Shadow payroll is a concept organizations need to be familiar with if they want to ensure global payroll compliance for their mobile workforce. Similar to global payroll, shadow payroll is all about meeting payroll obligations in different countries. The only difference is that a shadow payroll is a temporary payroll set-up for the duration of an international work assignment.
Sending an employee abroad on assignment can trigger new tax liabilities and reporting obligations in the host country that can’t be met through the home-country payroll through which the employee continues to be paid. That’s where setting up a shadow payroll comes into play.
But what is a shadow payroll? When is a shadow payroll required? And how does shadow payroll work?
A shadow payroll is a mechanism which is used to ensure tax compliance for employees on international assignments. Depending on the length of the assignment, the employee’s earnings may have to be declared in both the home country and the host country, which triggers the need to register the employee for a local payroll which is processed in parallel to the one in the employee’s home country.
Contrary to a regular payroll, the purpose of a shadow payroll is not to get the employee paid, but to simply replicate the home-country payroll to meet the tax and social security reporting obligations imposed by the host country.
The shadow payroll allows employers to remain compliant with the tax laws of both jurisdictions (i. e. the laws of the home country as well as the laws of the host country), since it ensures that the compensation paid to the employee on assignment through the home country payroll is reported to the respective authorities in both countries.
It’s important to note that running a shadow payroll in addition to the home-country payroll doesn’t mean that the employee is getting paid twice. After the shadow payroll calculations, which are necessary to determine the payroll taxes due in the host country, the net amount payable to the employee will be netted down to zero.
A shadow payroll is a second payroll which is run in the host country with the sole purpose of ensuring compliance with local tax and reporting requirements. It is run in parallel to the home-country payroll, which is the payroll through which the employee receives his or her pay.
The concept behind shadow payroll is quite complex. To fully understand the processes, challenges and requirements, businesses must also be familiar with the following terms which are frequently used when talking about taxation and global mobility:
Home country: This is the country from where the employee’s wages are paid. Normally, it’s the country where the worker is officially employed and where the sending organization is based. However, depending on the length of the assignment and the employee’s residency status, this may change.
Host country: Usually, the host country is the country where the assignment takes place. However, since the host country can turn into the home country (depending on the length of stay), the host country is sometimes also defined as the country where no compensation is paid.
Tax equalization: Tax equalization is a mechanism applied to ensure that an employee doesn’t pay more (or less) tax than usual while being on an international assignment. It basically means that any excess taxes that arise during the assignment are paid by the employer.
Hypothetical tax: Calculating hypothetical taxes means calculating how much the employee would have paid in income tax and social security contributions in the home country if he or she hadn’t gone on an international assignment. The so-called “hypo tax” is calculated as part of the home-country payroll and the amounts deducted in the process are then used by the employer to pay tax obligations in both the home and the host country.
Social security agreement: A social security agreement (also known as totalization agreement) is an international agreement between countries with the purpose of eliminating dual taxation in terms of social security contributions. If two countries A and B have a totalization agreement with one another, this means that employees from country A can go on a work assignment in country B while continuing to contribute to the social security schemes in country A, thus not being charged social security contributions in country B.
The need for a shadow payroll typically arises when employees are sent on a work assignment abroad. Since the employee continues to be employed by the company in his or her home country, wages and salaries earned during the assignment are also paid by the home-country entity.
However, depending on country laws and regulations, the employee’s compensation—although paid from another country—may also have to be reported in the host country. If that’s the case, then setting up a shadow payroll becomes necessary.
Not all countries require employers to withhold income tax and social security contributions on behalf of their employees—one example here is Switzerland. In countries where the employer doesn’t have a tax withholding obligation, there is no need to set up a shadow payroll when sending employees on an assignment there.
The need to implement a shadow payroll is closely linked to the individual employee’s tax liability in the host country; and since the latter is, in most cases, dependent on the length of stay, the duration of the international assignment has a direct impact on whether the organization needs to implement a shadow payroll or not.
