What is a hypothetical tax?

Hypothetical taxes (or hypotax) are the taxes an employee would have paid if they remained at home and not gone on assignment.

For example:

• An employee resides and works as an employee in New York.
• Her US income includes a base salary and a bonus.
• She accepts an assignment in Mexico where she receives a base salary, bonus, and cost of living allowances.
• During the assignment, she will need to file US federal and Mexican income tax returns and may need to file a New York state tax return, unless she meets specific criteria. She will also be subject to US social security taxes based on her full compensation package.

Hypos cover personal income tax and social security but not relocation-specific compensation such as housing allowances and school fees.
Hypothetical taxes are withheld from the employee’s gross salary just as income taxes are but they are not remitted to the home country’s tax authorities. Instead, the employer keeps them in anticipation of paying the host country’s taxes, which become due via the shadow payroll or after filing the foreign country’s tax return.

Is hypo tax a pre-tax deduction?

Hypothetical tax is a salary reduction that estimates the amount of tax an individual would have to pay if they had not gone on assignment. This amount is only an estimate. Individuals will still need to file their tax return and settle the final amount due with employers on a tax equalization.

What income is hypothetically taxed?

Hypothetical tax is not defined in tax law but is determined by company policy. Organizations must balance between accurately estimating home country taxes and standardizing procedures for employee equity.
Organizations typically start with the notional home gross salary and add any additional allowances and benefits-in-kind normally received in the home country. Some companies include personal income or spousal income.

Employers include guaranteed bonuses and in some cases, non-guaranteed bonuses to ensure they withhold enough tax.

How is hypotax calculated?

There is no official legislation that regulates hypothetical taxes and how to calculate them. However, many organizations use the below processes for calculating hypotaxes:

1. Establish the gross salary during the assignment
2. Calculate the income taxes for the gross salary using parameters around the individual’s tax statement (single vs married personal allowances, etc)
3. Calculate the state/local taxes (if applicable) due on the gross salary using the correct state/local tax rates
4. Add steps two and three to get the total hypothetical taxes
   After calculating the hypotaxes, organizations will need to determine the individual’s guaranteed net salary or amount they’ll receive regardless of the host level’s taxation.
5. Deduct federal (step 2), state (step 3) hypothetical taxes, and actual social security (FICA and Medicare in the US), and pension contributions from the reference gross salary
6. Add assignment allowances such as cost of living, housing, and relocation assistance.
   The total is net compensation payable to the individual to ensure that the employee is neither better nor worse off from higher or lower host country taxes under tax equalization.
7. Reconcile at the end of the year to understand if the hypothetical taxes withheld from the individual what they would have paid at home