Shadow Payroll Handles Taxes, Protects Wages for Global Employees

Shadow payroll helps mulitnational employers meet their global tax obligations and can help prevent wage losses for employees working abroad, a tax expert said July 11.

Multinational companies use shadow payroll to meet the tax requirements of countries that their employees work in while abroad on assignments, said Brooke Saulsbury, Expatriate Services Senior Tax Manager for KBF CPAs LLP. The tax obligations of these jurisdictions, or host countries, differ from those of an employee’s home country.

Shadow payroll complements primary payroll, which is the process used where the employee is being paid, she said. In most cases, employees are paid from their home country, so primary payroll would occur in the home country and shadow payroll would take place in the host country.

The primary payroll calculates taxes owed based on an employee’s income, while shadow payroll calculates taxes based on the employee’s work within the host country. An employee’s tax obligation will vary depending on the length and location of the assignment, but it is not uncommon for an employee to pay social security taxes to their home country and owe income taxes in the host country, Saulsbury said during PayrollOrg’s 2024 Virtual Congress.

“An important thing to note is that where [an employee’s] payment is made does not determine taxation,” Saulsbury said. “This is a frequent misconception we see from employees where they think that where they are paid from is the only placed they are taxed. It doesn’t matter where you are paid; it depends on the local tax rules.”

Employers may choose to either create a shadow payroll system internally or outsource it to a payroll provider that already knows the tax obligations of the host country, Saulsbury said. Regardless, employers must consider several factors when establishing a shadow payroll, including fluctuations in currency exchange rates, any totalization agreements between the home and host countries, and the sources of employee compensation.

“Currency exchange rates often need to be considered since payroll calculations often involve converting wages and benefits from the host country’s currency to the employee’s home country currency for reporting purposes,” Saulsbury said. “Exchange rate fluctuations can impact the accuracy of these conversions and may ultimately affect the employee’s net pay or tax liabilities.”

After determining the host country’s tax obligations for payroll purposes, some employers might discover that an employee on assignment in the host country will be subject to higher taxes than those in the home country, she said. To help employees maintain the save level of earnings while working abroad, employers can gross-up wages to account for the increased taxes.

The typical gross-up formula is the amount of wages divided by the difference between one and the sum of the total tax rates, she explained. For example, if $10,000 in wages needs to be grossed up and it is subject to a 22% income tax rate and a 1.45% Medicare tax, the formula would be $10,000 ÷ (1 - 0.22 - 0.0145), which would equal $13,063.36. In this case, the employer would need to increase wages by $3,063.36 ($13,063.36 - $10,000).

Before using this formula, however, employers should consider several factors that could affect the way tax gross-ups are calculated, Saulsbury warned. For example, the increase in wages might not align with the company’s budget, or there might be a wage base or cap on the amount of income subject to a certain tax.

“Not all tax gross-ups are the same,” she said. “What is your intention with the tax gross-up? What are you wanting to tax equalize?”

Employers need to establish clear external and internal policies and procedures for payroll to ensure that employers meet their global tax obligations and that employees wages are not severely impacted while working abroad, she said.

“Understanding what the policies are and how everything is going to flow is ultimately going to set you up for success to ensure that the shadow payroll is being administered as intended,” Saulsbury said.