The Expatriate Administrator
Autumn 2009  |  Volume 3
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How Shadow Payroll Can Help with Compliance

by Laurie Jones, KPMG LLP, Dallas
(KPMG LLP in the United States is a KPMG International member firm)


In today’s heightened regulatory environment, compliance with U.S. employment and payroll tax regulations is on the radar for many global mobility, payroll, and tax professionals. Investigative inquiries and published reports from governmental agencies continue to remind us of the increased scrutiny of payroll and tax compliance infractions. For example, the U.S. Internal Revenue Service (IRS) Web site has a page devoted to Employment Tax Evasion — Criminal Investigation (CI)1 and a recent Senate sub-committee hearing and related General Accounting Office testimony2 highlighted payroll tax non-compliance and negligence.

The willful failure to remit U.S. payroll taxes is a felony under U.S. federal law3. IRS records show that, as of September 30, 2007, over 1.6 million businesses owed over $58 billion in unpaid federal payroll taxes, including interest and penalties. IRS estimates that the annual net tax gap — the amount of taxes that go unidentified and uncollected each year — amounts to nearly $300 billion. One of the elements of this tax gap is unpaid payroll taxes.4 Payroll taxes are amounts employers withhold from employees’ wages for federal income taxes, Social Security, and Medicare, as well as the employer’s mandatory matching contributions for Social Security and Medicare taxes.5

Global mobility and payroll professionals managing international assignments generally have a process in place for their U.S.-outbound expatriates. During the year, they gather all of the international assignment-related compensation and impute those amounts into earnings on a regular basis. Their payroll system performs withholding, and taxes are remitted to the U.S. Department of the Treasury (“U.S. Treasury”). The process surrounding U.S.-outbound expatriates seems to work just fine. Right?

But what about the process for the U.S.-inbound expatriate (or inpatriate) population? They aren’t paid on the U.S. payroll system, but they are working in the companies’ U.S. offices. Does something need to be done to report their wages or withhold taxes? Isn’t it possible to just settle up at year-end or when the U.S. tax return is filed?

Case Study — Philippe from Belgium Comes to Work in the U.S.

Jane is the Global Mobility Director for ACME. She has just offered Philippe, a Belgian national, a position at the company’s U.S. headquarters. This will be a three-year assignment, and the company will tax equalize him. Philippe has an assignment letter stating he will be working for and is seconded to the U.S. company during the assignment period. He’ll be deemed a U.S. resident for federal and state tax purposes. In addition, the company will obtain a Certificate of Coverage, which exempts him from having to pay into U.S. Social Security.

Philippe will continue to be paid 100 percent from the Belgian payroll. After all, it makes sense that he remains tied to the home country compensation, benefits, social security, and pension schemes during his temporary assignment to the United States.

In the past, ACME has reported U.S. inpatriate compensation on the U.S. tax return and remitted any taxes due at the time. Jane assumes that there will be a balance due on Philippe’s tax return, so ACME will send in a check to the U.S. Treasury to settle up. Seems simple enough, right?

ACME should carefully review the facts and circumstances related to each of its U.S. inpatriates to determine the appropriate U.S. reporting requirements for compensation delivered to or on behalf of these individuals.

The above case study describes an approach often used by organizations with U.S. inpatriates.

In this article, we will explore why the foregoing approach does not comply with U.S. employer obligations related to payroll and withholding. We’ll also consider the logistics of executing a U.S. shadow payroll and the implications for the U.S. employer that fails to meet its requirements.

Background

U.S. employers are required to withhold U.S. federal and state income tax, Social Security tax, and Medicare tax plus pay federal unemployment tax (FUTA) and state unemployment insurance (SUI) on wages paid to U.S. citizens and U.S. resident aliens regardless of whether the wages were earned in another country.

What Is a Shadow Payroll?

Shadow payroll refers to a non-cash payroll established in the host country where an assignee is working. The shadow payroll is not the primary payroll from which the assignee is paid, as he or she usually continues to be paid from the home country payroll. The assignee does not receive any direct cash or funds from the execution of the shadow payroll itself.

What Is the Purpose of U.S. Shadow Payroll?

As a U.S. employer, the company is required to withhold taxes from its U.S. citizen and U.S. resident employees regardless of where services are performed. As such, the purpose of putting U.S. inpatriates who are working in the U.S. on what is effectively a “second payroll” is to calculate U.S. withholding, to pay appropriate income and social insurance taxes, and to fulfill U.S. payroll and tax compliance requirements.

