In an age of increased globalization, cross-border employment has become more common. Instead of hiring new talent in foreign countries, companies often choose to move existing employees to different locations. This strategy ensures smooth operations and leads to significant savings in both time and money for the organization.
As a result, expatriates frequently move to new countries, which can be great for their professional development and career paths. However, these moves come with complex tax issues. Differences in tax rates between an expatriate’s home country and their host country can create unexpected financial gaps. This can either lead to a heavy tax burden or, on the other hand, provide unexpected tax benefits.
To address these gaps and create fairness in both pay and taxes, companies use tax equalization and hypo tax systems. These methods make sure that expatriates do not face excessive taxes or receive unfair tax advantages due to differences in international tax rules. However, companies still cover the costs of relocation, which is separate from the tax equalization and hypo tax processes.
In this article, we break down tax equalization and hypo tax, looking at their importance, how they work, and what hypo tax means under Indian tax law.
What is Tax Equalization vis-a-vis Hypothetical Tax (or Hypo Tax)
Before delving deeper into the complexities of expatriate taxation, it is essential to first understand the concept of Tax Equalization and its significance in international assignments.
Illustrative Example: The Need for Tax Equalization
Consider an expatriate who is seconded from India to the United States for a two-year international project. In this scenario, suppose the tax rate in the U.S. is 40%, whereas the tax rate in India stands at 30%. All other aspects remaining constant, this relocation would result in a higher tax burden for the expatriate, reducing their effective take-home compensation solely due to differences in tax regimes.
To mitigate this disparity and avoid potential concerns between the employer and the employee, organizations implement Tax Equalization policies. These frameworks ensure that expatriates are neither financially disadvantaged nor unduly benefited due to varying tax rates between their home and host countries.
Defining Tax Equalization
Tax Equalization is a structured policy designed by organizations to ensure that employees seconded to foreign jurisdictions do not experience tax-related financial discrepancies. The core objective of this mechanism is to neutralize the impact of differing tax rates, thereby providing a tax-neutral experience for expatriates. By implementing this policy, companies ensure that employees neither bear an excess tax burden nor receive an unintended tax advantage due to international tax variations.
How Tax Equalization Works
Under a tax equalization framework, an employee’s total tax liability in the host country is adjusted to match what they would have paid had they remained in their home country. This adjustment is applied as follows:
Scenario 1 –
If the tax burden in the host country exceeds that of the home country, the employer compensates the expatriate for the excess tax payable.
Example – An expatriate is seconded from Singapore to India. Assuming the tax rate in Singapore is 20%, while the tax rate in India is 30%, the expatriate would face a higher tax liability in their host country. To ensure that the employee does not incur an additional financial burden due to this tax rate difference, the company compensates the expatriate for the excess tax payable, thereby maintaining tax neutrality
Scenario 2 –
If the tax liability in the host country is lower than the hypothetical home-country tax, the employer retains the benefit rather than passing it on to the employee.
An expatriate is seconded from USA to India. In this scenario, the tax rate in USA is 40%, whereas the tax rate in India is 30%, meaning the expatriate’s tax liability in the host country would be lower than in their home country. Under the tax equalization framework, rather than allowing the employee to benefit from this reduced tax burden, the employer retains the surplus, ensuring that the expatriate’s tax obligation remains consistent with what they would have paid had they continued working in India
Basis the above, it can easily conclude that the tax equalisation and hypo tax is nothing just the tools to neutralise the tax effect on the employee and the company in the case where the employees are seconded from one country to another.
Tax Equalization and Hypothetical Tax: A Matter of Interpretation Under Indian Tax Law
From our earlier discussion, we understand what tax equalization and Hypo Tax mean. Now, let’s explore these concepts through the lens of Indian income tax law, using real-life examples to make it more relatable.
Scenario 1: Salary Uplift in Higher-Tax India
Imagine an employee who is assigned to India after working in Singapore. Since the tax rates in India are higher, the employer increases the Indian salary so that the net take-home pay remains similar to what the employee earned in Singapore.
In this scenario, the extra amount is clear; it’s money given to the employee. Therefore, it counts as part of the salary and is fully taxable in India. There’s no debate here because everyone, including the tax authorities, agrees that if you receive money, it should be taxed.
