Designing Global Compensation Systems
An international assignment compensation system has to finely balance adequately rewarding and motivating expatriates while keeping costs under control for corporate headquarters. The cost of a three-year international assignment can easily exceed $3 million.
Because of the enormous investment, developing a comprehensive global compensation system for expatriates is one of the most critical challenges facing global human resource management.
Developing a Compensation Philosophy and Strategy
Companies with multinational operations need to develop compensation plans for employees that are in line with their global business strategy. Companies that articulate a clear global pay philosophy and develop corresponding compensation programs are best positioned to effectively execute their strategy. An effective global compensation strategy creates consistency in pay management and facilitates global employee mobility. See Viewpoint: Cross-Border Considerations for International Executives.
Establishing guidelines and practices with consistent communication of key messages is vital to the success of the compensation program.
Although multinational employers are striving to globalize their compensation practices, local and regional approaches to international pay are still most common.
Approaches to Global Compensation
International assignment compensation has many moving parts and is difficult to standardize. Many factors affect the compensation of a particular expatriate, including assignment type and length, location, family needs (if any), and benefits. The main compensation items for expatriates involve base pay, cost-of-living adjustments, housing allowances, home leave, education assistance for dependents and premium pay. See How Should We Compensate an Employee on a Foreign Assignment?
The U.S. Department of State indexes the living costs abroad, quarters allowances, hardship differentials and hazard pay allowances. The information, published quarterly, is used by many organizations to assist in establishing private compensation systems. See Salaries, Cost of Living and Relocation.
While the U.S. Fair Labor Standards Act does not apply to employees working outside of the U.S., employers must be familiar with the host country’s labor laws.
Do U.S. employment laws apply to U.S. citizens working abroad?
The New UAE Labor Law—What You Need to Know
Multinationals Strive to Meet Stringent Pay Equity Requirements
Compensation Plan Elements
A global compensation plan includes elements typical of any rewards strategy along with a few extra incentives and allowances, depending on the host country.
When an employee accepts an international assignment, it is up to the employer to determine the base rate of pay (referred to as the base salary). The base salary is normally related to pay ranges in the home country, which then may be adjusted based on local variances (i.e., fluctuations in the economy). Companies take one of the following approaches to establish base salaries for expatriates:
- The home-country-based approach. The objective of a home-based compensation program is to equalize the employee to a standard of living enjoyed in his or her home country. Under this system, the employee’s base salary is broken down into four general categories: taxes, housing, goods and services, and discretionary income.
- The host-country-based approach. With this approach, the expatriate employee’s compensation is based on local national rates. Many companies continue to cover the employee in its defined contribution or defined benefit pension schemes and provide housing allowances.
- The headquarters-based approach. This approach assumes that all assignees, regardless of location, are in one country (i.e., a U.S. company pays all assignees a U.S.-based salary, regardless of geography).
- Balance sheet approach. In this scenario, the compensation is calculated using the home-country-based approach with all allowances, deductions and reimbursements. After the net salary has been determined, it is then converted to the host country’s currency. Since one of the primary goals of an international compensation management program is to maintain the expatriate’s current standard of living, developing an equitable and functional compensation plan that combines balance and flexibility is extremely challenging for multinational companies. To this end, many companies adopt a balance sheet approach. This approach guarantees that employees in international assignments maintain the same standard of living they enjoyed in their home country. A worksheet lists the costs of major expenses in the home and host countries, and any differences are used to increase or decrease the compensation to keep it in balance.
Some companies also allow expatriates to split payment of their salaries between the host country’s and the home country’s currencies. The expatriate receives money in the host country’s currency for expenses but keeps a percentage of it in the home country currency to safeguard against wild currency fluctuations in either country.
The globalization of business has increased the use of variable and incentive pay around the world. But some cultures do not readily accept the practice of linking pay to individual or group performance. Other roadblocks to pay for performance include financial (not enough funding of the pool), target setting (defining performance parameters) and pay equity. Yet when it is done right, pay for performance effectively allocates limited rewards and retains top performers. As such, variable pay has become an increasingly important compensation element in many countries.
Variable pay plans generally fall into one of two categories:
- Short-term incentive plans are usually annual plans that link awards based on meeting individual or group performance criteria and objectives. Unlike long-term plans, these incentive pay plans provide for the payout to be awarded yearly.
