Employment contracts that define the employee's pay in 'net' terms

Foreign companies may enter into various types of employment contracts with employees posted in Finland. Salaries can be defined in terms of net salary. The objective is to avoid unexpected tax consequences. These contracts are intended to guarantee a planned net income level in the expatriate employee’s hands, and it is agreed that the employer pays the taxes.   

Another popular arrangement is a tax equalization policy that entails agreement between the employer and the expatriate employee or worker on a gross income, including equalization of taxes, or on 'tax protection'.

Tax equalization schemes aim to safeguard the net income that the expatriate would theoretically have if he or she stayed in their home country to perform the same labour or personal services. For the assignment period to a foreign country, the employer and the expatriate employee agree upon a grossed-up amount, from which a hypothetical tax amount similar to home-country taxes is subtracted. In reality, the expatriate employee’s actual income tax may be different. However, under a tax equalization employment contract the employer will pay the final assessed taxes both in the home country and in the assignment country. This payment is made on behalf of the expatriate.   If the total of home-country and assignment-country taxes actually stays below of what was agreed to be the hypothetical tax, the employer is not expected to restore the difference to the expatriate employee.

A clause in employment contracts with the effect of 'tax protection' means that the employer agrees to pay the expatriate employee the excess amounts of income tax that are over and above the income tax that would have been paid if he or she were to remain in the home country to do the same work.  Such a clause may give him or her a tax benefit. This means that if the tax coverage payments from the employer are greater than necessary to pay the actual taxes, the expatriate employee will keep the difference. Similarly as in tax equalization, an amount of hypothetical tax is first computed and then withheld from the expatriate's gross pay.

It should be noted that employers might apply hybrid schemes that combine some characteristics of all the above variants.

2 The Supreme Court ruling KHO:2008:31

Finland’s Supreme Administrative Court has examined and judged (KHO 2008:31) a case where a foreign employer paid income tax on behalf of an employee who was liable to tax in Finland as a nonresident.

The case involved an employment contract for a fixed net salary. The U.S. employer and the expatriate employee (assigned to work in Finland 24 February 2001 – 14 June 2002) had agreed that the same net amount as would be payable in the United States would be paid during the Finnish assignment. The U.S. employer had withheld taxes and tax-like charges from the pay. However, the withheld amounts had not been paid forward to the Finnish tax authorities. Also, when working in Finland the expatriate employee did not make any prepayments of Finnish income tax on his own initiative. Instead, the U.S. employer paid the Finnish tax authorities the outstanding taxes that had been invoiced, based on the incomes declared by the employee, by the Finnish tax authority afterwards in 2003 and 2004.

Under the Supreme Administrative Court ruling, the employer-provided payments of these back taxes, made on behalf of the employee, must be treated as taxable earned income in the hands of the employee inasmuch as a greater amount of money had been spent on the back tax payments than had been withheld from him. The benefit thus accrued was to be attributed to the taxable years when it had actually been earned i.e. to the 2001 and 2002 taxable years. Pursuant to § 10.1, subsection 4, Income Tax Act, the income was taxable in Finland, and pursuant to Article 15 of USA—Finland Tax Treaty, the employment being exercised in Finland, the salary could be taxed in Finland.

The Supreme Administrative Court has also made another ruling (KHO 1969-II-589, volume 10.3.1969/1487) regarding a similar case in Finland. It involved a housemaid who received in-kind benefits in addition to cash wages, and whose employment contract set out a fixed net pay in cash. The Supreme Administrative Court ruled that the monthly wages subject to tax should equal a grossed-up amount from which, after monthly withholding, there would only remain the monthly net cash amount and the monthly tax value of in-kind benefits.

3 Computations of gross income

3.1 The gross wages subject to tax

Pursuant to Income Tax Act, a taxpayer’s taxable income includes his income received in cash, or received in the form of assets or benefits; representing a taxable cash value (§ 29, Income Tax Act). However, what has been described above in the previous section means that agreements may be made between the employer and the employee on paying a total gross amount, the consistent parts of which are (1) a fixed net cash amount and (2) an amount reflecting the taxes, both in the home country and in Finland, payable by the employer on the actual taxpayer’s — the employee’s — behalf.

As it was ruled in the case (KHO:2008:31), the taxpayer’s gross pay for the income years had to be readjusted: The back taxes collected during the reassessment should be added to it.  It means that the outstanding Finnish income tax should already be declared during the income year, and it should be included in taxpayer’s gross pay.  However, because no exact amount of income tax is not yet available at the time when the employer draws up an Employer Payroll Report, and at the time when the employee should file his income tax return, the employer should make an arithmetical computation to arrive at a probable amount.

