What is shadow payroll? A complete guide for small businesses

Shadow payroll is a mechanism that allows companies to pay and tax an employee compliantly when that employee works in a different country to the one in which the company is based.

Shadow payroll records payments, tax, and benefits made to the employee for reporting or withholding purposes. It allows employers to comply with local payroll tax and reporting obligations by ‘shadowing’ local payroll reporting procedures.

Below you will find out what shadow payroll is, when it is required, why it exists, how it is implemented, and its benefits and challenges.

What is shadow payroll?

Shadow payroll allows companies to calculate tax obligations for employees who work in a different country – known as the host country – to the one in which the company that employs them is based, known as the home country.

The employee receives their salary from the home country, but shadow payroll is operated to comply with the host country’s tax rules.

It is a ‘mock’ payroll, run by a payroll service provider in the host country, that mirrors the actual payroll made by the home country – including wages, taxes, and benefits – but complies with the host country’s tax rules.

Shadow payroll calculations are submitted, and employment taxes are paid, to the tax authorities in the host country. Meanwhile, the employee is paid the net pay they are due by their employer in the home country.

The shadow payroll transaction must be made in the employee’s host country’s currency, and follow local tax rules.

A single employer may need to make shadow payroll transactions for many employees in different countries. This is a complex task. Payroll must follow multiple tax and benefit rules under different tax jurisdictions.

It is the employer’s responsibility to ensure shadow payroll is in place, but usually it is best to use a local payroll expert. The employer should engage the services of a local payroll service provider in each host country they assign employees to work in. The local payroll provider will know how to operate the shadow payroll to comply with all tax and employment laws in the host country.

When is shadow payroll required?

Shadow payroll is required when an employee works in a different country to where their employer is based, and the host country has payroll tax withholding obligations.

To check whether shadow payroll applies, a business should consider whether they have employees working overseas, and whether these employees’ assignments are short or long-term.

If the assignment is shorter than six months, a tax treaty between the relevant countries may apply, meaning shadow payroll is not required. If it’s longer than six months, the host country may require the worker to be on local payroll, and shadow payroll will apply.

Shadow payroll does not apply if:

• An employee transfers overseas and is hired as a local employee. Instead, they would be switched to the host country’s social security system.
• An employer gets an upfront dispensation, and the employee on a short-term assignment is exempt from tax in the host country.
• A host country doesn’t have rules regarding payroll tax withholding. Instead, the employee’s tax status is dealt with through year-end tax returns.
• An employer of record (EOR) arrangement exists in the host jurisdiction.

Check Gov.UK’s guide to having employees working abroad for further information.

There are other scenarios where shadow payroll processes can apply, usually when employees are required to be flexible at employers’ request and work on projects overseas.

When an employee is asked to work in a different country, shadow payroll may apply. It depends on the length of the project, their employment status, and which company sponsors the work permit.

Sometimes employees will work in different countries but for one employer, and in a single tax year. In this case, they are not resident in one country and tax treaties would not usually apply. Whether or not shadow payroll applies will depend on the number of days spent working in each country, and local tax rules regarding how to pay employees.

Short-term business travellers who work overseas in the normal course of their job won’t usually follow shadow payroll rules. It is best to check the rules of each country to see if shadow payroll applies.

Why does shadow payroll exist?

Shadow payroll arrangements were initially introduced to help companies pay expat employees who worked overseas temporarily.

Globalisation means more companies operate in multiple countries. This has increased their need for local knowledge and expertise to expand and compete.

Companies must consider whether to send existing employees to new territories or launch new local businesses. Usually, there is a period when companies carry out research and decide whether to launch in a new country.

Shadow payroll provides a tax compliance mechanism to match the exposure a company takes on in a host country in terms of how their employees work. There are three general tax policies:

• Fully tax equalised employees are entitled to specified net cash earnings and/or non-cash benefits. They pay the same tax and National Insurance as they would in their home country. If they work in a country where income tax is lower, they don’t keep any tax savings – the employer does instead. If taxes are higher, the employer pays the extra.
• Tax protected status employees pay no more tax than they would if they did not undertake the overseas work assignment. Employees keep any tax savings, but the company is still liable to pay any extra taxes.
• Laissez-faire status employees are responsible for their own tax affairs in both their home and host country, and must pay any excess tax. The employer is not responsible for advising the employee.

