What Is Shadow Payroll?

The pandemic has rapidly accelerated globalization and technological advances enabling remote working over the past few years. It has made businesses more dependent on employees with different skill sets, who may be located anywhere in the world. 

The work-from-home phenomenon has empowered workers to request to work from their chosen destinations, from New York to the beaches of Brazil. This has given rise to the issue of what happens when money is spent in one country but earned elsewhere. Or if an employee is working abroad in a host country, how can they ensure they meet their tax obligations?

This is where the concept of ‘Shadow Payroll’ comes in, and the function of shadow payroll can be critical to organizations with a significant foreign presence. When employees are sent on international assignments, payroll teams must ensure that the employees’ social security and tax positions comply with both the home country and the host country’s rules. This often involves reporting wage income in both countries via a shadow payroll. 

What does ‘shadow payroll’ mean?

Shadow payroll is a mechanism employers use to assist with payroll obligations for employees working abroad. It assists in managing employee reporting and tax withholding obligations at home while working in a foreign country. Usually, while working abroad, the employee remains on the home country’s payroll system. The host country payroll will then ‘shadow’ what is being reported in the home country without paying the employee any compensation. This ensures the employee remains liable for taxes in their home country while maintaining an accurate record of what they would potentially owe if they were being paid in the host country. This process helps ensure the home and host country do not double-tax employees. 

Why should you implement a shadow payroll?

There are three essential reasons why organizations should implement and manage a shadow payroll. 

1. Reporting Payments & Benefits

Shadow payroll helps employees working abroad meet their reporting obligations in their home and host country. During international assignments, the home country generally pays the employee base salary, while the host country may pay allowances to the employee, including taxes, housing, and education costs. Shadow payrolls assist in managing and tracking these payments and figuring out what must be calculated, reported, and remitted in a timely manner. 

2. Implementing Tax Equalization and Hypothetical Tax

This enables employees to undertake international assignments without worrying about meeting tax obligations. This means employers assist to ensure employees do not pay more taxes than they would have paid in their home country. By applying tax equalization, any tax differences are offset and employees pay this hypothetical tax as if they are still residents of their home country. 

3. Addressing the Issue of Double Taxation

Employees are less likely to pay double tax under a shadow payroll system. A sound shadow payroll system applies any relevant tax treaties and foreign tax credits between the home and the host country. It ensures that earnings are taxed appropriately and double taxation is avoided for the employee. 

Do you need a shadow payroll? 

There are two questions to consider in deciding whether your business requires a shadow payroll:

• Do you have employees who are sent on global assignments?
• Are employee assignments short or long-term?

That is because there is a difference between expatriates and home-country employees on international assignments. A shadow payroll distinguishes clearly between the two, which is important as expatriates are governed by different rules than home country employees on long-term assignments. For the purpose of this article, we only discuss home country employees on short and long-term assignments. 

Although many situations can trigger the need for a shadow payroll. We take a look at a few common scenarios to understand how the need for shadow payroll can arise:

Employees on short business trips (less than 6 months) — No shadow payroll required. Generally, tax treaties are applicable for assignments under 6 months. In this scenario, the employee generally remains on their home country’s payroll, and a host country payroll is not required. 

For employees on short-term assignments (between 6 months to 1 year), Shadow payroll is likely required. Tax treaties are often not applicable for time periods longer than 6 months. Therefore,  a host country will usually require an employee to be put on their payroll, and the employee’s income may be subject to tax in the host country. If a social security treaty is applicable between the home and host country, the employee usually remains on their home country’s social security system when undertaking short-term assignments. 

For employees on long-term assignments, Shadow payroll is required. Where an employee is required to work in a host country for over 183 days, it can be considered a long-term assignment, and shadow payroll is always required. 

How to process a shadow payroll 

Once the need for shadow payroll is established, we can review how organizations can process it within their existing payroll system. 

