“Some things can only be seen in the shadows”. The Spanish author Carlos Ruiz Zafon wasn’t writing about payroll per se when he wrote this, but it does serve as an excellent starting point for why shadow payrolls exist. Any business that deploys employees overseas is likely to encounter the requirement to run a shadow payroll.
So who would be included on one, and what are they for?
The requirement to run a shadow payroll gets straight to the heart of the employer’s role in the tax system. Put simply, the employer is required to follow the rules of any withholding system that local tax law has mandated they must enact against employee’s salaries. This doesn’t mean that the taxpayer’s obligations have been met in full, or indeed that those obligations haven’t been exceeded by the requirements of the withholding scheme. The employee will make any corrections required through the local tax return process. Withholding obligations often extend past the direct employees of an employer, and may be extended to employees temporarily on international assignment who are being hosted by a local company.
Example
Hank is sent on assignment from ABC USA Inc to ABC Ireland Ltd for one year. During this year he will work at the premises of ABC Ireland Ltd under the direct supervision of one of their managers. He remains paid in US dollars on the US payroll. As Hank will be in Ireland for more than 183 days, he will be liable for Irish Income Tax and Universal Social Charge. Under s985 of the Taxes Consolidation Act, ABC Ireland Ltd are deemed to be the relevant party who must ensure that the Irish PAYE scheme is operated against Hank – it doesn’t matter that they don’t actually pay Hank. This is because ABC USA Inc are not resident or present in Ireland.
What types of employee might a company have an obligation to operate a shadow payroll for? This will depend upon the withholding legislation in the jurisdiction being visited, but typical groups of visitors to look out for include:
Whilst those sent on a formal assignment will usually be easy to identify, other types of visitor may not be obvious for the payroll department to spot. If a withholding obligation does exist for them, failure to operate the local withholding scheme can expose the business to significant compliance issues. Being able to identify potential candidates for inclusion on a shadow payroll is therefore vital.
A shadow payroll is one that is run and reported to the authorities to ensure that a local hosting entity will fully meet its obligations under local withholding rules. It will calculate liabilities for local taxes and social security contributions as appropriate without necessarily delivering any net pay to the employee. This is because the “true” payroll remains in action back in the home country, and it is this payroll that would deliver the employee their net pay. The host entity will need to determine exact remuneration received by the employee subject to such calculations. The deductions calculated from the shadow calculation will then either be paid on behalf of the employee via a company tax equalization scheme, or if the employee is to be personally liable for such taxes, the amounts will be passed back to the home country payroll for deduction from the employee’s salary there.
A Shadow Payroll is not just confined to being run in a host country, it could instead be run back in the home country. Many companies insist that when an employee is sent on assignment abroad, that they receive all of their cash salary via the host country payroll to make tax compliance easier in that jurisdiction. However, there could be continuing obligations back in the home country. For example, where an employee has had a certificate of coverage issued under the terms of a Bilateral Social Security agreement ensuring that the payment of social insurance contributions continues under the home scheme rules (with a corresponding exemption in the host jurisdiction.
The purpose of a shadow payroll may extend much further than simply calculating tax in a second country. The provision of a regular detailed electronic submission of employee data generated from the processing of employee payroll is becoming the norm across the globe. Such reporting is likely to need to include employees on secondment – both in the home and host country. Reasons for including people on a shadow payroll include:
Examples
It is common for employers to pursue a split payroll approach. Many assignees will have ongoing financial commitments back home, but will also require funds to live on, payable in local currency, in the host country. The challenge in splitting the payroll is that both payrolls will potentially have to take into account the amounts paid on the other payroll, and shadow for them.
Example
Amy has her salary converted to US dollars at a guaranteed exchange rate of £1 = $1.50. She asks her employer to pay £800 of her monthly salary via the UK payroll to her UK bank account, with the remainder paid in US dollars on the US payroll. Her UK payroll will have to add a “shadow” amount on each month to reflect the actual Sterling value of the US dollars using the prevailing exchange rate rather than the fixed rate the Company has granted Amy, so that this and the £800 Sterling are used to calculate UK National Insurance. Conversely, in the USA the £800 Sterling will need to be added as a “shadow” amount for the purposes of correctly calculating US taxes, again converting the Sterling using the prevailing exchange rate each month.
One of the most challenging aspects of processing a shadow payroll is identifying the correct amount to start the shadow calculation from. The best approach is to “follow the money”. Whilst contractual documentation can be useful for identifying potential benefits, in order to perform an accurate statutory calculation you should focus on identifying the following:
All of this can be difficult to accurately identify, especially if you are only provided with local language documentation. It will be necessary to identify every element on pay slips and contractual documentation to determine whether or not it needs to be reflected in your shadow payroll records.
Example
Lars Jensen is sent on assignment from Denmark to the UK for two years. He continues to be paid on the Danish payroll, but becomes liable for UK income tax under PAYE. His Danish pay slip reveals the following two benefits in kind which have been processed in Denmark:
In Denmark, the provision of a mobile telephone (fri telefon) to an employee, even if it is primarily for business use always results in a benefit in kind charge valued at DKK 2,800 pa. However, in the UK an employer may provide one mobile telephone to an employee free of tax. As such, although this item has been correctly included on the Danish payroll, it does not need to be reflected on the UK shadow payroll
Where an employee is provided with any fuel for a company car (fri benzin), this results in a varying benefit in kind charge determined by the amount of fuel provided. However in the UK, the valuation of the provision of fuel for private use is performed by reference to a percentage of the benefit in kind charge made for the car – the payslip here has alerted us to the provision of the benefit, but we cannot simply take the amount shown in Danish Kroner for the shadow UK payroll, and must instead valorise the benefit using UK rules.
If you have a reporting and payment obligation in a particular jurisdiction you should investigate whether there are any special schemes available that may make the amount of taxes lower. Many countries wish to encourage the prompt registration of foreigners into their taxation schemes by offering in effect a discount. Others wish to encourage the posting of international employees to their country by offering generous tax discounts to assist with the costs of assignment. All can be reflected on shadow payroll arrangements.
Examples
All require prompt registration and payroll reporting of the employee.
Perhaps the greatest challenge on running a shadow payroll is the calendar. Payroll reporting typically requires all relevant pay to be reported and included in tax/social insurance calculations at the time that it is provided. That can be a difficult target to hit where you are not in control of paying the salary because it carries on being processed in the home country, possibly to a different pay cycle to the one deployed in the host country. The correct pay, including exchange rate conversion will have to be identified, and for most companies in effect that will mean running at least one month in arrears. Will this meet the strict rules of the host jurisdiction?
Some countries recognize this challenge and offer variants to the standard payroll calculation and reporting process to take account of these challenges. The UK in particular offers employers the option of modified PAYE and NIC’s schemes. These allow the employer to estimate earnings, perform statutory calculations based on these estimates, correct estimates towards the end of the tax year, and file final numbers via a tax return or NIC Settlement Return after the end of the year.
Examples
The obligations to operate PAYE withholding schemes around the globe are comprehensive, and having employees move into different jurisdictions is likely to create reporting and payment obligations which can only be met through payroll systems.
Shadow payrolls need careful attention, and the best approach is to be inquisitive and ask lots of questions. Remember that a copy of the employee’s pay slip from the other jurisdiction is usually the best source of truth. International employees can certainly seem to meet Zafron’s description of being hidden from sight, but eventually will turn up on some statutory authority’s radar. So make sure that everyone who needs to be is “seen in the shadow”!