Scenario 2: The Hypo Tax Conundrum
Now consider a slightly trickier situation. Suppose an expatriate is working in India but originally hails from the USA. In this case, the employee’s tax bill in India is lower than what it would be in the USA. To balance this, the employer subtracts the difference from the employee’s salary. This withheld amount is known as the Hypo Tax.
From the earlier discussion, a key argument emerges from the employee’s perspective: since the amount deducted as Hypo Tax is never credited to their account, it should not count as taxable income. In other words, the employee argues that because they never received this money, it never “accrued” to them and should not be subject to tax.
On the other hand, the income tax department may argue that the notional amount is taxable income. Their reasoning is that since it is part of the overall compensation package, it should be taxed, even if the employee doesn’t actually receive it.
Hence, in the above example, the challenge may arise in respect of INR 10 of hypo tax, withheld by the employer.
Due to the complexity and differing views on this issue, the matter has gone to court in India. The main arguments from the income tax department in these court cases are summarized below:
- No Exemptions in Writing: There’s no clear rule in the Income Tax Act, 1961 that exempts Hypo Tax or allows for a deduction. Without such a rule, they argue there’s no legal way to treat it as non-taxable.
- Part of Your Compensation: because Hypo Tax is included in your compensation, even as an adjustment, it counts as income.
- Avoiding a Double Benefit: allowing an exemption would give expatriates an extra tax advantage when they already benefit from tax credits for Indian taxes in their home country.
The key arguments from the assessee’s side in these judicial cases are summarized below:
- Never Received the Money: Since the money was never actually paid, it never “accrued” to the employee. If you never received it, why tax it?
- Only a Notional Figure: It’s just a number on paper used for balancing the tax liability; it doesn’t represent an actual benefit.
- Income Diversion Concept: The argument here is that the Hypo Tax adjustment is more about how income is allocated than income actually being received. Therefore, it shouldn’t trigger a tax liability.
An interesting fact about this litigation is that various High Courts and the ITAT have ruled in favor of the taxpayers. By giving a favorable view, the courts have observed the following:
- Favorable Rulings for Employees: In several rulings, Courts have agreed that since Hypo Tax never actually accrues as income for the employee, it shouldn’t be taxable.
- Key Judicial Observations: Courts have emphasized that Hypo Tax is a structural element of salary planning by multinational companies. Since it never becomes actual income, it cannot be taxed under the Income Tax Act.
- Adjustment of Salary Components: An important point from these rulings is that Hypo Tax should be viewed as a deduction from perquisites rather than from the basic salary.
A few notable cases that support this view include:
- CIT v. Dr. Percy Batlivala [2009] 2009 taxmann.com 1028 (Delhi)
- CIT v. Jaydev H. Raja [2012] 26 taxmann.com 357 (Bombay)
- ITO v. Lukas Fole [2010] 35 SOT 8 (Pune) (URO)
- CIT v. Rajasekaran Balasubramaniam [2015] 60 taxmann.com 402 (Madras)
- Roy Marshall v. ACIT (OSD)*, Circle -26(1) [2011] 11 taxmann.com 135 (Mum.)
In all of these cases, the Courts supported the employee’s position. They ruled that Hypo Tax, which is just an accounting adjustment without a physical receipt, should not be taxed.
Conclusion
Tax Equalization and Hypo Tax play a crucial role in making sure that an expatriate does not face an unfair tax burden or gain an unintended advantage due to different tax systems in various countries.
As an expatriate, it’s important to understand both Indian tax law regarding Hypo Tax and the tax equalization policy used by your organization. However, the Indian Income Tax Act does not have clear rules on this topic, which leads to disputes about the taxability of Hypo Tax. Although several court decisions favor treating Hypo Tax as a non-taxable adjustment since it never truly goes to the employee, the Income Tax Department may still dispute this perspective.
In summary, the treatment of Hypo Tax is still a debated issue with various interpretations and ongoing legal cases. For expatriates and employers, it is crucial to keep clear records of tax equalization policies and, when uncertain, seek legal advice or request advance rulings to prevent possible disputes.
Vaansh Sharma
Vaansh Sharma is a Manager at the Tax and Regulatory division of Coinmen. He specialises in restructuring advisory, corporate tax, and M&A business and transaction advisory. Also, he has worked with clients from various backgrounds including Multinational Corporations, Charitable Institutions, and Ex-patriates.