It is the position of the Finnish Tax Administration that the practical guideline derived from the ruling will be applicable to any situation where a foreign employer agrees to pay an employee’s Finnish taxes. This means that the gross pay subject to tax in Finland consists of the net salary plus the amount that the employer should compute (i.e. gross up) reflecting Finnish income tax.  Computations to "gross up" the net amount should include all the relevant conditions of the employment contract regarding the employer’s responsibility to pay tax for other income, the maximum limits of such responsibility, and also regarding the beneficiary party — agreed to either be the employer or the expatriate employee — of any tax deductions or credits. When the pay has been agreed as a fixed net amount, only the result of the above computation, called the 'calculated Finnish tax', will be added to the taxable income of the same year for which the net amount was earned. For all other purposes, the cash principle must be followed i.e. any benefit or income must be treated as taxable during the calendar and tax year when it is paid.

In this context, ‘foreign employer’ means an employer who is not liable to carry out payroll tax withholding in Finland. Some employment contracts include a provision that a company located in Finland will pay a portion of the expatriate employee's salary. When a portion of the pay is received by the employee from a Finnish payor, that portion must also be included in the computations to arrive at the gross pay subject to Finnish tax.

For situations not involving other countries, it is the position of the Finnish Tax Administration that comparable assessment situations and tax decisions should be governed by the guideline derived from the above KHO 1969-II-589 ruling.

3.1.1 The 'net' amount of pay

Net pay as it is defined in Finland for tax purposes includes all the payments from the employer to the employee during the tax year:

• Cash salary or cash wages;
• Fringe benefits valued as defined by tax rules;
• Retroactive payments (such as vacation or holiday pay, and any corrective payments to equalize the employee's tax burden in a foreign country);
• Bonuses;
• Benefits that arise from employee stock options;
• Payments of taxes on behalf of the employee to home-country tax authorities;
• Payments of social security charges on behalf of the employee;
• Payments on behalf of the employee of previous years’ outstanding back taxes and as explained in section 3.3 later in this article;
• Payments on behalf of the employee, of prepayments of taxes and any supplementary prepayments as explained in section 3.2 later in this article;
• Payments that other payors instead of the actual employer make to the employee if the amounts are dependent on the same work performance as is discussed in the employment contract that defines the employee's pay in terms of a net amount.

The employment contracts defining pay as a 'net' amount are usually designed to cover the taxes to be collected on the compensation received for a certain job. When such a contract also includes the coverage of the taxes to be collected on other income as well, such as investment income (=capital income) and any sideline income, and the employer pays these taxes — either as prepayments or as back taxes afterwards — such coverage must be included in the total of the net pay received.

However, the amounts of taxes going to foreign countries cannot be included in the net amount if they are creditable against the taxes in Finland. And conversely, if the foreign tax authorities give credit for the taxes collected in other countries including Finland, only the portion of the paid taxes that actually remain to be paid must be included in the net amount.

If it is agreed between the employer and the employee that the employer will pay the employee's taxes as if the income derived from the employment were the only income that the employer receives, no other income or sideline income etc. is included in the computations.

3.1.2 Calculated Finnish tax

Calculated Finnish tax is the Finnish tax to be paid according to the gross-up computations based on a known net pay.

The gross pay subject to tax in Finland should be the sum of two components: Net pay plus Calculated Finnish tax. Computations to gross up the net should include all the deductions against income, and all the tax credits to be subtracted from the taxpayer’s taxes. Some deductions and credits are granted ex officio, which means that they are automatically deducted during the assessment procedure, others are taxpayer-declared and dependent on his or her personal and family situation. If an agreement has been made between the employer and the employee that there must be no benefit to the employer that would result from the employee's personal tax deductions, their amounts must not be included in the Calculated Finnish tax estimate. The amount of Calculated Finnish tax must not include any late-payment interest for payments of back taxes and any interest that accrues on tax refunds.

If the employee has no other income, the outstanding back taxes to be invoiced later will be exactly the same as Calculated Finnish tax. In this case, the employee will receive no additional taxable benefit for the fact that his foreign employer (or the Finnish subsidiary or other related party) is paying them.

The requirement to make an estimate for the Calculated Finnish tax is designed as a tool to facilitate taxation during the year when the income is earned of the benefit derived from the fact that the employer pays the taxes. It makes it feasible for the employer to pay the correct amount of tax as prepayments so that there will neither be an outstanding back tax nor a refund to be dealt with later.

