If you are working in a multinational environment, you have probably come across the term “shadow payroll” and you probably have a vague concept of it. But what exactly constitutes a shadow payroll and how does it really work? Well, this article is intended to clarify the concept of shadow payroll, when it is used and how it works. Recognizing shadow payroll as an important concept in any foreign employment assignment is critically important and your understanding of the concept will help to mitigate potential risks involved for your company and the employee. Properly understanding the concept has become particularly important over the past year where more and more employers have granted their employees to work remotely and many employees have chosen to work from outside of the country where they are legally employed (e.g. moving back to their home country for many international employees). Without careful consideration of the tax implications, you can create significant liabilities for the company and the employee.
What is Shadow Payroll?
Here is a definition: A shadow payroll is typically used to properly report and pay taxes and social security for an ex-pat employee while he or she works in a foreign country (i.e. in their host country) but retains further tax and social security obligations at home (i.e. in their home country). In an international assignment, the employee is either paid through the home country’s or the host country’s payroll (or sometimes through both countries), and shadow payroll is established to determine and report the local tax and social security obligations in the country where the employee is not paid – i.e. it is a shadow calculation without making the actual salary payments to the employee.
An Example of Shadow Payroll
Let’s use an example to illustrate the concept: A US-based company sends one of its employees, Sarah, to Germany to help grow their business in Europe. While Sarah is on her two-year assignment in Germany she will remain on the US payroll (i.e. her pay is being processed in her home country, including US tax and social security deductions). However, since Sarah will be working for more than 6 months in Germany, the company will be required to also remit income taxes and social security payments to German authorities, both on behalf of the employee and as an employer.
It is important to understand that while the US and Germany have both a tax treaty and a social security agreement (often called “Totalization Agreement”) in place, the company still needs to submit tax and social security filings in both countries, and it potentially needs to pay the delta between taxes and social security already paid in one country versus payments owed in the other country. So, fundamentally taxes and social security need to be considered both in the home country (US) and in the host country (Germany).
This is where shadow payroll comes in. It is used to figure out the local taxes and social security obligations in the country where the employee’s actual payroll is not processed.
How Does Shadow Payroll Work?
So now let’s talk about how a shadow payroll actually is applied:
- First, the company will be calculating the taxes and social security charges due in the country where the actual salary is paid (Sarah’s case in the US, the home country) and the taxes and social security charges are withheld from the local payroll (i.e. US taxes and social charges are being withheld).
- Next, the company needs to calculate the taxes and social security charges in the other country (in Sarah’s case in Germany, the host country) in order to properly file statutory submissions locally and make any remnant payments to the local authorities.
- Since the company does not want to process and pay the employee’s salary twice, this second part is done via a shadow payroll instead of a “normal” payroll – which essentially means that taxes and social security payments are being calculated without processing the actual salary payment (hence the term “shadow”).
- By running a shadow payroll to calculate the appropriate local tax and social security liabilities in the host country, the company is able to remain compliant with the host country’s income tax obligations while paying the employee on the US payroll and fulfilling your US tax and social security obligations.
In an increasingly international work environment, often complex tax situations can apply to employees like ex-pats and mobility workers who are working across multiple jurisdictions. Therefore, shadow payrolls have become an increasingly important means for multinational companies to ensure proper compliance and avoid running afoul of local tax obligations, either in the home country or the host country.
Other related concepts that are often directly tied to shadow payrolls are so-called tax equalization or tax protection schemes. The schemes are essentially used by companies to mitigate any adverse impact that ex-pat or global mobility employees might experience from being subject to multiple tax jurisdictions during their international assignment. The objective is generally to ensure that the employees do not pay more or less in taxes and social security that they would have done if they had remained at home, as not to create an unwanted tax disadvantage (or advantage) for the employee from taking on the foreign assignment. Implementing such schemes requires expert tax advice both in the home and host country and typically involves the calculation of hypothetical taxes (often referred to as “hypo tax”) in order to establish what the ex-pat would have paid in home-country taxes had he or she remained at home. The tax balancing calculation often results in a year-end adjustment to make sure that the employee is “kept whole” from a taxation perspective.
Given the rapid internationalization of the workforce and loosely formulated remote work, cross-border employment arrangements becoming more common, the concept of shadow payrolls is critical as it allows multinational companies to maintain compliance with tax and social security obligations in one jurisdiction while properly compensating an employee through payroll in another jurisdiction. In order to ensure proper handling of often unique and complex tax situations, companies moving their employees abroad or setting up new international offices should seek legal and tax expert advice to evaluate the best possible options, including understanding the implications for the company to set up local entities, registering with the local tax and social security authorities, availing of global employer-of-record services or engaging staff as freelancers/contractors.
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