It is the responsibility of employers to decide which tax policy to apply. They are free to choose as long as tax rules for both home and host country are complied with. Further information on tax equalisation is available from HMRC.

The final decision depends on several factors, including the home-host location combination, who requested the cross-border arrangement, how much the employer wants to manage all aspects to ensure tax compliance in home and host countries and how each option impacts cash flow.

How is shadow payroll processed?

In all cases, an employee is only ever paid once.

If an employer sends an employee on an overseas assignment and shadow payroll applies, how it is processed depends on the rules that apply to each specific country and tax jurisdiction.

Shadow payroll works out what an employee’s pay, tax, social security contributions, and other deductions would be in the host country, without actually distributing these.

The main elements of shadow payroll are to:

• Track the work or assignment an employee does and monitor the engagement.
• Calculate tax liabilities that would be due in the host country.
• Report the details to the host country tax authorities to comply with local rules.
• Coordinate host country calculations with home country payroll reporting by adjusting home country payroll for tax equalisation policies.

Finance teams can use a checklist for which elements of shadow payroll apply for each case.

This is useful when multiple employees work in different countries. It can indicate which rules apply for each case and ensure shadow payroll is operated consistently, correctly and compliantly each time.

The local shadow payroll service provider must collect all salary, benefits, and other relevant data received by the employee from the home country employer, and then decide how to treat each element to ensure local tax rules are complied with. Total taxable income is converted to local currency and processed to calculate the correct withholding amount.

If an employee moves to the host country permanently, the arrangement may flip, so the host country pays their full salary and the payroll service provider in the home country operates a shadow payroll. This is usually the case when an employer employs an overseas worker to work in the country the employer is based in.

Read more: The national living wage explained

What are the benefits of shadow payroll?

Using shadow payroll means you can avoid the extra cost of hiring a foreign employee, at least initially. This is important if a company is considering launching in a new country, but wants to research first and assess the opportunity.

For employees and employers, shadow payroll offers an arrangement that ensures they operate compliantly and don’t become liable for fines and other penalties.

Shadow payroll can improve the global mobility of workers, and provides a vital option to recruit the right talent and widen the candidate pool.

It also provides existing employees with career advancements and promotion opportunities, and enables them to work from interesting new locations.

Employees can also maintain their pension contributions or healthcare plans while working abroad.

What are the challenges of shadow payroll?

Shadow payroll is a complex subject and a major challenge to operate correctly and compliantly. It involves many different types and sources of data, and requires knowledge of a range of local tax and payroll rules. The payroll calculations can be complex.

Many existing HR and payroll software solutions are not configured to deal with shadow payroll processing or to operate payroll in more than one country.

You may need to do manual calculations, or contract this out to a payroll provider in the host country who understands local employment laws, tax rules, and compliance obligations.

This impacts the ability of a company to scale up quickly, because ensuring they employ people in new countries compliantly is a major challenge. After all, it is the employer’s responsibility to get everything right and avoid getting the company or employee’s tax affairs wrong.

The main aspects a payroll administrator must ensure they get right are:

• Calculate, report, and pay the correct amount of pay and tax
• Decide how and when to do the actual calculations
• Correctly account for benefits, including holiday pay, housing allowances, and bonuses
• Send through payroll data on time and make payments by the deadline
• Take advantage of and account correctly for relevant tax relief available via tax treaties
• Categorise employees correctly by using an employer of record (EOR) service.

Conclusion

Shadow payroll operates to ensure an employer complies with both home and host country tax rules when sending an employee to work abroad in a country with its own tax and employment laws.

Shadow payroll is a mechanism to ensure employers comply with tax rules, and that they pay and tax affected staff correctly. It is required when a worker performs their duties in a different country to the one in which their employer is based, and they are not employed as a local employee.

It operates by the host country payroll service provider ‘mirroring’ the pay, tax, and benefit transactions applied to the employee to meet local withholding requirements, but the employee is only paid once.

Benjamin Salisbury - business journalist

Benjamin Salisbury is an experienced writer, editor and journalist who has worked for national newspapers, leading consumer websites like This Is Money and MoneySavingExpert.com, business analysts including Environment Analyst, AIM Group and written articles for professional bodies and financial companies. He covers news, personal finance, business, startups and property.