3.2 Prepayments of income tax

Pursuant to § 1, Prepayment Act, taxpayers are expected to make prepayments to the Tax Administration in order to cover their actual tax liability for the current year.  It is also required that advance prepayments be accurate, as prescribed in § 3, Prepayment Act.  If the employer is not liable to withhold tax and pay it forward to the Tax Administration, the employees must follow the prepayment rule and carry out the tax payments themselves.

Prepayments must be made on the gross amount subject to tax, computed according to the instructions in this article.

3.2.1 Prepayments and supplementary payments made in the course of the tax year

The prepayment equals Calculated Finnish tax

If the employer — on behalf of the employee — makes prepayments during the tax year, and the sum total of these prepayments does not exceed Calculated Finnish tax, the sum to be treated as the employee's gross pay will be the sum of his net pay plus Calculated Finnish tax.

The prepayment is higher than Calculated Finnish tax

When the employer has made prepayments that exceed the Calculated Finnish tax amount, the surplus must be treated as part of the employee's net pay if the employee does not have the obligation to pay it back to the employer.

The prepayment is higher than Calculated Finnish tax, and the employee must pay back the surplus

The surplus must not be treated as part of net pay if the employee must pay it back to the employer with interest, and if the employer's coverage of the employee's taxes is restricted to the taxes that relate to the employment contract, not to any taxes on other income that the employee might have.

The prepayment is lower than Calculated Finnish tax

If the employer has made prepayments that do not reach the level of Calculated Finnish tax, the amount to be treated as the employee's taxable gross pay will be the sum of his net pay plus Calculated Finnish tax.  In this case, the prepaid amount will not be treated as income subject to tax.

3.2.2 Supplementary payments and prepayments after closure of tax year

If the employer — on behalf of the employee, after the tax year is over — makes supplementary payments or prepayments, in addition to the prepayments made in the course of the tax year, and the sum total does not exceed Calculated Finnish tax, the sum total of the employer-provided prepayment will not be added to the employee’s gross pay for the year.  The tax treatment is the same in the case when prepayments arrive late after the tax year is closed and their sum total does not exceed the amount of Calculated Finnish tax.

If the employer — on behalf of the employee, after the tax year is over — makes supplementary payments or prepayments, in addition to the prepayments made in the course of the tax year, and the sum total is greater than Calculated Finnish tax, the surplus will be added to the employee’s gross pay for the year.  

The prepayment is higher than Calculated Finnish tax, and the employee must pay back the surplus

If it is agreed that the employer's coverage of the employee's taxes is restricted to the taxes that relate to the employment contract, not to any taxes on other income that the employee might have, and that the employee must pay back any surplus employer-provided payments of his taxes, the calculation of the employee's 'net' pay must not include such surplus.

3.3 Payments of outstanding taxes (back taxes)

When an employer-provided payment of an outstanding amount of his taxes has been made, the part of it that exceeds the Calculated Finnish tax for the tax year must be treated as part of the net pay for the year of payment.  The usual time to pay outstanding taxes is December the year after the tax year, and if there is a second installment it must be paid two months later in February.

Any payments of interest on it are not included in the net pay.

3.4 Refunds from the Tax Administration

If the employee has agreed to pay back any received tax refund with interest to the employer their amounts must not be included in the calculation of taxable pay. The only possible causes for receiving a tax refund are too high prepayments or too high supplementary payments. Excess employer-made prepayments have not been included in the employee's net pay because the employment contract has stipulated that the employee must restore such amounts to the employer.

However, if employer-made prepayments have been utilized for offsetting some taxes on other income in the hands of the employee it gives rise to a receivable: the employee must pay the amount back to the employer. Then the amount going to the employer is similar to a tax refund paid to the employer and will not affect the calculation of the employee's net pay.

If the employer relinquishes the right to receive compensation for any surplus, the amounts that would have been payable as such must be included in the calculations of net pay as from the year when the employer relinquished this right.

3.5 Payments from the employee to the employer

If it is agreed in the employment contract that the employer withholds money from the employee’s pay, and these amounts have been treated as the employee's net pay during an earlier tax year, the amounts are to be deducted from the employee’s net pay during the year when they are withheld. For example, it is not uncommon that too little home-country hypothetical tax has been withheld through the payroll system so a further settlement must be due to the employer. Such a payment back to the employer is deducted from the employee’s net pay during the year when it is made. Additional payments back to the employer may thus be related to a corrective calculation of hypothetical tax (in this case the sum total of hypothetical tax payable in the home country would grow).

