The Federal procurement policy on income tax differential pay is very straight-forward and we have not seen much in the way of controversy surrounding the application of this principle. When employees take temporary assignments in another country or another state, their personal income tax situation often changes. They might owe foreign income tax or income tax to another state. If the assignment is a foreign assignment, contractors can provide an allowance for any increased income tax liability. If the assignment is domestic, such an allowance is unallowable. Domestic assignments might result in increased taxes if an employee, based in a non-income tax state, took a temporary assignment in a state with income taxes.
It is often necessary for contractors to provide incentives to encourage employees to take temporary assignments. After all, there is a personal hardship for being away from home for extended periods. A "site differential" is often used to compensate employees for such hardships, whatever those may be. The exact basis for the differential is often nebulous and could include many unstated and intangible factors. As long as compensation in total is reasonable, site differentials are allowable.
There is an exception to the prohibition against differential allowances for additional income taxes resulting from domestic assignments. FAR 31.205-35(a)(10) states that payments for increased employee income or social security taxes incident to allowable reimbursed relocation costs are allowable. In this case, a permanent employee relocation is necessary.
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