There are 5 overarching steps to processing shadow payroll:

• Establish the employee’s home country and add them to the home country payroll. If the employee’s home country is the US, as income is taxed in the US regardless of where earned, the employee must stay compliant with their US tax obligations while also considering the host country obligations. 

• Process the home country payroll, including variable pay elements as standard. Any tax and insurance obligations are calculated for the employee as normal. 

• Prepare the home country payroll reports. This is then provided to payroll processing departments in the host country. 

• Add the employee to the host country payroll. After handling the home country payroll, the employee is added to the host country payroll as a new starter. The employer can then remove any host country tax or social security/pension payments (applying a ‘net of foreign tax scheme’). Once the employee’s tax obligations for the host country are calculated, any payment is reduced to zero on the payroll by including a net deduction. This step ensures the employee isn’t double-taxed.

• Implementing tax equalization and hypothetical tax. Where an employee may be liable to pay both home and host country taxes on their income earned abroad (i.e., no ‘net of foreign tax scheme’ exists), the host country’s tax payments are reapplied onto the home country payroll. This is referred to as ‘hypothetical tax’, and is then offset by the employer so that working abroad is tax neutral for the worker and they are not out of pocket. Even in scenarios where tax in the host country is required, it is usual for the employer to pay the taxes so that the employee concerned avoids any potential hardship due to paying excess tax. Implementing tax equalization can encourage employees to take up overseas assignments without concerning themselves with complicated tax matters. 

Although this may seem complicated, let’s look at an example to simplify the above steps. 

Shadow payroll — a worked example 

An organization sends an employee on a two year assignment from the US (home country) to Ireland (host country). To be compliant with both countries’ payroll rules, the employer is obligated to report 100% of the employee’s wages in both the US and Ireland. 

Facilitating this process requires the employer to undertake the following two steps to ensure global compliant reporting:

• The U.S. entity needs to ‘shadow’ report any payments and/or benefits that are paid outside of the U.S. (such as host housing allowances, Irish taxes, and education costs paid in Ireland)
• The Irish entity needs to ‘shadow’ report all wages and/or benefits deemed taxable income paid outside of Ireland (such as base salary and any 401k benefits paid in the U.S).

In this scenario, it may seem like salary and benefits are being over-reported and possibly double-taxed. However, foreign tax credits and tax treaties between countries applied in shadow payroll systems ensure that any income is taxed in the appropriate jurisdiction, avoiding double tax. 

Although all salaries and wages are reported, taxes may not be withheld and/or assessed on all wage amounts (I.e., implementing tax equalization and hypothetical tax) 

Challenges of Shadow payroll 

There are a few challenges and risks associated with implementing shadow payroll. One of the major challenges organizations face is determining exactly what to calculate, report, and remit. Additionally, organizations must determine how and when it should carry out these activities. 

We have noted a few of the biggest challenges and risks employers face when setting up a shadow payroll:

• Knowledge: Shadow payroll requires a high level of expertise in tax obligations in various countries. 
• Incorrect tax calculations: Slight errors can result in large liabilities in fines, overpayments, and bans for both employer and employee. 
• Currency differences: There can be fluctuations in exchange rates and inflation that may negatively impact employees and employers. 
• Local payment obligations: This is a consideration for countries where paying in the local currency is mandatory.
• Tax obligations based on days spent: The amount of tax applicable can vary depending on the length of an assignment and the number of days the employee spends in the country. 
• Calculation of the correct taxable amount: Tax obligations can be very complex in shadow payroll due to the variance in which different items may be taxed across jurisdictions.
• Tax refund issues: It can be difficult for employees and employers to require refunds on overpaid taxes as some countries are reluctant to return overpaid tax amounts. 

These challenges highlight the importance for global payroll departments to be familiar with payroll tax obligations in the various countries and jurisdictions they operate to ensure accuracy and international compliance. 

EY also suggests five essential ways employers can avoid the pitfalls of shadow payroll and future-proof their business. These can be found here.