Shadow Payroll- Everything you need to know

December 9, 2020 | David Daly 5 Mins read

“Shadow payroll” is a catchy term you have probably heard about but may not fully understand. If you’re considering sending an employee to work abroad or perhaps recruiting a wide range of new remote workers based in their home countries around the world, then understanding the implications of shadow payrolls could be very important in terms of managing overall global payroll risk.

In this article, we will examine in detail the concept of shadow payrolls and give you a high-level understanding of what they are and why they are used. We will provide an example of how to process shadow payroll and explain the challenges and benefits for multinational organizations. 

What exactly is Shadow Payroll?

Shadow payroll is a mechanism established to assist with an ex-pat employee’s host-country reporting and tax withholding obligations while the employee is on assignment in the host country. During this time, the employee remains on a home-country payroll. The payroll in the host country will “shadow” what is being reported in the home country, but the employee will not receive any compensation from the host country. A shadow payroll can also be established in the home country where an employee is paid through a host-country payroll. 

To understand shadow payroll more clearly, let’s look at a likely scenario:

An Example

A US-based company that is expanding internationally decides to send an existing employee on a two-year international assignment to Ireland. During their time in Ireland, the employee may be liable for paying tax and social insurance in both locations and to avoid this, they will remain on a US payroll.

In these situations, companies use a shadow payroll to assist in meeting their reporting and tax withholding obligations for the host country -because employees are to remain on their home country’s payroll system during their placement abroad.

Here, it is vital to understand the difference between an employee’s home country and host country. Basically, the home country is where the staff members receive net pay, and the host country is the one in which they receive no payment. However, the home country may not be the same as the one they employee is originally from. 

For example, if a company is based in the UK but has placed an employee from Sweden on assignment in the Netherlands for more than 183 days, their home country will likely be the Netherlands as that is where they receive their net pay. The host country for the employee in this instance would be the UK. 

How to determine if you need a Shadow Payroll?

It is best to consider the below questions when deciding whether or not you need to run a shadow payroll in your organization: 

1. Do you have employees who are sent on global assignments?

2. Is the employee’s assignment a short-term or long-term?

Here are a couple of examples to better understand What could trigger in need for shadow payroll:  

    • Short business trips (less than 6 months)in most cases, a tax treaty will apply for assignments that are less than 6 months. In this case, the employee remains on home payroll. There is no host country payroll requirement, and the employee remains on home country social security program. No shadow payroll is needed here
    • Short- term assignment (from 6 months to 1 year) – The tax treaty will not apply as the period is longer than 6 months. Host country usually requires that the employee be put on payroll. Some or all of the employee’s income may be subject to tax in the host country. The employee remains on home country payroll and if social security treaty applies, the employee usually remains on home country program. Shadow payroll is needed here.   
    • Long- term assignment (more than 183 days) If the assignment requires employees to work in another country for more than 183 days, it is considered a long-term assignment and a shadow payroll will be required

How to process Shadow Payroll?

Now that we already know what shadow payroll is and when you require it, let’s see how to process it within your global payroll system.

1. Confirm employee’s home country and add him/ her as a joiner onto the home country payroll

In the US example above, the home country will be the US. The employee is traveling on a two-year term assignment to Ireland. Since the US taxes income on a worldwide basis, the employee and employer must stay compliant in the US while also taking into consideration any tax requirements in Ireland.

2. Process the US payroll with variable pay elements as standard

The US payroll need to be processed the same as any other local employee with variable pay elements. Calculate tax and national insurance as normal.

3. Prepare the US payroll reports needed for the internal staff or payroll providers who process global payroll in the host country

The employee will receive no payment in their host country Ireland. Once ready, the US payroll reports must be sent to the person who processes the Irish reports.

4. Add the US employee onto the Irish payroll as a new starter

As soon as the employee is added to the Irish payroll as a joiner, it is necessary to apply any foreign of net tax scheme. This policy enables the employer to apply for removal of the host country tax and social or pension payments.

The next step is to reduce the payment to zero by including a net deduction on the payroll. All items such as salary, bonus and commissions from the home country payroll must also be included on the host country payroll. This is to ensure that the employee avoids double taxation.

5. Implementing tax equalization and hypothetical tax (“Hypo”)

If there is no net of foreign tax scheme, you will need to re-apply the host country’s tax payments onto the home country’s payroll as “hypothetical” tax – this involves offsetting any tax difference so that working abroad is tax neutral for the worker, so they pay taxes as if they were still a resident in their home country – in the next pay cycle. Remember, if there is no net of foreign tax scheme, it is usual for employers to pay the host country’s taxes so that the employee concerned avoids hardship.

The purpose of tax equalization or tax protection is to encourage expatriates to take up overseas assignments without having to worry about tax-related matters.

Challenges for multinational organizations

Shadow payroll calculations are often very complex because of data availability, accuracy, inconsistent policies, and lack of local payroll expertise. There are several challenges with accurately calculating shadow payroll. Probably the biggest challenges that arise from administering a shadow payroll are: 

    • Figuring out what should be calculated, reported, and remitted. 
    • How such calculations need to be done? 
    • When to carry out such calculations, reports, and remittances? 

Typically, during the international assignment, the employee gets paid his/her base salary from the home country, even though the costs may eventually be charged back to the host country. Other assignment-related allowances such as taxes, housing, and education costs for dependents are often paid from the host entity. 

Another headache is that many existing HR, HCM or global payroll systems are not designed to cope with the pace at which multinational organizations around the world are scaling and internationalizing. Companies acquire other companies or decide to expand into new regions- they quickly locate new people there, often doing so without consulting the human resources or global payroll department to understand best practices for this global mobility activity. Some also forget the need for local expertise in a foreign country- a local country payroll provider needs to be engaged as they have the expertise to fully understand the local country employment laws, income tax nuances and compliance obligations.

Reporting difficulties are also an issue as the software was not designed to account for multi country reporting at employee level or payment element level. It is therefore difficult for global payroll head office professionals to state with certainty that an employee based overseas has fully complied with local law and has been taxed correctly.

For this reason, global employers need to ensure that they have innovative technology in place to handle the complexities of international and shadow payroll. Ideally, their global payroll needs to be deployed in a cloud platform using technology that integrates with the human resource HCM system. This will ensure greater visibility and control when it comes to paying employees accurately in different locations.

Here are some other best practices to calculating shadow payrolls: 

Establish strong communications between the home and host countries

Review data for integrity to ensure the appropriate data is complete and captured accurately

Invest in innovative technology and digital reporting tools

Review payroll and tax program for reasonableness and accuracy annually

Update payrolls monthly with all compensation changes and benefits

Create a taxability matrix for each country where expatriate taxes are required

Multinational organizations should also look to automate their entire global payroll function – removing the likelihood of human error, reducing pressure on internal resources, ensuring compliance in real-time, and saving money. Automation and integration technology can be the solution to a complex multi-vendor landscape and several other challenges that multinational organizations face when it comes to payroll management on a global level.

 

logmein logo

Using Payslip, we can manage all our payrolls across nine in-country vendors on one platform. When the global Covid-19 pandemic arose, it was not an issue from a payroll perspective, and critically getting everyone paid. The Payslip platform enabled continuity for our international payroll service including the fast and seamless implementation of the Payslip Employment Self Service during this time.

Colin Smith

Payroll Manager, LogMeIn

With business and employee growth rates of above 50%, we rely on our vendors to deliver on time, every time. Payslip’s workflow automation, enables Phorest to manage our payroll provider process – data driven, real time and transparent. Payslip saves us time so we can focus on our business growth.

Ana Kelly

International Payroll Manager, Phorest