Is hypothetical tax deductible or creditable on my US return?

No. Hypothetical tax is a contractual reduction in your pay that the employer keeps; it is never paid to the IRS or HMRC. An IRS Chief Counsel memorandum on tax equalisation treats the amount removed from salary as neither wages nor income, so it is simply absent from your Form W-2. It must never be entered as federal withholding, an estimated payment or a foreign tax credit on Form 1040.

Do I still file a UK Self Assessment return under a modified PAYE scheme?

Yes. Under HMRC's EP Appendix 6 arrangement the employer pays PAYE on an estimate of grossed-up earnings, but the actual figures are reported on your Self Assessment return by 31 January after the tax year, and the employer pays any additional tax after that. HMRC has removed the requirement to make payments on account for employees covered by a modified PAYE scheme.

Why does my Form W-2 show far more than my agreed salary?

Because the UK and US income taxes your employer pays for you are treated as additional compensation in the year they are paid, while the hypothetical tax deducted from your pay is excluded. Each tax payment is itself taxable, so the employer also funds a gross-up. The result is a W-2 figure that can exceed your stay-at-home package by a large margin.

Can I claim a foreign tax credit for UK tax my employer paid?

Generally yes. UK income tax paid on your behalf remains your liability, so it is creditable on Form 1116 in the general category, provided the related wages are not excluded under the foreign earned income exclusion. The credit is limited to the US tax on that foreign-source income; unused amounts carry back one year and forward ten years under Publication 514.

What happens if HMRC refunds tax after my assignment ends?

Most equalisation policies require you to pass refunds of employer-funded UK tax back to the employer. On the US side, a refund of UK tax you previously credited is a foreign tax redetermination, which usually means reducing the credit for the year concerned through Form 1040-X with a revised Form 1116, or reporting it on Schedule C (Form 1116) where US tax is unchanged.

Will my employer's tax provider file my FBAR and Form 8938?

Often not. Providers are engaged to handle company compensation and the equalisation settlement, and many policies exclude personal income and personal reporting. The FBAR is required when your foreign accounts exceed $10,000 in aggregate at any time in the year and is filed through FinCEN's BSA E-Filing System. Confirm the provider's scope in writing and arrange anything missing yourself.

US Tax Return Preparation for Expats: Tax Equalisation

US tax return preparation for expats on a tax equalised UK assignment is different from any other expat return, because your employer pays your actual US and UK income taxes and every dollar or pound it pays becomes more taxable compensation for you. The short answer is this: hypothetical tax is not tax, employer-paid tax is income in the year it is paid, UK tax paid on your behalf is generally creditable on Form 1116, and anything the policy leaves out, such as personal investment income, the FBAR and Form 8938, remains your own responsibility.

In the returns we prepare for senior US executives and bankers seconded to London, the equalisation layer causes most of the errors and surprise settlement bills. Residence, housing, social security and equity vesting are covered in our general secondment guide; this article stays on the equalisation mechanics.

What are tax equalisation and hypothetical tax?

Tax equalisation is a contractual policy under which an employer keeps an assignee in broadly the same tax position they would have been in had they stayed at home. The employee bears a notional home-country tax, and the employer bears the actual US and UK taxes the assignment generates, whether those are higher or lower. Tax protection is the softer version: the employee pays their own taxes and is reimbursed only if the combined actual burden exceeds the notional home burden.

Hypothetical tax is the estimated US federal (and usually state) income tax you would have paid on your company compensation had you remained in the US. It is deducted from your pay, but it is never remitted to the IRS or to HMRC. An IRS Chief Counsel memorandum on tax equalisation, published at https://www.irs.gov/pub/irs-wd/202202010.pdf, describes the mechanism precisely: salary is reduced by an approximate hypothetical tax, the employee is not entitled to that amount, and so the hypothetical tax removed from salary is not wages or income. The Form W-2 then reports the reduced salary plus the taxes the employer pays on the employee's behalf. The memorandum states that it may not be cited as precedent, but it is a clear statement of how the IRS reads these programmes.

Most policies share the same building blocks; reading yours against this list is the first job:

A hypothetical tax withheld on stay-at-home salary and bonus, recalculated after the year end
An employer undertaking to meet actual UK and US federal income tax on company compensation, often with state tax
A year-end equalisation calculation, usually prepared by the employer's appointed tax provider, producing a settlement owed to or by you
A rule on personal income: most policies exclude it entirely, some charge hypothetical tax on it at an assumed rate, and a few cover a fixed amount
Cooperation clauses: file on time, use the appointed provider, and pay over refunds of employer-funded tax
A trailing-years clause covering tax years after you return home

Why does employer-paid tax count as more taxable income?

