Shadow payroll means ensuring employment and payroll tax compliance overseas, while still paying employees their salary in their ‘home’ country. Here we explain what shadow payroll is, how to process shadow payroll, and the benefits of engaging a global expansion partner to support the task.
Key Takeaways
1. Shadow payroll is a payroll concept meaning tax compliance for payroll outside the country that a worker gets paid in.
2. Depending on which jurisdictions you are operating in, a shadow payroll arrangement may not be necessary.
3. Shadow payroll is just one of many options open to organizations looking to utilize an international workforce. Others include setting up a professional employer organization (PEO) or engaging workers as independent contractors.
The Modern Work Environment
It goes without saying that the modern employment environment is completely different to how it was just a couple of decades ago.
Traditionally, employees worked in rigid environments. Your working hours were set in stone, and you were expected to be in your workplace at a given time for a predetermined number of hours per week.
Home-based and wider remote working simply did not exist, and employees who had to work elsewhere, say in another country, either within the same business at another office or on secondment to a client would typically need to move abroad in the medium- to long-term.
However, with the growth of technology and the advent of true, multinational global organizations, in addition to the rise of brand-new economies and markets, this is not the case any longer.
Shadow Payroll in a Global Market
Organizations are now taking advantage of a professional landscape that is highly mobile, global, fast-moving, and far-reaching. Indeed, we are living in an age of complete global mobility where people can live and work from anywhere. No longer are organizations limited by a local talent pool, and can instead hire a global team.
While employees are now able to work across countries and continents more easily on shorter-term assignments, there are still challenges that need to be overcome, especially when it comes to employee management considerations like paying your international remote workforce.
If you are looking to expand your business internationally by sending a team of employees abroad or are considering hiring remote workers in their home countries around the world, then understanding shadow payroll and the potential implications of it is important for managing your risk and ensuring that you tick all the right boxes.
To read more about international payroll processing generally check out What is International Payroll Processing?
In this guide, we are going to look at the concept of shadow payroll in detail and provide you with the basic understanding you need about what it is and why it is used.
So, What Exactly is Shadow Payroll?
Shadow payroll is a mechanism that was first introduced to help organizations pay their expat employees who were working in another country temporarily. It is a critical component of global payroll implementation, and it often allows the company to (temporarily, at least) avoid hiring a foreign employee instead. Shadow payroll is often referred to as ‘expat payroll’ because of this.
The idea behind shadow payroll or expat payroll is that while the expat employee is working in a host country, he or she remains on their home country’s payroll system. At the same time, the payroll system in the host country “shadows” what is being reported in the home country, but the expat employee receives zero compensation from the host country.
An Example of How to Process Shadow Payroll
A worker is employed by an organization in the United States. The organization decides to expand to France and sends this worker overseas as an ex-pat to manage the expansion project. During their time in France, this worker may be liable for paying things like income tax and healthcare contributions in both legal jurisdictions.
By using the shadow payroll mechanism, however, this can be managed as the worker will remain on the organization’s US-based payroll. Under the shadow payroll mechanism, the organization still meets its reporting and tax withholding obligations for the host country, in this case, France.
While shadow payroll was originally designed for paying ex-pat employees, it can also be applied to international remote workers as one of a few payroll options available for paying remote workers.
When is Shadow Payroll Used?
Shadow payroll is mostly used when employment taxes (including payroll taxes) are required to be withheld by the organization in the host country.
The shadow payroll acts purely to calculate and pay the required employment taxes and employment contributions to the host country’s tax and employment authorities. It runs in the background to fulfil any tax obligations that might apply to the organization due to its operations in the host country.
It is relatively common to use a shadow payroll when transferring employees overseas, such as where appointing a country manager.
How Are Employees Paid?
It is important to note that even under a shadow payroll arrangement, employees are only paid their salary once. How this is done, however, depends on individual circumstances.
In the case of an ex-pat working temporarily in a host country, he or she will usually be paid their salary via their home country’s payroll to maintain things like 401(k) pension contributions, and Medicare. On the flip side, the employee may opt to be paid their full salary via their host country payroll if they have moved permanently.
In this case, the host country payroll will become their home payroll and the organization’s regular payroll system will become the shadow payroll. This is also the typical arrangement when international remote workers are engaged through an organization’s payroll system.
In either shadow payroll arrangement, the shadow payroll itself will be netted down to nil, zero. This makes sure that the employee is not paid twice and that there is a clear audit trail. There are different ways to do this, but the usual method is to make an after-tax deduction equivalent to net pay as reported on the shadow payroll.