- Long-term incentive plans, on the other hand, can vary in length from three to five years. These plans typically include equity-based incentives, such as stock options, restricted share grants and other types of equity-based plans like phantom stocks or stock appreciation rights. Awards are closely linked to the achievement of company goals and objectives over the three- to five-year period.
Participation and eligibility for each type of plan, as well as the level of incentives and average payouts, vary greatly among different companies, industries and countries around the world.
PREMIUMS AND ALLOWANCES
Premiums and allowances are added to the base salary so expatriate employees can maintain their standard of living. Those add-ons are removed when the employee repatriates. Some types of premiums and allowances are as follows:
- Hardship and hazard/danger pay. Employers sometimes need to send employees on assignments to host countries where conditions are difficult or hazardous (i.e., remote locations or countries with high rates of violence). As a result, a hardship allowance may be granted as an additional incentive to compensate employees for accepting assignments in less-than-desirable countries. Premiums typically range from 10 percent to 50 percent of base pay, depending on the severity of the hardship. For assignments in developing countries that have a history of violence or are experiencing political unrest, expatriates often receive some form of hazard pay, such as an additional 25 percent of their base salary. See Hazardous Duty Pay Policy: By Position and Location.
- Cost-of-living adjustments. A cost-of-living adjustment is an increase or decrease of an expatriate employee’s pay in response to fluctuations in the economy, such as inflation or deflation. To prevent attrition of the global employee’s purchasing power, companies often raise the employee’s base salary to keep up with inflation. When price levels drop, companies may also decrease the base salary accordingly.
- Educational assistance. Educational assistance for dependents of expatriate employees varies based on conditions in the host country. Assistance is usually not provided if local educational institutions are deemed adequate. When the educational system of the host country is substandard, employers may use a variety of benefits, such as employers operating a school in the foreign country; paying for dependents’ educational expenses, including room and board, to attend schools in the United States; or providing an allowance for attendance at private schools in either the United States or the host country. Other employers may simply choose to pay employees a specified amount (stipend) considered necessary for schooling at the nearest adequate school, and the employees make up any difference to send their dependents to an institution of their choice.
- Housing assistance. Assistance for housing is usually provided either in the form of free company-owned housing or via a housing allowance that is typically equal to the difference in housing costs between the home and host countries or based on a specified percentage of an employee’s base salary. Housing allowance rates are usually calculated based on either a single person or a two-person household. For employees with larger families living with them, employers may provide an additional supplement, typically ranging from 10 percent to 30 percent of the two-person allowance.
- Home leave. The objective of home leave policies is to give the assignee and his or her family the opportunity to maintain personal and business relationships and remain abreast of any economic, political, social or cultural changes in the home country. Although home leave policies vary among multinational corporations, most policies grant leave based on the employee’s level within the organizational structure. Executives, managers and more senior-level professionals are most often granted home leave once a year, or once every other year for a duration of up to four weeks, and lower-level employees may be allowed only a single visit during the course of their assignment. Companies that provide home leave allowances generally purchase or reimburse the employee for any travel-related expenses, such as airline tickets for the employee, spouse or partner and any dependent children younger than college age.
COMPENSATING THIRD-COUNTRY NATIONALS
Third-country nationals (TCNs) are employees who are not from the home country or the host country. TCNs have traditionally been technical or professional employees hired for short-term employment and are often considered international freelance employees. See What are the differences among a local national, an expatriate, a third-country national, and an inpatriate?
In the case of TCNs, multinational companies have one of three options regarding compensation:
- Pay the TCNs as if they were local nationals.
- Treat them as any other U.S. citizen would be treated.
- Establish an arrangement based primarily on the third country’s existing pay ranges.
The option a company chooses depends primarily on how these employees were hired into the organization or how they obtained the international assignment. The most common practices include the following:
- If the company is hiring locally in the host country, a TCN who applies for a job (including a professional or managerial position) may be assumed to be applying under the terms being offered. In this case, unless the TCN was specifically targeted and individually recruited for the position, he or she would most likely be offered the same compensation package provided to other local nationals.
- If a TCN who is already employed by the company transferred or reassigned from another country, the compensation arrangement usually depends on the individual’s particular career pattern. TCNs who occupy positions that involve regular transfers or reassignments are most likely to be compensated on the same basis as any one of their U.S. counterparts who are also subject to frequent transfers. This approach, however, may require that these employees be paid based on U.S. salary ranges that are adjusted to support differences in locations each time a transfer occurs.
