As more companies expand internationally and embrace remote work, payroll becomes increasingly complex. And one concept that often causes confusion among global HR and finance teams is shadow payroll.
Though it sounds mysterious, shadow payroll is a vital mechanism for maintaining compliance when employees work across borders.
But what is it? When is it required? And why is it important? In this comprehensive guide, we’ll break down the answers to these questions and show you how to manage shadow payroll effectively. So let’s jump straight in.
What is shadow payroll?
Shadow payroll is a mechanism used by companies to stay tax-compliant when they send employees to work in a different country (temporarily or long-term), but still pay them through their home country payroll. Here’s how it works.
For the employee in question, you run payroll as normal.
At the same time, you run an additional “shadow” payroll in the country you’ve sent your employee to (i.e., the host country), and mirror their pay. However, you don’t actually pay them; this shadow payroll is used solely for reporting and remitting local taxes (such as income tax and social insurance) to the host country’s authorities.
For example, let’s say that you’re based in Spain and you send an employee, Maria, to work in the US for nine months.
You would continue to pay Maria in Spain as normal, but you’d also need to set up a shadow payroll in the US to calculate and report what Maria would earn if she were on a US payroll. Based on this, you’d then need to pay any required US taxes on her behalf.
It’s important to note that no money is paid to the employee from the shadow payroll.
Is the employee taxed twice?
No — not if it’s done correctly. The goal of shadow payroll is actually to avoid double taxation, not cause it. This is because shadow payroll uses tax treaties and payroll coordination to balance taxes between countries.
For instance, in Maria’s case:
- The shadow payroll in the US calculates what Maria owes in US taxes.
- Then, the original Spanish payroll adjusts Maria’s tax withholdings to account for what was paid in the US. This could be done through a foreign tax credit in Spain, or a gross-up by your company if you’re covering the additional tax cost.
- Tax treaties between Spain and the US then help determine who gets to tax what portion of income, and how credits or exemptions are applied.
Ultimately, the employee only pays tax once — but the shadow payroll ensures the right portion goes to the right country, in line with local laws and tax treaties.
However: If there’s no treaty, or taxes aren’t coordinated properly, then your employee could potentially be taxed twice. That’s why shadow payroll must be implemented carefully, ideally with input from international tax advisors.
Is shadow payroll the same as split payroll?
No. Split payroll involves actually dividing pay between countries, whereas shadow payroll is for reporting only.
When do you need to set up shadow payroll?
Shadow payroll is typically required if your employee is going to be in the host country long enough to be classed as a tax resident there (often 183 days). This usually happens in the following situations:
- International assignments. When your employees are temporarily assigned to work in another country, typically for more than 183 days.
- Long-term remote work. When employees choose to live and work from a different country than their employer's legal entity.
You may also need to set up shadow payroll if:
- There are other local conditions that make your employee’s income taxable.
- The host country considers the employer to have a reporting obligation.
- Your employee has a contract in more than one country.
Not every international employee requires shadow payroll. It depends on tax residency, duration of stay, and local laws, and each country has its own rules. As a result, it’s important to always consult local experts.
How to set up shadow payroll
Setting up shadow payroll involves several steps:
- Assess tax residency. First, determine if — and when — the employee becomes a tax resident in the host country. As mentioned, this is typically after 183 days, but different countries have different rules.
- Calculate the taxes. Calculate the local income tax and social security contributions based on the host country’s rules.
- Run a parallel payroll. Report these taxes through a local payroll system.
- Reconcile and remit. Taxes may be paid by your company on behalf of the employee, with adjustments made in the home payroll to avoid double taxation.
- Report to authorities. Submit the required filings and ensure compliance with both home and host country obligations.
How do you set up payroll in another country?
This is simple if you already have a legal entity in the host country; you just add your employee to your existing payroll for that entity.
However, if you’re sending them to a country where you don’t have an existing entity, things are a little more tricky. You’ll need to opt for one of the following:
1. Partner with a local payroll provider or tax agent
Some global payroll companies or tax service providers can register your company for limited tax purposes only, without creating a full-blown legal entity. They can also report and remit taxes for your employees in the host country under a shadow payroll arrangement.
However, this option is not available in every country, and requires significant tax expertise on your behalf.
2. Engage a global mobility consultant or tax firm
These firms can set up local compliance frameworks under your name (where possible), and coordinate with your home-country payroll team to ensure tax credits and social security arrangements are handled properly.
However, these firms are typically very expensive, and can represent a significant outlay for smaller businesses.
3. Use an employer of record (EOR)
An EOR is a third-party company that acts as the legal employer on your behalf in the host country. It:
- Runs compliant local payroll
- Handles withholding and remitting local taxes
- Covers social security, insurance, and statutory benefits
- Mitigates permanent establishment risk
In this setup, the EOR runs real payroll (not just shadow), so shadow payroll becomes unnecessary. However, you can still mirror the data in your home-country systems for internal tracking.
This is often the most cost-effective way to proceed, and comes with a whole host of additional advantages, too.
Best practices for managing shadow payroll
When managing shadow payroll, there are a few best practices you should adopt to make the entire process easier and reduce any potential risks. Always aim to:
Start early. Plan your potential shadow payroll needs as part of any cross-border hiring or assignment.
Use local experts. Work with local partners to obtain the relevant expertise or, for a more consistent and cost-effective approach — particularly if you want to send employees to multiple countries — work with an EOR partner.
Centralize your data. Use a centralized global employment platform (like Remote) to manage your data consistently and reduce the likelihood of errors.
Document everything. Maintain clear audit trails for tax filings and compensation structures. This is far easier with a centralized platform (see above).
Educate and communicate. Equip your HR, finance, and mobility teams with the knowledge to recognize when shadow payroll is needed, and ensure your employees understand how their tax withholdings and benefits may be impacted.
It’s also important for you and your team to be aware of:
- Tax treaties, which help avoid double taxation.
- Social insurance agreements, which determine whether home or host country social contributions apply.
- Permanent establishment risk, which can trigger corporate tax obligations if not managed properly.
- Payroll reporting deadlines, as shadow payrolls must align with host country filing requirements.
Final thoughts
Without a shadow payroll, your company potentially risks:
- Non-compliance with local tax laws
- Double taxation for employees
- Fines, audits, or reputational damage
- Incorrect social security contributions
Understanding when and how to use shadow payroll is key to reducing these risks and supporting your talent effectively, and you should always consult with local tax experts.
You should also ensure that you have a mechanism in place to run payroll in the countries you send your employees to. Remote’s EOR service enables you to do this quickly and easily, and is ideal as both a short- and long-term solution.
To learn more about how it works — and how else an EOR can make HR and payroll easier — speak to one of our friendly experts today.