In today’s globally interconnected world, businesses often find themselves expanding operations into new markets and dispatching employees to work in foreign countries. While this is a testament to the growing reach and capabilities of modern enterprises, it also introduces complex challenges, especially in terms of payroll tax compliance. Shadow payroll is an effective way to mitigate the risk of such challenges.
Shadow Payroll Explained
Shadow payroll is a method used by companies to manage the tax obligations of employees working in a foreign country (host) by running a parallel payroll (shadow) to help ensure compliance with local employer tax regulations while the employee continues to be paid in their home country (home).
This type of payroll is crucial for multinational companies with a globally mobile workforce, as it facilitates accurate tax reporting and compliance in cross-border employment situations. However, it is equally important for domestic companies, especially after COVID-19, as employees often decide to move to a different jurisdiction and work remotely. Such a scheme can create additional tax implications for a domestic entity beyond just shadow payroll compliance.
Integrating shadow payroll into a global human resources strategy allows for global payroll compliance and financial transparency. By accurately tracking and reporting the tax obligations of employees working abroad, companies can maintain compliance with local regulations, avoid penalties, and provide a better experience for their employees working abroad, as they will understand their tax exposure and net payroll. Employees who are U.S. citizens living abroad can claim a housing exclusion to cover different types of housing costs, as defined by the Internal Revenue Code (IRC), in addition to a foreign earned income exclusion on their individual income tax return filed in the United States.
It is important for employees to understand the allowances offered by the tax authorities in their home country, given that each country has different caps and company-imposed limitations. Employees should also discuss the foreign earned income exclusion limits that are applicable in the U.S. with their individual tax professional.
When to Consider a Shadow Payroll & Required Documentation
Shadow payroll may be necessary if you are operating in multiple countries, sending employees to work in multiple countries for a defined or an extended period, and/or having employees on payroll in one country while they are working in another. It is important to identify those situations and seek the assistance of a global mobility professional who can also advise on the various treaties between the operating countries, in order to mitigate double taxation, or to become aware of the tax implications, if they are to be taxed in both jurisdictions.
There are a few important documents to consider to properly calculate the payroll obligation and related payroll taxes. Apart from the identification documents of the employee, such as a tax ID or a passport, there should also be an employment contract in place that indicates which company the employee is working for. This is particularly important in a parent/subsidiary relationship, which is often missed.
A travel calendar is important as it is a reliable tool to calculate the days worked in different countries. In the event a temporary assignment extends over 183 days, some countries will state that the employee will then be subject to an individual income tax return filing in that country, in addition to any individual income tax filing requirements in their home country.
An A1 certificate, which states in which country a worker’s social insurance premiums are paid, may be required. Depending on the country an employee is traveling to work, the absence of an A1 certificate may deter employment. The absence of such a certificate can result in high fines if an employee is working in another country without it. In the Netherlands, for instance, the A1 certificate applies in both scenarios; if a company employs someone in the Netherlands from another country, and vice versa. Please note that this certificate is valid for employees working in the European Union (EU), for countries of the European Economic Area (EEA), and for countries with which the Netherlands has a Totalization Agreement (acting like Social Security). These agreements are with a treaty country, like the Netherlands, which has concluded agreements in place, where the government secures that the people receive income or care in the event of unemployment, incapacity to work, or illness.
In Asia and non-EU countries, an A1 Certificate is not applicable, but there are similar documents that exist, such as the Certificate of Coverage (CoC), which ensures that employees continue to contribute to their home country’s social insurance system equivalent. As each country has its own employer payroll rules, compliance, and regulations, it is advisable to consult with payroll and global mobility professionals in the home and host countries.
Payroll Tax Burden & the Importance of Tax Equalization/Protection
When it comes to the tax implications of shadow payroll, employees and employers can come to an agreement regarding the tax burden, or in other words, who would bear the tax.
There are three avenues:
- Tax Equalization: The employee is entitled to a specified net case of earnings and/or non-cash benefit. This means that the employees should be paying the same amount of tax as they would have paid if they had remained in their home country. Under this arrangement, if the employee is to continue employment in a country that has no income tax or the income tax regime is lower than their home savings, they typically are not entitled to keep the tax savings. Therefore, the benefit remains with the employer. However, if the opposite happens, and the host country’s tax is higher than the home country’s, the employer bears the cost and covers the additional tax due.
- Tax Protection: This arrangement benefits the employee, in that they get to keep the tax savings if the host country has no income tax assessed or has a lower income tax regime. The employer is obligated to cover the tax if the tax in the host country is higher.
- Gross Salary Arrangement or Laissez-Faire: This is the least beneficial arrangement for an employee, as they are responsible for covering even the excess taxes between the host and home country.
There are several factors that can influence the decision as to which of the three arrangements to agree upon between an employee and an employer. It is advisable to thoroughly review and discuss with the employer and an individual tax advisor prior to accepting a new assignment.
Best Practices for Shadow Payroll
To effectively implement shadow payroll, businesses should consider the following best practices:
- Engage Professionals: Collaborate with tax and payroll professionals who have experience with international assignments and shadow payroll. It is important to point out that, in addition to payroll tax and withholdings, shadow payroll can also trigger corporate income tax filings for the entity in the host country, as payroll is one of the factors that can create nexus in a particular state in the U.S. or a permanent establishment in a particular foreign country.
- Invest in Technology: Utilize advanced payroll software that can handle multijurisdictional payroll processing and reporting.
- Regular Training: Regularly train HR and payroll teams in the latest tax laws and compliance requirements.
- Continuous Monitoring: Regularly review and audit the shadow payroll processes to help ensure ongoing compliance and accuracy.
How Forvis Mazars Can Help
Shadow payroll requires a full understanding of treaties and regulatory requirements between the countries involved. It can get even more complicated if a company offers stock options or restricted stock units (RSUs) to entice employees to take on an assignment in a different country for a period. It is highly recommended to seek professional advice from advisors with experience in global mobility.
If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.
For more information about payroll and initial setup, please refer to our previous FORsights™, Entering the U.S. Market: Essential Steps for Business Success and Navigating Shadow Payroll Tax Compliance for International Employees.