Global benefits for expatriates can be complicated for HR professionals to navigate, given the myriad national health care and pension systems and the laws governing foreign residents. See Do we have to offer the same benefits to our employees who work in other countries as to the employees working in the United States?
HEALTH CARE PLANS
Health care coverage can pose significant challenges for expatriate employees because not all U.S. health care plans provide coverage for employees residing abroad. For this reason, the practice of providing health care benefits varies greatly among multinational companies. Multinational companies can provide coverage to employees in one of the following ways:
- Include the assignee in an international health care plan.
- Continue coverage under the U.S. health care plan.
- Provide coverage for the employee through a host country health care plan.
Regardless of the compensation approach a multinational company chooses to adopt, most companies commonly provide assignees with the same level of Social Security and pension plan benefit coverage, without any interruption in service, as enjoyed by other employees in the home country location.
Some countries require expatriate employees to participate in their social security or other government welfare benefit schemes. In this case, many companies provide for reimbursement of any payments made to the host country’s government scheme.
Since approximately half of all U.S. marriages are dual-earner partnerships, dealing with international assignments can pose significant challenges for the trailing spouse or partner, the expatriate employee and the sponsoring organization.
Trailing spouses face many challenges to finding suitable employment in the host country, including language and legal barriers as well as differences in educational, professional or licensing requirements.
Assistance with job searches, visas or work permits, career and educational counseling, and resume writing are just a few examples of the types of assistance a multinational employer can provide spouses or partners of transferring employees. A less common approach is to offer a financial sum to spouses of expatriate employees for any loss of income resulting from the relocation.
Other add-ons that are less commonly offered but can significantly ease expatriate package negotiations include cultural competence training, language training and repatriation assistance.
The purpose of these programs is to enhance the knowledge and awareness about the employee’s new location and the cultural differences affecting communication, behaviors and viewpoints. Training programs typically last a few days; however, for assignments to more remote or difficult locations, programs may also include security training that lasts for a longer period of time. The length and type of training should be directly related to the perceived level of assignment difficulty or differences in the assignment country.
Employers may conduct training either as an individual program for a single transferring employee and his or her family or as a group program when a number of employees are transferring to the same location within the same general time frame. However, it is advisable when conducting group training to also provide individuals with one-on-one time with the trainer to discuss any specific issues related to the employee’s job responsibilities or to address any other more personal concerns or issues. See Helping Expatriate Employees Deal with Culture Shock.
The inability to communicate can create a sense of vulnerability and loss of control. A basic knowledge of the language empowers expatriate employees to build critical relationships with host country nationals. Some jurisdictions require that employee communications be in the local language.
Most companies provide some form of language training for expatriate employees assigned to countries where they are nonnative speakers. Training program options include the following:
- Intensive total immersion courses.
- Cross-cultural training with integrated language instruction.
- Private tutoring or coaching.
- Group language classes.
- Use of language software or audiovisual applications.
Expatriate pay considerations do not end when the assignment ends. Pay can be a significant factor in making it difficult for a person to repatriate. Often employees returning home realize they made considerably more money with a lower cost of living in the host country; returning to the home country means a cut in pay and standard of living. If the foreign compensation package is disproportionate, an expatriate can suffer financial issues upon repatriation or reassignment to the home or other foreign country. Expatriate families and employees benefit from repatriation training to help readjust to living in the home country and returning to the original work environment. The length of the training often depends on the length of the assignment and the ages of the employees’ children. See Managing International Assignments.
Similarly, if the leading motivator of the expatriate employee is the long-term career aspect, the company needs to provide a challenging assignment upon return to the home office or shortly thereafter. If this is not feasible, communication about future plans for such an assignment and the timing should come from a mentor or a member of the senior management team. Otherwise, the company may risk losing its entire investment to turnover of returning expatriate employees.
United States citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside the United States. Multinational companies take one of four approaches to ensure tax compliance:
- Employees are responsible for their own taxes.
- The employer determines tax reimbursement on a case-by-case basis.
- The employer pays the difference between taxes paid in the United States and the host country.
- The employer withholds U.S. taxes and pays foreign taxes.
See How do we handle income taxes for expatriates?
Qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.
The foreign earned income exclusion allows an expatriate’s annual employment earnings income (up to a cap that is adjusted each year for inflation) to be exempt from U.S. gross. The foreign housing exclusion provides for the amount of housing expenses in excess of U.S. norms to be excluded from taxable income. A foreign tax credit of the amount of foreign tax imposed on overseas earnings can be used to offset the amount of U.S. tax otherwise due by the U.S. citizen or resident.
