The question “what is a shadow payroll” comes up quite frequently in our conversations about working abroad with organisations and individuals.
For this reason, we have decided to write this article with the aim of providing the answer to this somewhat intriguing and recurring question.
Furthermore, we will also explain when a shadow payroll is needed and how it ties in with the concepts of tax equalization / protection and hypothetical taxes.
What is a shadow payroll
As mentioned in our global mobility guide:
A shadow payroll is essentially a host country “mock” payroll run in parallel to the home country actual payroll.
The home country payroll delivers the net pay to the individual whereas the shadow payroll is used to calculate and report the taxes due in the host location.
With the exception of a few countries such as Singapore and Japan where the taxes due on the expat’s earnings can be calculated and reported via the tax return at year-end instead of on a monthly basis, running a shadow payroll in the host country is usually a requirement when assignments exceed 6 months.
Having said that, there are some countries, such as the UK, in which running a shadow payroll may also become relevant even for assignments and frequent business trips lasting in total less than 6 months in a given tax year.
When is a shadow payroll needed
Essentially, a shadow payroll becomes relevant in situations where:
– an individual generates tax and/or social security liabilities in a host country which need to be reported / paid to the local tax authorities in “real time”; AND
– the expat also maintains ongoing requirements in the home country such as net salary payment, tax and social security payments and/or benefits payment withholdings / contributions.
Example of a potential Shadow Payroll scenario
A US employee is seconded to the UK for 3 years whilst remaining employed and payrolled in the US.
The employee prefers (and is entitled to) to remain in the US social security and benefit programs (401K, Medicare, FICA, etc.).
The individual has various outgoings in the US during the duration of the assignment hence it makes sense for them to continue to be paid in USD in a US bank account.
The parties might eventually agree on a specific percentage of net USD pay to be delivered in a foreign bank account so the individual is able to meet day-to-day costs in the host location too, however this is irrelevant to the underlining mechanism of a shadow payroll.
All of the above is best accommodated by keeping the employee on the US payroll through which their net pay continues to be paid for the duration of the assignment.
In addition, withholding and reporting requirements also arise in the UK as a result of the assignment.
A UK shadow payroll is therefore set-up, whilst continuing to operate the US payroll as normal with the exception of hypothetical taxes (see further below) replacing actual Federal and State income taxes, to:
- Calculate the UK taxes due on the expat compensation whilst on assignment
- Remit and report UK tax liabilities each month to the UK tax authorities
However, no net pay is delivered to the individual via the UK shadow payroll.
Why is tax equalization / protection relevant
Is it important to highlight that the shadow payroll mechanism goes hand in hand with the chosen assignment tax policy and by extension, with the degree of responsibility the employer wants to take on in the host location.
The 3 main tax policy options can be summarised as follows:
- Fully tax equalized
- Tax protected
Fully tax equalized
According to the UK government website:
A tax equalisation arrangement involves an agreement under which the employee is entitled to specified net cash earnings and/or non-cash benefits. The employer undertakes to meet UK Income Tax arising from the earnings and/or benefits and to provide a professional adviser or in-house specialist to deal with the individual’s UK tax affairs.
In other words, fully tax equalized individuals are kept neutral and end up paying, overall, once all the relevant true ups have been calculated, the same amount of taxes they would have paid, had they remained in their home country.
Under a fully tax equalized arrangement, if an employee is seconded to a country which has an overall lower tax regime or no income tax at all, the employee is not allowed to keep the tax savings for themselves.
It is the company who ends up benefiting from the lower taxes (or lack thereof) savings in the host location.
Conversely, if the taxes in the host location are higher than those the individual would have paid, had they remained in their home country, the delta between the taxes due in the host location and those which would have been due at home, is for the company to cover.
In a tax protected arrangement, the company ensures the employee pays no more taxes than they would have paid, had they never gone on assignment.