To facilitate the process of reporting compensation, withholding taxes, and remitting tax deposits, companies generally establish a U.S. shadow payroll for purposes of remaining compliant with the stated U.S. employer obligations.

Companies that defer compensation reporting, do not withhold, and choose to remit taxes when the annual U.S. tax return is calculated, are not meeting their U.S. employer obligations to report taxable wages and to remit taxes on a current basis. These companies could be exposing themselves to additional scrutiny and the potential for audit by the taxing authorities, which may lead to additional penalties and interest.

Why a U.S. Shadow Payroll?

Based on meeting certain criteria, compensation attributable to services performed in the U.S. by inpatriates is generally considered taxable in the U.S. and must be reported on their respective individual income tax returns. According to U.S. requirements, an employer, whether foreign or U.S., is required to report remuneration for services performed in the U.S. on Form W-2 for each calendar year. In addition, the U.S. employer must withhold and remit all applicable U.S. income, social, and payroll taxes in respect of such remuneration.

A company may not be in compliance with U.S. payroll reporting, withholding, and remittance rules for U.S. inpatriates if income taxes are being paid for such individuals at the time of the annual U.S. tax return filing. In order to be compliant with U.S. payroll tax requirements, employers may wish to consider a U.S. shadow payroll which would be implemented on at least a monthly basis for any U.S. inpatriates who are deemed to have U.S. taxable compensation.

What Are the Potential Benefits / Implications of Running a U.S. Shadow Payroll?

The potential benefits and the implications to the company include, but are not limited to:

  • Compliance with U.S. payroll tax reporting, tax withholding, and tax remittance requirements
  • Reduced audit exposure
  • Reduced penalty/interest exposure.

When Does the Company Need to Start and Stop U.S. Shadow Payroll Reporting?

When assignees commence an inbound assignment to the U.S., the host country payroll entity should set up and maintain the requirements for a U.S. shadow payroll. Alternatively, the company can engage a third-party service provider to help administer the U.S. shadow payroll by reporting the income and tax deposit information back to the company.

Once the company is notified of an inbound assignee to the U.S., it is suggested that the host country payroll entity communicate with the home country payroll entity, on a monthly basis, to request the home country payroll and/or non-payroll (if applicable) information. This compensation information is used to calculate the necessary U.S. tax obligation. The assignees would remain on the U.S. shadow payroll for the duration of the assignment. Upon repatriation back to the home country or localization to the U.S. payroll, the company would no longer need to perform a U.S. shadow payroll for that specific assignee.

What Does the Company Need to Do to Set Up the U.S. Shadow Payroll?

All compensation, regardless of its source, should be considered in the U.S. shadow payroll process. Some companies utilize a tax adviser to assist with determining what is reportable in the United States.

Below is a representative sample of some items that the company may need to consider when setting up a U.S. shadow payroll process.

U.S. shadow payroll set-up includes:

  • Creating earning and deduction wage types on U.S. payroll, then assign appropriate taxability.
  • Identifying all sources of compensation:
  • –  Home country payroll — are there 13th or 14th month salary payments made?
  • –  Are assignees receiving any other compensation from any source, U.S. payroll, U.S. accounts payable, third party provider, relocation vendor, or other source?
  • Creating a monthly U.S. shadow payroll processing schedule and confirming payroll transaction dates.
  • Coordinating information exchange between home country payroll and host country payroll.
  • Establishing a process in order that no net pay is delivered to the U.S. inpatriate after earnings have been imputed.

Assignee Specifics
Below is a representative sample of some of the documentation and procedures that the company may need to consider when setting up a U.S. shadow payroll.

  • Obtain valid U.S. Social Security Number (“SSN”) for inbound assignees
  • Create an active assignee record in the appropriate HRIS system for host country payroll purposes
  • Track and report assignee U.S. work days (accurate reporting of the days worked in the U.S., by U.S. state, is necessary (on a monthly basis)
  • Obtain information about previous assignee presence (at least two years prior to arrival) in the United States
  • Retain a signed and executed copy of Letter of Secondment / Letter of Assignment
  • Retain a valid copy of the Certificate of Coverage, if any
  • Gather home country pay slips / pay registers for each pay cycle while on assignment
  • Confirm any compensation reported / paid in the U.S. prior to the commencement of the U.S. shadow payroll
  • Complete U.S. Form W-4 for inbound assignees.