4 How to declare the income subject to tax

4.1 The employer's reporting requirement

Foreign employers must deliver annual information to the Tax Administration on all payments made, cash or cash equivalent, any corrective entries or corrective payments related to them, on the identity of the beneficiaries/employees, and on the reasons for payments if employees are staying in Finland for a consecutive period longer than six months (§ 15 and § 15a, Act on Assessment Procedure).  

The Employer Payroll Report form to fill out and deliver to the Tax Administration is Form 7801e — Annual Information Return – Summary and Itemization. Wage payments under employment contracts with fixed net amounts are to be reported as code 7N (Wages paid by foreign employer with no permanent establishment in Finland, having responsibility to pay and discharge employee’s taxes (employment contract ”Net-of-tax”)). Furthermore, if the employees are not covered by the Finnish social security system the gross pay must be entered in line 36 (for Payments of wages not included in the base of health insurance contributions).

Employers must report their employees' gross pay on Form Veroh 7801e according to the instructions in this article; the calculations to gross up the net amount must include the deductions ex officio i.e. the automatic deductions during the assessment procedure. Thus if the employer is aware of the personal circumstances that play a role when granting tax deductions to the employee (such as pension insurance premiums, other insurance premiums and any tax-deductible costs for the production of income), the employer should include information on them when filling out Form 7801e. This requires that it has been agreed that the employer gets the tax benefit for the deductions. It is permissible to make corrections to the Employer Payroll Report later when facts about the employee's personal circumstances and deductions have become known. Fringe benefits are entered in lines 20 to 49 and cash salary in line 14, computed according to the instructions in this article, but with the sum total of fringe benefits subtracted.

4.2 The employee's reporting requirement

Pursuant to § 7, Act on Assessment Procedure (18 December 1995/1558), taxpayers must declare their incomes to the tax authorities, and specify the details on their tax deductions against their income, explain their assets and liabilities, and give other details that have an effect on the assessment of their annual taxes. The employee's total annual gross income subject to tax, calculated as instructed in this article, must be reported on the tax return form.  The taxpayer must set out the total amount of cash or cash equivalents viewed as his 'net' pay as additional information relevant to the income tax return and give details on any other matters affecting the gross pay in Finland. Such details include specification of the consistent parts of the net amount and explanation of what has been agreed with the employer on the division of responsibility to bear the cost of any personal tax liabilities resulting in Finland.  

When the employer has used the 7N Type of Payment code to report the wages the collection of health insurance premiums is automatic. (The Finnish names of these premiums are päivärahamaksu and sairaanhoitomaksu). However, the income entered in line 36 of the Employer Payroll Report is not subject to the collection of health insurance premiums. If the employee is not covered by the Finnish residence-based social security system, any paid-in premiums called sairaanhoitomaksu must be cancelled in connection with the final assessment of the employee's taxes for the year. The taxpayer must write a claim in the 'Additional Information' section to request the cancellation and enclose a document obtained from a competent authority in the country of residence (such as A1 or E101 certificates). An alternative enclosure is a Finnish document obtained from Kela stating that the employee is not covered by Finnish social security.

5 Readjustments of gross income

Taxpayers have a legal right to lodge an appeal if they disagree with a tax assessment decision or find it erroneous. Appeals should be made within five years of the beginning of the year after the tax assessment year. (§§ 61 – 64, Act on Assessment Procedure.)

In the case of errors in a completed tax assessment it is also permissible for the Tax Administration itself to perform readjustments (§§ 55 – 56, Act on Assessment Procedure).

Such readjustment may be related to an error in the computation of the gross amount of pay subject to tax in Finland in situations including the following:

• Original tax assessment has depended on an incorrect 'net' pay amount;
• Original tax assessment has failed to take account of deductions properly.

Pursuant to § 57a, Act on Assessment Procedure, if the amount to be added to the taxable income in readjustment stays below €4,000 it is permissible to adjust the current-year income only, for which the assessment has not yet been closed, and not go back to reopen a previous tax year’s assessment (“Readjustment transfer over taxable periods”; in Finnish: Verotuksen oikaisun johdosta lisättävän tulon siirto).  This transfer procedure has been designed in an effort to simplify the correction of small errors. It may cover periods of one, two or five tax years (§ 56, subsections 2 – 4, Act on Assessment Procedure). Nevertheless, in cases initiated by taxpayer appeal against a tax assessment decision under §§ 61—64, Act on Assessment Procedure, the adjustment must always concern the tax year in respect of which the taxpayer has appealed.

