What’s a Shadow Payroll?
By Katie Davies, VP International Solution Development, Vistra
“Shadow payroll” is a catchy term you’ve probably heard about but may not understand. It is in fact a somewhat slippery concept that requires an understanding of numerous other technical areas like tax equalization and protection, hypothetical taxes, permanent establishment, legal entities and more. “Shadow payrolls,” then, are aptly named — they’re enigmatic and even a little daunting.
This post is intended to demystify the concept of shadow payrolls, to give you a high-level understanding of what they are and why they’re used. If you’re considering sending an employee abroad, understanding why shadow payrolls are important is a critical first step to lowering your company’s risks.
Let’s start with a basic description: A shadow payroll is commonly established to report and pay an expat employee’s host-country taxes while he or she remains on a home-country payroll. (A shadow payroll can also be established in the home country where an employee is paid through a host-country payroll.)
I’ll illustrate with an example. Let’s say you’re part of a US-based company that’s new to international expansion. You decide to send an existing employee named Jane on a three-year term assignment to the UK to test the market there. Jane will remain on a US payroll during her time in the country.
This seemingly simple decision will trigger a host of considerations and obligations. For example, depending on Jane’s length of stay, the nature of her job activities and other factors, your company will likely be required to remit income and social taxes to UK authorities, both on her behalf and to cover your employer obligations under local law. This may in turn require you to establish a legal entity through which those payments will be made. The legal-entity requirement will be determined by the nature of the activities to be performed, where they will be performed and whether you expect to hire more employees in-country. Even where a legal entity is not strictly speaking required, your company will need to register a local payroll.
Now, let’s say you consult a third-party expert and determine that Jane’s assignment will in fact require your company to set up a UK legal entity and remit taxes to UK authorities. Keep in mind that since US citizens are taxed on their worldwide income, Jane will also be taxed by US authorities on the money she earns while working in the UK.
Critically, the US and UK have both a tax treaty and a social security agreement in place. The good news for Jane is that the social security agreement will allow her to avoid paying UK social security, since her assignment will last less than five years. The tax treaty, however, will not protect her from exposure to UK income taxes, since the assignment will last more than six months.
To summarize: Jane will be subject to pay income and social taxes to US authorities and income taxes (but not social security) to UK authorities while on assignment. Since she will remain on a US payroll, however, you don’t want to establish a traditional UK payroll because of course you don’t want to pay her twice.
Enter the shadow payroll. Establishing a shadow payroll in the UK in this situation will allow you to remain compliant with host-country income tax obligations while at the same time paying Jane on a US payroll and fulfilling your US tax and social obligations. In our global economy, tax authorities in all jurisdictions are intent on collecting applicable taxes from foreign nationals working within their borders, so shadow payrolls have become an increasingly important means for multinationals — and their expat employees — to avoid paying fines and penalties associated with noncompliance.
To return to our example: In order to run the shadow payroll for Jane, you’ll need to calculate the amount of tax owed under UK law based on her earnings (including any non-salary benefits she receives from your company, such as any additional compensation you may choose to pay her to offset the tax burdens arising from the assignment). You’ll then use the shadow payroll as a means to report and pay taxes through your UK legal entity, though not to pay Jane.
There are many other considerations related to running shadow payrolls. In our scenario, for example, even though Jane remains on a US payroll she’ll need to have some monies sent to her in the UK to fund day-to-day living expenses. There are different ways to accomplish this, such as wiring money to Jane’s personal account or using your local legal entity to issue a cash disbursement. You may also choose to reimburse Jane for any exchange-rate losses she incurs. A further consideration is how you address foreign exchange fluctuations between home- and host-country currencies. (This is particularly relevant at this time of a falling British pound against the US dollar, where US expatriates converting to GBP have had an unexpected windfall after the Brexit referendum — but that is another story!)
It’s important to emphasize that shadow payrolls are often used to carry out a company’s tax equalization or tax protection policy, a subject we’ve barely touched on here. These policies are used by multinationals to promote compliance and employee engagement, and fundamentally to ensure that expatriate employees pay no more (or less) tax than they would have done had they remained at home. Such approaches help ensure that employees are not discouraged from accepting expat assignments in high-tax jurisdictions. Implementing such policies requires among other things calculating hypothetical taxes, or hypo tax, to determine what the expat would have paid in home-country taxes had he or she remained at home. This process also requires making a year-end adjustment, or tax balancing calculation.
Shadow payrolls, then, are important as they allow multinationals to maintain compliance with tax and social security obligations in one jurisdiction while compensating an employee through a payroll in another jurisdiction. That much is reasonably straightforward, but effectively implementing a shadow payroll — including complying with any attendant tax equalization or tax protection policy — is often complex.