The principle comes from the 1929 Supreme Court decision in Old Colony, 279 U.S. 716, as summarised in the Chief Counsel memorandum: an employer's payment of an employee's income tax is made in consideration of services and is additional gross income, because discharging someone's obligation is equivalent to paying them. The memorandum concludes that payments for a US citizen employee's taxes in the United States and in the host country are included in income and wages unless an exception applies, with the US tax treated as withheld on the Form W-2.

IRS Publication 54 at https://www.irs.gov/publications/p54 points the same way. Its list of employer-provided amounts, in the foreign housing exclusion chapter, includes amounts your employer pays to a third party on your behalf and amounts paid to you by your employer as part of a tax equalization plan. Publication 525 at https://www.irs.gov/publications/p525 gives the parallel rule for payroll taxes: where an employer pays your social security and Medicare taxes without deducting them from your wages, the amount paid for you is taxable wages. The consequence for an equalised banker is that the UK income tax your employer remits to HMRC is US taxable compensation to you, and so is any US tax it deposits.

What is the timing lag, and why does tax on tax never quite stop?

Individuals file US returns on the cash basis, so employer-paid tax is income in the calendar year the employer actually pays it, not the year the underlying salary was earned. A UK balancing payment made in January 2026 for the 2024 to 2025 UK tax year is 2026 compensation for US purposes. A US balance due on your 2025 Form 1040 that the employer pays in April 2026 is also 2026 compensation. Each of those payments is itself taxable, so the employer must fund the tax on it, and that funding is taxable too. Practitioners call this the gross-up or tax on tax cycle.

The cycle converges, because each layer is a fraction of the one before, but it never closes while the assignment runs. In year two of a London assignment, equalisation income typically stacks like this:

Current-year UK income tax paid through the UK payroll on estimated grossed-up earnings
UK balancing payments for an earlier UK tax year, paid after the UK Self Assessment return is filed
US federal income tax the employer deposits through US payroll during the year
US tax the employer pays on the prior year's Form 1040 balance due
Any equalisation settlement paid to you, plus the gross-up the employer funds on it

The UK runs the cycle on a different clock. HMRC's guidance on modified PAYE at https://www.gov.uk/hmrc-internal-manuals/paye-manual/paye82002 requires the employee's UK return to show cash remuneration, benefits and other employment income grossed up on a current year basis. The UK therefore closes each tax year's gross-up within that year's computation, while the US picks the same money up whenever cash leaves the employer. That single difference explains a large part of the reconciliation problem discussed below.

How do equalisation settlements work, and who owes whom?

The estimated hypothetical tax withheld during the year is only a forecast. After the year end, the employer's provider recomputes a final hypothetical tax on actual stay-at-home compensation and compares it with what was withheld. The Chief Counsel memorandum describes the standard outcome: if the estimate was too high, the employer pays the difference to the employee and usually pays the additional tax on that payment; if the estimate was too low, the employee repays part of the prior year's remuneration to the employer.

A settlement paid to you is compensation in the year paid, normally grossed up through payroll. A settlement you repay is not simply netted off the next Form W-2; its US treatment depends on how and when the employer books it. We always obtain the employer's written description of each settlement first, because one booked twice in different years creates double counting that IRS matching will not untangle.

Settlements also arrive late: final hypothetical tax needs both returns substantially complete, so a 2025 settlement is often paid or collected in late 2026 or 2027.

Why do the Form W-2 and the UK P60 and P11D never reconcile?

Your US wages and UK pay figures are not supposed to agree on their face. The Form W-2 is a calendar-year, dollar, cash-basis report from the US payroll. Under a modified PAYE scheme the P60 is issued by 31 May showing grossed-up pay and total PAYE for the UK tax year from 6 April to 5 April, and the P11D is due by 31 January with form P11D(b), rather than by the normal 6 July deadline listed at https://www.gov.uk/employer-reporting-expenses-benefits/deadlines for ordinary employers. The main reasons for the gap are:

Different periods: a calendar year against a 6 April to 5 April year, so each US year straddles two UK years
Different currencies, translated at different rates on different dates
Different gross-up bases: current-year grossing up in the UK against cash-basis recognition of tax payments in the US
Hypothetical tax removed from US wages, while the UK grossed-up figure is built from the net package the policy promises
Benefits valued under UK benefit-in-kind rules on the P11D against US fair market value rules, with some UK-taxable items excluded or excludable in the US and vice versa
Split or shadow payrolls, where part of the pay is delivered in the US and part in the UK and each payroll reports only some of the other's items

We build a written bridge from the UK figures to the W-2 for every assignment year and keep it with the return. If the IRS questions the credit, it shows which UK tax relates to which US year and income.

How does the UK run PAYE for tax equalised assignees?