Shadow Payroll Double Deductions
A shadow payroll arrangement of course means that tax liabilities can arise in two jurisdictions.
Depending on the tax rules of both the home and host country and the employee’s personal circumstances, however, what happens can vary.
Some countries, for example the United States (U.S.), apply taxes based on employee citizenship, not their place of residency. This means that U.S. ex-pats must pay taxes twice, once in the U.S. and, usually, once in their host country.
Most organizations will cover the cost of the host country tax liability rather than forcing their employees to pay it, however. While this has a serious cash flow disadvantage, it’s generally seen as a cost of doing business and expanding internationally.
This isn’t always the case, though.
For example, a tax treaty exists between the United States and the United Kingdom relating to double taxation.
Essentially, this treaty means that U.S. ex-pats working in the United Kingdom are protected from double taxation. The U.S. has similar treaties with several countries including Russia, Italy, Belgium, Japan, and each treaty has its own terms and arrangements.
As you can therefore see, the situation regarding double tax liability very much depends on each organization’s unique situation and where it plans to either send ex-pats or hire international remote workers.
This is why it’s crucial that, before you embark on an international expansion, you seek professional advice concerning any potential tax liabilities for staff.
Does Shadow Payroll Apply to Independent Contractors?
No—independent contractors are just that, independent.
They don’t tend to be included on an organization’s official payroll as an employee. They are also responsible for reporting and paying their own taxes; organizations engaging the work of independent contractors typically do not need to withhold any taxes.
Independent contractor payments can still be managed by the same firm that manages shadow payroll, however.
Is Shadow Payroll Always Necessary?
No, not always. Shadow payroll might not be necessary depending on your specific circumstances, nor may it be the right option.
Reasons why you might not need a shadow payroll include:
- No employment and payroll tax withholding options in a jurisdiction
- An exemption from taxation on ex-pats or remote workers
- A professional employer organization or employer of record arrangement exists in the host jurisdiction instead.
At the same time, you have got to consider the fact that many existing global payroll systems—perhaps even the one that you use—haven’t been designed with globalization in mind.
After all, it’s not uncommon for organizations to be using systems designed in the ’90s. This adds pressure onto your payroll specialists who are probably only familiar with your home country’s payroll situation and cannot say for certain whether an employee based overseas has been taxed correctly.
For these and a myriad of other reasons, firms need to ensure that they have got the right technology in place to handle the complex minefield that is paying international workers, whether that be through a shadow payroll system, professional employer organization (PEO), or another arrangement.
Read more about how a PEO services firm can help implement a shadow payroll in our article ‘What are PEO Services?‘.
Shadow Payroll Challenges
Shadow payroll calculations are inherently complex. Not only does the taxation situation alter dramatically between different countries, but laws can change at any time, annual budgets can alter tax rates, inconsistent government policy can lead to confusion and complications, and in the absence of local payroll experts it’s easy to make mistakes.
As the employer, however, the onus is on you and you only to make sure that you are doing everything correctly.
Tax authorities don’t care if you made an innocent mistake or failed to withhold the right amount of tax because you didn’t take note of a recent change to the income tax rate—your shortcomings are yours to own, and you can be heavily penalised for them.
As such, it’s incredibly important when operating a shadow payroll process to be on top of:
- Calculating, reporting, and remitting the correct amount of tax
- Submitting payroll data at the right time and making payments on time
- Accounting for things like holiday pay, bonuses, and 13th/14th-month pay
- Correctly categorising your employee (e.g., employee vs contractor?)
- Ensuring that you take advantage of any relief (e.g., tax treaty relief).
Why Use a Global Partner for Shadow Payroll?
Due to the high level of complexity involved, and the huge scope for things to go wrong, organizations that want to make a success of international expansion often seek a global partner to handle their payroll or shadow payroll for them. For many businesses, using a global payroll firm for outsourcing payroll or shadow payroll for their international operations is a cost-effective and compliant solution.
Horizons’ global payroll experts and technology solutions allow you to coordinate and simplify your international payroll operations and ensure their compliance with applicable tax regulations. We ensure accurate, on-time payroll and benefits distribution, to more than 180 countries worldwide, whether you are paying employees under an international subsidiary, via shadow payroll, or as independent contractors.
Contact us today to work out which payroll solution is right for your enterprise as it begins its international expansion.