6 Net pay during the employee´s post-repatriation period

The employer must pay tax at source during the actual year of payment if the employer pays any amounts that relate to the employee's work in Finland to — or on behalf of — a nonresident employee, after he or she has left Finland, and the amounts should be considered a part of the net pay as outlined above in section 3. To facilitate the debiting of the tax at source it is required that an income tax return is filed. Its 'Additional information' section must include a statement making it clear that the income tax return has been filed for the purpose of having tax at source debited. If it is the employer's responsibility to pay the debited tax at source, the tax rate of 35% must be used when figuring out the amount of Calculated Finnish tax. Then the deduction referred to in § 6, Act on the Taxation of Nonresidents' Income must also be accounted for in respect of an amount of pay, accrued for a certain period. The period for which this deduction is valid is the same as the length of the employee's work period under the employment contract 'net-of-tax' during the income year.

In an inverse situation, the employee’s pay can be reviewed afterwards and it may be established that too much was paid. In this case the employee would have to refund some of his income to the employer after repatriation. Similarly, an employer-paid amount on behalf of the employee may later be corrected so as to become smaller. These situations lead to readjustments of the gross pay for the relevant tax year, which is the year when the amounts concerned were included in the employee’s income (unless a correction can be made by withholding a sum of money from the employee's net pay during the current year).

7 Protection of legitimate expectations; protection of confidence; transfer to a new definition of gross pay subject to tax

Act on Assessment Procedure includes provisions in its § 26 on the protection of taxpayers' confidence i.e. the protection of their legitimate expectations. Accordingly, if a disputed tax matter is unclear, or there is room for interpretation, and if a taxpayer has carried out his actions in good faith adhering to the guidelines or practices of the tax authority, the disputed matter should be resolved in the taxpayer’s favour.

The court ruling KHO:2008:31 cited above in this article has effectively changed the assessment practices of Finnish tax authorities because of the following new guidelines derived from it: The new attribution rules of income in respect of different tax years, new income-source rules, and new rules on the scope of nonresidents' liability to pay tax. Whereas the previous practice would not accept the inclusion of the taxpayers' outstanding taxes during the post-repatriation period in their income for the current income year, the new practice, in light of ruling KHO:2008:31, does include these amounts. Similarly, whereas the previous practice would not view Finland as the source of income for employer-provided payments of outstanding tax, the new practice, in light of ruling KHO:2008:31, does treat them as Finnish-sourced income. It is the position of the Finnish Tax Administration that the protection of taxpayers’ confidence and legitimate expectations will continue to be justified up to the payments and reporting of invoiced outstanding taxes for tax year 2007 as if the old rules would still apply.

However, as of tax year 2008, the taxpayers who file their income tax returns must compute their annual gross income as instructed in this article. Invoiced outstanding taxes or reassessment taxes for the 2006 and 2007 tax years must not be included in the computations of annual gross income for 2008 and correspondingly, any refunds paid by the employee to the employer must not be subtracted from it.

This article is an updated version of an earlier similar article addressing employment contracts with 'net-of-tax' clauses. The updates are effective as of the 2012 tax year.

If an employer-provided prepayment of taxes has been included in the employee's pay prior to the effective date of the updated rules, and the employee then receives a tax refund and pays it back to the employer because it has so been agreed, the refunded amount can be deducted from his net pay during the year of payment.

8 Using the Tax percentage calculator

To compute gross pay and Calculated Finnish tax, go to www.tax.fi/taxcalculator. Nevertheless, its results are but a rough estimate.

1. First enter your own estimate of the grossed-up annual income in the Calculator's Wages from principal occupation with fringe benefits line.  If the employee is not covered by the Finnish social security system tick the box for Social insurance in another country.
2. Press Calculate, and then work out the difference between Total annual income and Total annual taxes (this difference is the net pay).
3. If the results do not match your planned net pay amount you must figure out how far from it you are i.e. figure out the difference. Then divide it by (100 minus the marginal tax rate*) and multiply the result by 100. This will show the amount to add to or to subtract from the annual gross income (i.e. the necessary correction).

If net pay as shown by the Calculator is greater than your planned amount, subtract the correction from the annual income. Conversely, if net pay is smaller, add the correction to it. Reiterate as many times as is necessary to arrive at your planned net pay amount.

*The marginal rate means the additional rate of tax in the Table of  Finnish state taxes on earned income, plus a municipal and Church rate and an appropriate healthcare contribution.

To compute gross pay and Calculated Finnish tax, you can use also Gross Income Calculator (tax.fi/grosscalculator).