HMRC's overview at https://www.gov.uk/hmrc-internal-manuals/paye-manual/paye81740 describes tax equalisation as an arrangement under which the employee receives a net amount of cash earnings and non-cash benefits and the employer agrees to meet all of the UK income tax arising. Because the employer is paying the tax, the earnings are grossed up, and the employer is liable to make good any PAYE underpayment caused by inaccurate grossing up.

For employees sent to the UK by an overseas employer, HMRC offers modified PAYE, known as EP Appendix 6 and set out at PAYE82002. PAYE is calculated on a grossed-up best estimate of earnings and benefits; payment can be quarterly where five or fewer employees are covered; and actual figures go on the employee's Self Assessment return, with any additional tax paid after the 31 January filing. The employer must equalise UK income tax on all general earnings, and the arrangement does not cover National Insurance contributions.

Two consequences follow. You still file a UK Self Assessment return, and HMRC's Self Assessment manual at https://www.gov.uk/hmrc-internal-manuals/self-assessment-manual/sam121620 confirms that HMRC has removed the obligation to make payments on account for employees under a modified PAYE scheme. And UK tax reaches HMRC partly in-year and partly as a later balancing payment, which drives the paid versus accrued question on Form 1116.

US tax return preparation for expats: claiming Form 1116 credits for employer-paid UK tax

UK income tax paid by your employer on your behalf is still your UK liability, so it is generally a creditable foreign income tax for you, reported on Form 1116 in the general category alongside the wages it relates to. The Form 1116 instructions at https://www.irs.gov/instructions/i1116 list wages, salary and overseas allowances of an employee as general category income, and require a separate Form 1116 for passive income such as dividends and interest. The amount of employer-paid UK tax included in your US income and the amount claimed as a credit should be the same figure in the same year; when they are not, one of them is wrong.

Timing is governed by Publication 514 at https://www.irs.gov/publications/p514 and its rules on paid and accrued taxes. On the cash method, which almost every individual uses, you claim the credit in the year the tax is paid. You can elect instead to claim credits when taxes accrue, by checking the Accrued box in Part II of Form 1116 on a timely filed original return. The election cannot be made on an amended return, it applies to all your foreign taxes, and once made you must follow it in all later years. Publication 514 explains that foreign taxes generally accrue on the last day of the foreign tax year, so UK tax for the year ending 5 April 2026 accrues in US tax year 2026. Under equalisation, the accrual election often matches credits to income more neatly over the life of the assignment, but it is irreversible, so it should be modelled across the expected trailing years before it is made.

Several Publication 514 rules bite hard on equalised returns:

Unused credits are carried back one year and then forward ten years, and Schedule B (Form 1116) reconciles the carryover each year
Accrued UK tax not paid within 24 months after the end of the US tax year must be removed from the credit until paid
A refund of UK tax, or a change in the UK liability, is a foreign tax redetermination that generally requires a revised Form 1116 with Form 1040-X, or reporting on Schedule C (Form 1116) where US tax does not change
No credit is allowed for foreign tax that is reasonably certain to be refunded if you claimed it, which matters where modified PAYE estimates are known to be too high
Days you work in the US produce US-source wages, which shrink the foreign-source income in the limitation fraction and can leave US tax that no UK credit offsets

Because UK rates on senior pay usually exceed US rates, equalised bankers often finish with excess general category credits. These cannot offset US tax on passive income and are hard to use once you are back on US-source wages, so do not assume they have value.

Should an equalised assignee use the FEIE or the foreign tax credit?

Publication 514 bars any credit for UK tax on wages excluded under the foreign earned income or housing exclusions, and reduces the credit proportionately where wages are partly excluded. Where UK tax exceeds US tax on the same wages, the credit usually wins, and the exclusion also needs a foreign tax home that short assignments often lack. Under equalisation the employer's provider normally makes the choice, since the employer bears the actual tax. One warning from Publication 54: after revoking the exclusion you cannot choose it again within five years without an IRS ruling.

What does the employer's tax provider prepare, and what do you still own?

The employer's provider is engaged by the employer, usually to prepare the employment income sections of your Form 1040 and UK return, the related Form 1116 and the settlement. Anything that is not company compensation is often outside its scope or based only on what you volunteer. The items that fall through the gap are:

Personal investment income: dividends, interest and gains on US and UK accounts, UK funds and investment companies, and rental income
The FBAR, which FinCEN at https://www.fincen.gov/report-foreign-bank-and-financial-accounts requires from a US person whose foreign accounts exceed $10,000 in aggregate at any time in the calendar year, filed through the BSA E-Filing System; UK payroll and salary accounts count
Form 8938, the statement of specified foreign financial assets described at https://www.irs.gov/forms-pubs/about-form-8938, which has its own thresholds and overlaps with but does not replace the FBAR
A spouse's own UK employment or self-employment income and its US and UK reporting
The marginal-rate effect of personal income, because most policies stack company compensation first and leave the higher-rate tax on personal income with you

Your signature is on the Form 1040 whoever prepares it, so confirm the provider's scope in writing and have the rest prepared consistently with its figures; mismatched exchange rates are the commonest reason we amend equalised returns.