How It Would Work in Practice: Revisiting the Case Study

Based on the facts and circumstances of our case study, Philippe is considered an employee of ACME. Although he continues to be paid from the Belgian payroll, ACME, as his U.S. employer, is required to withhold U.S. federal/state income tax, and pay FUTA/SUI taxes on the wages deemed reportable in the U.S., even though his wages were paid to him from a foreign country. Since Philippe has a valid Certificate of Coverage in place, he is not subject to U.S. FICA tax.

In order to meet its U.S. employer requirements, ACME sets up a monthly U.S. shadow payroll. ACME works with a third party to capture all sources of compensation, whether through home country payroll, accounts payable, third party reimbursements, or other sources. ACME’s tax adviser helps to determine the appropriate withholding that should occur based on the reportable compensation in the United States. The calculations are driven by various inputs, taking into account the number of assignee work days, tracked per U.S. state.

Using a U.S. shadow payroll, ACME remits the appropriate tax deposits to the U.S. Treasury throughout the year. In January of the following year, the company produces a U.S. Form W-2 for Phillipe that records the total taxable earnings and the total taxes paid during the previous calendar year. The company’s tax adviser is provided a copy of the U.S. Form W-2 to begin the process of preparing Philippe’s U.S. tax return.

Summary: Why Shadow Payrolls Can Help

The company no longer waits to report taxable compensation until the U.S. tax return is prepared nor does it assume it is acceptable to remit the tax liability when submitting the tax return in our case. ACME recognizes its U.S. employer obligation to report and withhold on a current basis to meet its compliance obligations. This enables ACME to operate and function according to the letter and spirit of the applicable laws and mitigate – or even avoid – infractions that could lead to audit, penalties, and interest.

The U.S. government, in recent years, has been seeking to address the corporate governance and other regulatory issues tied to such experiences as Enron, WorldCom, Arthur Andersen, and Lehman Brothers. In addition, it is seeking ways to cope with the fiscal issues tied to general tax evasion, offshore accounts, and declining revenues. In light of this, proper compliance should be front and center for companies with international assignment programs, with effective and efficient processes in place, including shadow payroll where appropriate.

Footnotes:

1 See: http://www.irs.gov/compliance/enforcement/article/0,,id=130608,00.html. Also, see: United States Department of the Treasury, Internal Revenue Service. “Employer and Employee Responsibilities – Employment Tax Enforcement,” July 17, 2008, page 1 (see: http://www.irs.gov/compliance/enforcement/article/0,,id=106704,00.html): “Evading employment taxes can have serious consequences for employers and the employees. Employers who do not comply with the employment tax laws may be subject to criminal and civil sanctions for willfully failing to pay employment taxes.”

2 United States Government Accountability Office. Highlights of GAO-08-1034T, a testimony before the Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, U.S. Senate. “TAX COMPLIANCE: Businesses Owe Billions in Federal Payroll Taxes,” statement of Steven J. Sebastian, Director Financial Management and Assurance. July 29, 2008.

The Sub-committee hearing examined the magnitude of outstanding payroll tax debt, the policies and procedures that are used to collect unpaid payroll taxes, and whether some businesses are engaged in abusive or potentially criminal activities with regard to the payment of payroll taxes.

3 U.S. Code § 7202 (“Willful failure to collect or pay over tax”). Section 7202 is used to prosecute persons who fail to comply with their legal obligations to collect, account for, and pay over taxes. “Any person required under this title to collect, account for, and pay over any tax imposed by this title who willfully fails to collect or truthfully account for and pay over such tax shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, be fined... or imprisoned not more than five years, or both, together with the costs of prosecution.” For offenses under § 7202, the maximum permissible fine is at least $250,000 for individuals and at least $500,000 for organizations.

4 United States Government Accountability Office, GAO-08-617, “Unpaid Payroll Taxes,” July 2008, page 3.

5 Withholding refers to the system for collecting tax on a current basis that approximates the tax liability of an individual. Amounts withheld are deposited with the U.S. Department of Treasury. This process enables the U.S. Department of Treasury to receive its tax deposits on a current basis as required.

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