Shadow payroll: Why emerging multinationals should consider this tax strategy

May 28, 2020

For emerging multinationals looking to get their tax reporting straight—and compliant—shadow payroll is a strategy worth considering.

There’s no doubt about it, multinationals are having a huge impact on the global economy. All told, U.S. multinationals employ over 42 million people, both at home and abroad, and that number will grow as the global economy continues to expand. 

With that many employees on the job, multinationals have their hands full with payroll and tax reporting, especially with staffers living and working in foreign countries.

Gone are the days when a multinational could treat an employee’s overseas paycheck the same way it was treated back in the U.S.—there are too many reporting risks on that path. 

Now, as companies go global, many have turned to so-called shadow payroll to accommodate increasingly stringent payroll mandates in each of the countries where they have employees.

Companies have increasingly embraced shadow payrolls, with one study noting that 70% of foreign employees operate under shadow payroll scenarios.

What is shadow payroll? 

Shadow payroll is a tax accounting strategy that allows multinationals to build parallel tax and income reporting mechanisms for employees working in foreign countries. Implemented correctly, shadow payroll solves dual purposes, accommodating home country tax and income reporting rules while meeting the unique income reporting mandates in the country where the employee is working.

Consider a U.S. company that sends a software engineer to Singapore to handle critical work for a foreign subsidiary. The employee is slated to spend one year working overseas but remains employed by his U.S. firm.

While in Singapore, the U.S.-based company employing the staffer is technically liable for income taxes and social benefit insurance in both countries. Under a shadow payroll mechanism, the U.S., as the “host country” can deduct the necessary taxes from the employee’s pay and thus meet U.S. tax and income reporting obligations. 

The U.S. company can also establish a shadow payment to the same staffer to meet Singapore’s tax and income reporting requirements, without the employee having any additional taxes deducted from their paycheck every pay period.

Why do you need a shadow payroll system?

For emerging multinationals especially, the risks in not leveraging shadow payroll programs and taking your chances with employee tax and income reporting are abundant—because they’re likely adding employees overseas faster than they can implement a global payroll solution.

According to data analysis platform Statista, in 2017: 

  • 6.63 million Americans employed by multinational manufacturing companies worked abroad
  • 1.75 million worked abroad while employed with retail trade-based U.S. multinationals
  • 1.62 million technology-based employees worked overseas for U.S. companies

With all of those employees drawing paychecks in foreign lands, avoiding accounting and regulatory headaches is a good reason to embrace shadow payrolls. Here are a few other reasons a multinational would need shadow payroll:

Noncompliance fines and penalties. Companies that bypass the shadow payroll route risk substantial fines from local tax authorities. Increasingly, local regulators want to see foreign workers’ income on the books—and will levy severe financial penalties to ensure U.S. multinationals comply.

Getting employee payroll data right. U.S. companies operating abroad also need a secure way to know they’re properly keeping key employee benefits up to date and that Social Security taxes and income reporting are accurate. Shadow payrolls allow multinationals to cross those items off the overseas accounting checklist.

Paying too much when you don’t have to. Additionally, by not keeping track of wages paid overseas, U.S. companies also run the risk of the corporate financial version of double indemnity—overpaying payroll taxes both at home and in the country where their employees are on the job.

When is shadow payroll specifically needed for your company?

Although the use of shadow payroll is pervasive, multinationals have unique business needs and some companies might require tailored financial reporting more than others. 

How does a corporate financial officer know for sure? By and large, these indicators could mean shadow payroll makes sense for your company operating in foreign markets:

You have employees engaged on your behalf overseas. If your company is steering high numbers of employees to foreign countries, your payroll reporting processes must pass muster not just in the U.S., but in the country where the job is done, as well.

Your employee is working for your firm overseas for more than 183 days. The clock is always ticking, financial reporting-wise.

Case in point. 

In most countries, tax agreements are in place that allow for “short-term” workers to work in a specific country, with no need to report income to local tax authorities. 

If that employee spends more than six months working in the country, the “183-day rule” kicks in, the employee is deemed a “long-term” employee, and the multinational must report income and tax information.

Forging a shadow payroll formula that works for you

The mission for multinationals is to plan ahead, get organized and get professional payroll accounting expertise if you need it, when deploying shadow payroll initiatives.

Take these steps as you move forward:

Know the rules. Pleading ignorance on local income and tax reporting rules is a nonstarter. Stay on good terms with local tax officials by knowing the regulations up front. Consulting with experienced compliance experts before you set up a shadow payroll system is highly advisable.

Establish good contacts in foreign countries where you do business. Nobody knows the local regulatory landscape like a tax reporting expert located in the country and (ideally) city or town where your firm is established outside the U.S. 

Call around and ask business associates, partners and even customers in your foreign port of call for reliable local tax professionals. A good accountant who is plugged in with municipal governments can help cut regulatory red tape.

Hire a third-party payroll provider. Multinationals entering a foreign market for the first time have enough on their hands without worrying about regulatory payroll reporting problems. 

That’s where outsourcing with a third-party payroll partner can help. 

A global payroll specialist can bring multiple benefits to the shadow payroll table, serving as your regulatory eyes and ears in unfamiliar foreign markets and helping you adjust to reporting issues on the fly, so you can keep your business operating on all cylinders in foreign lands.

The key is to find the right payroll outsourcing partner who can implement an automated and robust shadow payroll process on your behalf. That way you can focus your attention where it should be: on growing your multinational business.

Speak with a global payroll expert today and take the first step in being fully compliant with foreign employee payroll requirements.

 

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