Many countries base an individual’s liability to pay local income tax and social security contributions on the so-called 183-day rule. What this means is that an international employee only becomes liable to pay payroll taxes in the host country if the length of their stay exceeds 183 days, i.e. 6 months, within any given 12-month period. That’s why setting up a shadow payroll may not be required for short business trips of less than 6 months.
However, as soon as the 6-month mark is passed, it’s a different story. Since a long-term assignment usually triggers tax liabilities in the host country, a shadow payroll would be needed to comply with local tax reporting and payment obligations.
A US-based company is looking to send several employees on a one-year assignment in the UK to conduct some local market research. It’s agreed that the employees will remain on the home-country payroll (i. e. the US payroll) for the duration of the assignment, which means that the usual tax amounts and social security contributions will be deducted from their wages and salaries.
However, given the length of the assignment, the employees will also be liable for income tax in the UK. Although the employees are exempt from making UK social security contributions thanks to a totalization agreement between the two countries, a shadow payroll needs to be set up to calculate, report and remit UK income tax every month.
While the US payroll will be used to calculate and deduct income and social taxes due in the US and pay the employees’ salaries and wages, the UK shadow payroll will exclusively be used to determine the amount of local income tax due and report and remit the withheld taxes to the local authorities.
Understanding shadow payroll is a challenge, but not as much as actually processing it. Here are the basic steps to follow:
Collecting all the compensation data for each employee, including additional allowances paid out in relation to the international assignment
Signing employees onto a shadow payroll in the host country
Processing home-country payroll as usual
Running a shadow payroll in the host country to calculate taxes and social security charges—at the end of the process, the employee’s net earnings must be netted down to zero
Implementing tax equalization measures/applying the provisions of an existing double tax treaty to protect the employee from paying income tax and social security contributions twice
Fulfilling reporting and payment obligations in the home country and the host country
The aim of running a shadow payroll is to avoid tax issues when working with a mobile workforce and ensure compliance across geographies. However, there are many things that can go wrong in the process. Here are some examples.
Fines: Being fined by local authorities is one of the most common consequences businesses face when failing to put a proper shadow payroll in place for the duration of an international assignment. Fines can be imposed on businesses for many different reasons if they don’t comply with payroll requirements in both the home and the host country. One example is failing to register employees on a host-country payroll on time.
Overpaying: A crucial part of the shadow payroll process is figuring out what the employee’s tax liabilities are and working out ways to avoid double taxation. Unfortunately, it’s not uncommon for businesses with employees on international assignments to overpay taxes and social security contributions—overpayments that they often never recover.
Tax residency issues: In order to pay payroll taxes where they are due—i. e. either in the home country or the host country, or both—employers need a firm understanding of the rules for tax residency in both countries as well as of the scope and rules of any existing double tax treaties. Getting the employee’s tax residency wrong could result in severe headaches when payroll taxes have been paid in the wrong jurisdiction.
Running a shadow payroll is anything but a walk in the park, and there are many pitfalls along the way. Here are some things to keep in mind:
Strong communication: The home-country entity and the host-country entity should make sure to communicate openly and frequently to always be up to date and detect potential problems early on in the process.
Correct and timely data collection: Accurate compensation and payroll data is crucial for a successful shadow payroll. Home country and host country should make sure to collect data on all compensation provided to the employee (in both jurisdictions) and make this data available on time to process both the home-country payroll and the shadow payroll.
Careful review of the payroll results: After each payroll run, the results of the home-country and shadow payrolls should be reviewed carefully for their accuracy to detect any discrepancies.
Adaptability to changes: The international assignment may not go as planned, resulting in an intended 3-month stay suddenly turning into an 8-month stay and different tax liabilities than initially expected. To avoid compliance issues with regard to taxation, businesses should always have a back-up plan and be prepared to respond to changed circumstances quickly.
The Lano Academy is for informational purposes only and should not be construed as legal advice. Lano Software GmbH disclaims any liability for any actions you take or refrain from taking based on the content contained in this article.
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