A common misconception that contributes to the international tax gap is that this potentially excludable foreign earned income is exempt income not reportable on a U.S. tax return. In fact, only a qualifying individual with qualifying income may elect to exclude foreign-earned income, and this exclusion applies only if a tax return is filed and the income is reported. See Where do expatriates pay income tax?
U.S. income tax is calculated on foreign-source income and translated to U.S. dollars at the time of receipt. Blocked currency, which is foreign income that is not readily convertible into U.S. dollars, does not constitute taxable income and may generally be deferred until the currency is convertible into U.S. dollars or is used for nondeductible personal expenses. Withholding of U.S. income tax is not required if the employer is required to withhold the host country’s income tax.
The U.S. Social Security tax is mandatory if services are performed by a U.S. citizen or resident, and if the employment is for a U.S. employer or for an affiliate of a U.S. company with a 3121(l) agreement. An entity is an affiliate if the U.S. company owns at least a 10 percent interest in the voting stock or profits of the entity. However, employees performing services for an international organization are exempt from FICA, FUTA and federal income tax withholding because services rendered for international organizations do not constitute employment, and remuneration for services rendered to international organizations does not constitute taxable income. Organizations that qualify as international organizations are those that have been designated as such by the president of the United States. The exemption applies to citizens and residents of the United States as well as to nonresident aliens.
Although foreign tax rules vary significantly by location, local taxing authorities also reserve the right to impose taxes on any income earned by the expatriate employee in the host country.
EQUALIZATION, REDUCTION AND TOTALIZATION AGREEMENTS
To prevent an expatriate employee from suffering excess taxation of income by both the U.S. and host countries, many multinational companies implement either a tax equalization or a tax reduction policy for employees on international assignments.
A tax equalization policy is an agreement between the employer and the employee to reduce the employee’s wages, for which the employer agrees to assume the obligation for the worldwide tax liabilities of the employee. Equalization is accomplished by the use of a hypothetical tax. The hypothetical tax is calculated as if the employee had never left the United States, and it represents the employee’s normal or expected tax liability for U.S. income.
Tax equalization is implemented by the use of advances to the employee; proceeds of the advance go to the tax authorities on the employee’s behalf. These advances are settled at year end. The result is deferred compensation to the employee, which the host country does not tax.
Under a tax reduction policy, expatriates gain from the differences in income taxes in the United States and the foreign country to which they are assigned, or the compensation of expatriates is adjusted so they experience no loss in income as a result of the net effect of income taxes, both foreign and U.S.
Additionally, the United States government has Totalization Agreements in effect with several countries. These agreements eliminate dual coverage of employees by both the home and host countries. U.S. International Social Security Agreements coordinate with comparable programs in other countries. These agreements assign coverage according to objective rules, provide for no individual coverage elections and require that the employee remains covered by the home country and is exempt in the host country. The expatriate assignment must be for a period of five years or less, and the employee must remain an active employee of the sending employer.
All agreements exempt expatriates from the host country’s version of the U.S. Old Age, Survivors, Disability and Health Insurance (OASDHI) program. Some agreements also exempt them from other foreign benefits, such as health insurance, unemployment insurance, workers’ compensation, family allowances, cash sickness benefits and maternity benefits.
The United States has income tax treaties with a number of foreign countries. Under these treaties, residents (not necessarily citizens) of foreign countries are taxed at a reduced rate or are exempt from U.S. income taxes on certain items of income they receive from sources within the United States. These reduced rates and exemptions vary among countries and specific items of income. Treaty provisions generally are reciprocal in that they apply to both treaty countries. Therefore, a U.S. citizen or resident who receives income from a treaty country and who is subject to taxes imposed by foreign countries may be entitled to certain credits, deductions, exemptions and reductions in the rate of taxes of those foreign countries. Treaty benefits generally are available to residents of the United States. They generally are not available to U.S. citizens who reside outside the United States. However, certain treaty benefits and safeguards, such as nondiscrimination provisions, are available to U.S. citizens residing in the treaty countries. See Tax Guide for U.S. Citizens and Resident Aliens Abroad.
Many states impose taxes on the foreign income of expatriate employees who maintain a home in that state. In addition, states also may impose unemployment insurance taxes on employers that have employees with homes in that state. The reasoning is that, like other resident citizens, the employee derives certain benefits from the state, and the state where the employee resides is the most plausible place for an unemployed worker to seek unemployment compensation.
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