of $1,500 to cover his projected shortfall on the U.S. income tax return.
When the tax equalization settlement is completed, Joe owes the company $1,500. In this case, the entire balance due to the company relates to the federal income tax advance. Remember, the $1,500, was not reported as compensation in 2003.
Once the company determines that the outstanding TEQ balance is uncollectible, the $1,500, would have to be reported as compensation to Joe. The company would not issue a Form 1099, since the advance occurred as a result of an employee-employer relationship. The company would be required to report the $1,500, on Form W-2 and calculate the appropriate gross-ups.
Was Balance Due from Combination of Under-withholding of Hypothetical Taxes and Advances Not Reported in Compensation?
In the final example, we look at a scenario that combines Examples 1 and 2 to demonstrate a more commonplace occurrence.
On January 1, 2003, Joe Expat, an employee of Company X, accepts a two-year international assignment under the company's tax equalization program. He receives base wages of $100,000, which are reduced by $20,000 of hypothetical tax withholding. Joe also receives various foreign allowances that add up to $40,000. Joe's compensation reported on the 2003 Form W-2 is $120,000 ($100,000 - $20,000 + $40,000). In addition, Joe receives a federal income tax advance of $1,500, to cover his projected shortfall on the U.S. income tax return.
The 2003 tax equalization reconciliation, prepared following the completion of Joe's 2003 return, shows a $4,500 balance due from Joe to Company X, due to insufficient hypothetical tax withholding during the year and reimbursement to the company for the income tax advance. Joe resigns without paying Company X the $4,500, and at the end of 2004, the company determined that it would not be able to collect the outstanding TEQ balance.
Similar to Example 1, $3,000 of the repayment relates to under-withheld hypothetical taxes, so the company would not have any reporting obligation for that amount since it was included in compensation during 2003. However, as in Example 2, the $1,500 would have to be reported on Form W-2 as compensation in 2004.
An uncollectible TEQ receivable does not always result in a reportable transaction. International assignment program administrators must review the underlying nature of the uncollected amount to determine the appropriate reporting requirements.
The collection of tax equalization settlements can be an arduous task for employers of international assignees. Understanding the appropriate withholding and reporting requirements surrounding uncollectible TEQ receivables is very important. It is possible for companies to reduce the number of incidents relating to the pursuit of assignees for outstanding settlements with some very simple planning. Planning and documentation, and adequate systems, are the keys to effectively managing the TEQ receivables collection process.