Unlike in the tax equalization scenario, tax protected employees get to keep any tax savings arising from being seconded to a host country which demands less taxes from them than their home country.
The company however still agrees to reimburse the employee for any excess taxes due in the host location.
This approach usually implies the employee is on their own when it comes to taxes both in home and host location.
This means they are fully exposed to excess taxes they need to pay overall between home and host locations.
Usually, under such arrangement, no tax return adviser or in-house specialist is provided by the employer either, thus making the entire assignment quite burdensome on an individual both in terms of cash flow and administrative compliance.
The final decision on which of these 3 options to choose from depends on several factors such as:
- home-host location combination
- requestor of the assignment / cross-border arrangement
- cash-flow abilities (or lack of it)
- appetite of the employer to oversee the entire process to ensure compliance in both home and host locations.
A shadow payroll process can then be adjusted accordingly depending on the chosen option.
How hypothetical taxes play a role
Either way, if either the fully tax equalized or tax protection option is chosen, hypothetical taxes typically come into play.
Hypothetical taxes (also commonly referred to as “hypotax” or simply “hypos”) are the taxes an individual would have paid, had they never gone on assignment.
Hypos usually cover personal income tax and social security but not taxes and social security due on assignment specific compensation items (COLA, housing allowances, school fees, relocation payments, etc).
Hypo taxes are withheld from the expat gross pay in lieu of actual Federal and State income taxes but are not remitted to the home country tax authorities such as the IRS / State of California.
In the US for example, in general, it is possible to stop remittance of Federal income taxes if an individual is out of the US for more than 12 months and to stop remittance of California State taxes if an individual is outside of California for more than 18 months.
The hypo taxes withheld from the employee’s home country gross pay are instead kept by the employer in anticipation for the taxes due in the host location (in accordance with the cadence of the shadow payroll set-up).
Typically, the hypo taxes withheld from the expat home payroll gross pay will never match the taxes due in the host location (this is due to different tax rates, assignment compensations items being taxable, etc.).
For US outbounds it is quite often the case in fact, though not always, that the taxes due in the host country are higher than those withheld from them.
Who pays for the shortfall (or enjoys the savings of lower taxes due) is a decision made when choosing the assignment tax policy under which the expat will be covered.
For instance, as described in the previous section, under a fully tax equalized arrangement, the company is responsible for covering the delta between the taxes withheld from the individual and those due in the host location if higher whilst also retaining the actual tax savings if the expat is seconded to a location with lower or no income taxes due.
Whereas, under a tax protection arrangement, the company may still agree to pay for any excess taxes due in the host location but the employee gets to keep any tax savings if seconded to a location with overall lower or no income taxes payable.
FAQ on shadow payrolls
Is a shadow payroll easy / difficult to operate?
Shadow payrolls are not as straight-forward as standard, local hires payrolls to operate.
The majority of household name, global payroll providers we have come across in fact, have always struggled to deal with anything other than a standard gross to net calculation typical of locally hired employees.
Most of them seem unable to offer a non-standard net to gross calculation which is one of the essential steps needed in a shadow payroll under a tax equalized / protected arrangement.
Moreover, additional complications can be encountered when using off-the-shelf payroll services from vendors in terms of their ability to fulfil non-standard payroll functions and requirements such as:
– the removal of host country social security contributions deductions as a result of a Certificate of Coverage / A1 being obtained for the employee
– the incorporation into the shadow payroll calculations of special tax concessions such as those afforded by the Spanish Beckham ruling, the 30% Dutch ruling, the Italian tax break for impatriates or the French expat tax regime.
– the addition of supplemental pays such as RSUs and stock options resulting in the shadow payroll needing to be operated in a different way for these items.
It is therefore recommendable to engage the expertise of a niche expat tax and global mobility specialist to at least advise on and supervise the shadow payroll process.
Contact us should you require further clarifications on how a shadow payroll is operated. We offer a free ½ hour consultation.