Shadow Payrolls Are Key Part of International Assignments

Running shadow payrolls can ensure that a globally mobile employee’s income and taxes are reported and paid properly, a managing director at a Big Four firm said June 22.

Shadow payrolls primarily are used to report and pay host-country taxes while the employee remains on a home-country payroll, Kathy Soderman, a managing director at EY and a leader of EY’s Global Payroll Operate, said.

Less often, the term is also used to refer to employer-paid taxes or benefits in the host country that must be imputed to an employee’s income, or the primary arrangement can be reversed such that a shadow payroll is used in the home country while the employee is on a host-country payroll, Soderman said.

Soderman said that employees prefer being paid in the more familiar home country, especially more senior US-based employees, while employers believe host-country payrolls are more cost-effective. More junior employees are often put on host-country payrolls, she said. Soderman spoke at PayrollOrg’s 2023 Virtual Congress.

Split payroll, in which employees are paid in both the home and host country, “has its pros and cons,” Soderman said. “It’s typically a little bit difficult to administer,” she said.

For example, wages may be paid in the home country while benefits such as a housing allowance required to be paid in the local currency may be paid in the host country or by a relocation provider, Soderman said.

Other factors influencing whether a shadow payroll is needed include the duration of an assignment and whether a double taxation agreement or social security agreement applies, Soderman said.

The US has more than 60 DTAs in effect, but only 29 SSAs . Soderman emphasized that one type of agreement but not the other might apply to an employee.

With the changing face of remote work, government regulations and payroll audits have increased, which also speaks to the importance of remitting taxes timely and correctly, Soderman said.

“It’s imperative that we have policies in place that employees understand what their employers’ expectations are of where they work, and that we have mechanisms for payroll to know where they are actually working so that we are paying and remitting taxes in the right jurisdictions,” Soderman said.

A high-level overview of the shadow payroll process for a US-inbound employee starts with tax residency being vaildated, which is not usually done by payroll, Soderman said. The employer must understand what has been paid to the employee or paid on their behalf, what is taxable in the shadow payroll location, and then prepare withholding calculations based on the relevant tax rates.

“A good next step” is to reconcile the results with the given instructions, Soderman said. She emphasized the importance of “compensation collection,” or determining all amounts paid to or on behalf of an employee.

“There needs to be a process in place for compensation collection,” Soderman said. “It is best that this process happens after each pay period from all sources. Having an ongoing process in place ensures accuracy and timeliness, which in turn minimizes any compliance risks,” she said.

Challenges to the process include dealing with multiple sources of information and employee income, multiple currencies, different definitions of taxability and different year-end periods, and language barriers, Soderman said.

In particular, restricted stock units are often used to hire and retain employees and, depending on the company, can be “a significant part of an employee’s compensation,” Soderman said. “There is a significant amount of variety in cross-border taxation from country to country” of equity, she said.

Taxable wages may need to be converted into a local currency, so Soderman recommended establishing a standard practice of choosing exchange rates from a given source, adding that some countries, such as China, Germany, and India, require central bank rates to be used.

Soderman recommended as other best practices to establish one central system for sharing payroll or compensation information to make that easier to find for running a shadow payroll. She added that employers should ensure employees are completely set up for payroll in each country they work in with pay codes for imputed income that ensure taxes are applied correctly.

Documentation should include a calendar, sources of data and exchange rates, methods and rates for grossing up payments, taxability matrices for each country, the frequency of running shadow payrolls, and key contacts, Soderman said.

Soderman recommended running shadow payrolls at least monthly to meet many countries’ requirements, even though some US employers run them quarterly or even annually for small payrolls. “In the US, we can generally get away with doing shadow payroll less frequently than other countries,” she said.

“To be truly compliant, the best practice is monthly,” Soderman said.