What happens after the assignment ends?

Equalisation does not stop when you fly home. The UK return for the year of departure is filed after you leave, any balancing payment the employer makes on it is US compensation in the year paid, and it is grossed up again. The final settlement for the last assignment year usually comes a year or more later, and equity earned partly in the UK can feed the same cycle for several more years.

UK refunds are the other trailing issue. Most policies require you to hand any refund of employer-funded UK tax to the employer. For the US return, a refund of UK tax previously claimed as a credit is a foreign tax redetermination: the credit for the year to which the tax relates must be reduced, generally through Form 1040-X with a revised Form 1116, and Publication 514 explains that where the UK refund carries interest, interest is also owed to the IRS up to the amount the foreign government paid. If the UK tax had instead been deducted, the tax benefit rule in Publication 525 applies: a recovery is included in income in the year received up to the amount by which the earlier deduction or credit reduced your tax. How a refund you pass to the employer interacts with the original compensation depends on the policy and payroll treatment, so address it explicitly.

Worked scenario: a London assignment under tax equalisation

This is an illustration only. All figures are assumed, rounded and simplified, they ignore housing, allowances and state tax, and every sterling figure is converted at an assumed exchange rate of 1 pound to 1.30 US dollars. They are not computed tax liabilities.

Elena is a US citizen managing director seconded from New York to London for three years under a tax equalisation policy. Her stay-at-home salary and bonus for calendar 2025 are 600,000 dollars. The employer withholds an estimated hypothetical tax of 190,000 dollars, so her cash pay is 410,000 dollars. During 2025 the employer remits UK income tax of 230,000 pounds, or 299,000 dollars, through its modified PAYE scheme, and in January 2025 it also paid a UK balancing payment of 20,000 pounds, or 26,000 dollars, for an earlier UK tax year. It deposits 15,000 dollars of US federal income tax for her during 2025, mainly reflecting days she worked in New York.

Her 2025 Form W-2 shows wages of 750,000 dollars (410,000 cash pay, 299,000 and 26,000 of UK tax paid for her, and 15,000 of US tax), with 15,000 dollars withheld. Wages exceed her 600,000 dollar package because hypothetical tax is not income while all actual tax paid for her is. Her P60 for the year to 5 April 2025 covers a different period in sterling; the bridge explains the gap.

On the cash method, UK tax paid in 2025 is 250,000 pounds, or 325,000 dollars. Assume the Form 1116 limitation on her general category income works out at 240,000 dollars. She can credit 240,000 dollars in 2025, and the excess of 85,000 dollars is carried back one year and then forward, recorded on Schedule B. She also has 60,000 dollars of dividends and gains on a US brokerage account, which her policy excludes, so the US tax on that income is hers to pay and is reported outside the employer's work. Her UK salary account and UK savings account together exceed the FBAR threshold, so she files an FBAR herself.

In late 2026 the provider finalises her 2025 hypothetical tax at 196,000 dollars, 6,000 dollars more than was withheld, so she owes 6,000 dollars to the employer. The UK balancing payment for the year to 5 April 2026 and the US tax the employer pays on her 2025 return are both 2026 compensation, which starts the next turn of the cycle.

Checklist for an equalised US return

Obtain the full equalisation policy, the assignment letter and the provider's engagement scope for you
Collect the Form W-2, every UK P60 and P11D covering the calendar year, and the employer's schedule of tax paid on your behalf by date and currency
Build the bridge from UK figures to the W-2 and agree it with the provider
Confirm the paid or accrued method for Form 1116 before the first return of the assignment is filed
Track UK tax by UK tax year and by US year of payment, with carryovers on Schedule B
Identify US workdays and agree the sourcing method
Report personal income and accounts yourself, including the FBAR and Form 8938
Diary the trailing years: final settlements, UK refunds, redeterminations and the amended returns they may require

What are the most common equalisation errors on the US return?

Entering hypothetical tax as federal withholding or as a payment on Form 1040
Omitting employer-paid UK tax from income while still claiming it as a credit, or including it in income but forgetting the credit
Claiming UK tax in the year it was earned on a cash-basis return, or switching between paid and accrued from year to year
Ignoring UK refunds paid over to the employer, leaving an overstated credit in an earlier year
Assuming the employer's provider has filed the FBAR or Form 8938

Equalisation makes the assignment tax-neutral, not the return simple. With a written bridge, a deliberate Form 1116 method and clear scope, returns hold up to IRS matching. Our team prepares the personal US and UK returns that sit alongside the employer's equalisation work.