Shadow Payroll- Everything you need to know
“Shadow payroll” is a catchy term you have probably heard about but may not understand. If you’re considering sending an employee working abroad, understanding why shadow payrolls are important is a critical step to lowering your company’s risks.
This post is intended to demystify 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.
So what is Shadow Payroll?
Shadow payroll is a mechanism established to assist with an expat 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:
EXAMPLE: You are part of an US-based company that is new to international expansion and decide to send an existing employee named Sarah on a two-year term assignment to Ireland. During her stay in Ireland, Sarah may be liable for paying tax and social insurance in the both locations and to avoid this she will remain on a US payroll. In such situations, companies use a shadow payroll to assist in meeting their reporting and tax withholding obligations for the host country if 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, be aware that the home country may not be the same as the one they originate.
For example, if a company is based in the UK but has placed a Sweden employee 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 in this instance would be the UK.
How to determine if you need a Shadow Payroll?
There are two simple questions that you need to answer yourself:
- Do you have employees who are sent on global assignments?
- Is the employee’s assignment a short-term or long-term?
What situations trigger Shadow Payroll?
Here are a couple of examples to better understand when shadow payroll is required:
- 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.
- 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 is 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, employee usually remains on home country program. Shadow payroll must be implemented.
- Long- term assignment (more than 183 days) – This is Sarah’s case. 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
As we already mentioned above, our employee’s name will be Sarah and her home country will be the US. She 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 like for any other local employee with variable pay elements. Calculate tax and national insurance as usual.
3. Prepare and save the US payroll reports needed for the internal staff or payroll providers that undertake processing in the host country
Sarah will receive no payment in her 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
Once Sarah 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 way Sarah will avoid the 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 and key success factors
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 many existing HR systems are not designed to cope with the high volumes and fast speed of people moving locations. They cannot track them accurately or on time. Too often, they simply generate a long list of invoices, a paper trail that attempts to track employees down and that remains one step behind the real-time situation. This can lead not only to incorrect tax calculations, but it can have more wide-reaching implications.
Above all, shadow payroll key success factor is about “Getting It Right First Time”. Here are some other best practices to calculating shadow payrolls:
- Establish a strong communications between the home and host countries
- Create a taxability matrix for each country where expatriate taxes are required
- Update payrolls monthly with all compensation changes and benefits
- Review data for integrity to ensure the appropriate data is complete and captured accurately
- Review payroll and tax program for reasonableness and accuracy annually
- Perform consistent and timely compensation accumulation
Another advice for multinational organizations is to automate the entire function – removing the chance of human error, reducing internal resources, ensuring compliance in real-time, and saving money. An automated solution provides peace of mind that you’re paying the right amount of tax in the right place, at the right time.
“Automating shadow payroll solution reduces your business risk and cost, ensures you report the right information in real-time from day one, and enables you to make better business decisions.”
The global workforce is expanding and processing a shadow payroll is common practice for established multinational organizations, but it is a complex process for companies that are new to international expansion. Keeping compliance with home and host income tax reporting and withholding obligations is putting increased pressure on HR and payroll managers. That is why understanding shadow payroll is a must.
If you process global payroll and want to learn more about shadow payroll, the tax implications, and how to set it up internationally, contact us today.