[Tax Corner] Running like clockwork: 6 steps to getting expatriate pay

04 Feb 2020

Like clockwork?

When you post an expatriate employee (an "Assignee") overseas, one of the early challenges is getting payroll set-up correctly.

Once set-up correctly, the payroll process should indeed run like clockwork. Happily, this normally means timely and accurate payments to the tax authorities, no penalties and the correct pay being delivered.

Great. How do you get there?

This can be more difficult than it may first appear. Not least because traditional assignments (i.e. where the Assignee remains employed by the home country employer and is assigned/seconded overseas) normally require two payrolls.

Two payrolls and each pays the Assignee?

Not quite. Normally, we would see a payroll in the “home country” via which the Assignee is paid and a payroll in the "host country" which normally only operates withholding in respect of remuneration paid from the home country (i.e. it is not used to deliver remuneration).

The payroll in the host country in these circumstances can sometimes be referred to as a “shadow payroll” (that is, it does not deliver pay but is used to calculate and pay across withholding which is required under the host territory tax rules).

This may seem a little odd and you may naturally ask the question why this added complexity?

The rationale for such an arrangement (i.e. individual continues to be employed and paid in the home country) is normally a combination of factors.

These include compliance (tax and/or social security may be required in the home and host country), the desire to keep the Assignee on a home country employment contract and in the home country remuneration structure, employment law considerations, pensions (in order for the Assignee to remain in the home country pension scheme) and Assignee needs (e.g. desire to continue to be paid in home country currency, to satisfy home country financial obligations etc.).

Of course, there are other permutations and possibilities when it comes to the assignment arrangement and how you employ and pay Assignees but let’s stick with this basic model for now for ease of demonstrating the key points.

Problems

In my experience, the seeds of an expatriate payroll problem are often sown right at the start of an assignment.

The set-up and operation seem to work fine and then something happens - ordinarily, a tax authority seeking tax from you that was never withheld, the Assignee asking what has happened to their home country social security contributions or someone owing a lot more tax at year-end than they had expected (never a good position to be in).

To reduce the risk of issues and problems, I follow some key steps when advising on the set-up of payroll for any expatriate assignment.

These should provide you with a framework for managing the process and some insights as to where you may need to seek support from an expatriate tax advisor and where you can perhaps take care of things in-house.

As you may have gathered, we are talking here about the big cross border related payroll issues that can occur (e.g. no payroll operated in a country where there should be withholding, social security withheld in the wrong country etc.). Routine payroll processing issues can, of course, also occur (e.g. incorrect bank account details used), although these are not the focus of this article.

At the end of the article, I also explore an increasingly popular alternative possibility to the traditional assignment arrangement (known sometimes as "Localisation" or "Local Plus"). This may simplify payroll in expatriate cases, but there are downsides too.

The 6 Steps

Step 1: Determine the Assignee’s tax position

Alongside paying someone, the payroll’s key function is, of course, to withhold tax (and social security which we cover in Step 2). So the first task is to determine where tax is due.

Note: The country in which tax is ultimately due on an Assignee’s earnings is not determined by the location of the payroll. If it were, I suspect that many people would choose to be paid from a country with no income tax! This may seem an obvious statement but it sometimes gets forgotten when people get embroiled in the mechanics of setting-up an assignment.

The country or countries in which expatriates are subject to tax on employment income is normally determined by two things:

Country of residence: If an employee is resident in a country, then that country will normally seek to tax income in respect of an employment, wherever the duties are performed. As always with tax, there are some deviations because some countries allow tax relief in respect of overseas workdays in some limited circumstances. There is also the exception of US citizens who are taxed on a worldwide basis, whether they are resident in the US or not.
Country in which duties are performed: Even where an employee is non-resident in a country, they will normally be subject to tax on income earned in respect of the duties performed in that country. That said, there may be some exemptions, for example for short-term business visitors who qualify for exemption under a double tax treaty).

This is not always straightforward but is crucial to get right. For example, a UK Assignee seconded to Germany may become non-resident in the UK and resident in Germany.

Ordinarily, this may mean that no UK tax is required and income tax is due in Germany only. However, if the employee comes back to the UK from time to time to perform duties that are more than incidental, then UK tax would normally be required in respect of those duties (in addition to tax being required in Germany).

Note: Where there is ‘double tax’, this can normally be mitigated to some extent by the use of the double tax treaty or the under the tax rules of a country. I expect to cover this area in a future article.

So, determining the tax position up-front is crucial since it will be a significant driver in terms of how the payroll is set-up. In the example above, if the individual was seconded from the UK Company to work with the German company, both companies would have payroll and withholding obligations - the German Company to withhold on account of the individual being resident and the UK Company to withholding on account of the taxable duties the individual is performing in the UK.

Get this step wrong and you are likely to get payroll wrong too, leaving the company exposed to compliance failure.

Step 2: Determine the Assignee’s social security position

Once the tax position is sorted, social security should be considered separately. The reason for this is that the social security rules (and specifically where contributions are due in cross border cases) are normally very different from the tax rules. Unfortunately, you can't assume that that tax and social security will be due in the same country.

For regular non-assigned employees who only work in the country in which they are resident, this isn’t usually an issue since the withholding for tax and social security will almost always be required in that country alone.

For Assignees, it is quite common for tax to be due in one country and social security to be due in another. For example, a UK national seconded to the US for three years would normally be subject to US tax withholding. However, it is likely that the same employee may be required to pay UK National Insurance Contributions rather than US Social Security (under the US/UK reciprocal social security agreement).

This is one of the reasons, as outlined above, why two payrolls may be required.

Determining where social security is due is dependent on a number of factors including the location in which an individual is employed, whether there is a reciprocal social security agreement between the home and host country (i.e. such as the agreement between the US and the UK), whether the move is within the EU (EU members are signed up to a regulation which governs where social security should be paid in such circumstance) and the duration of the assignment.

Step 3: Determine the correct payroll set-up

Once the tax and social security position has been settled, you have half of the information required to determine the payroll set-up:

Normally, withholding (and therefore a payroll) will be required in a country where:

The employee has a tax and/or social security liability (as determined under Steps 1 and 2); and
The employer has a presence in that country (i.e. a permanent establishment, branch or subsidiary company) for or on behalf of which the expatriate is working.

Whilst this is the general rule, it is not always the case and the rules in the relevant territory should be reviewed.

For example, a company with no presence in Spain is still likely to be required to set-up and operate a payroll in Spain where they have an expatriate working in Spain who is subject to Spanish tax (or social security).

At the end of this stage, you should have the payroll structure (whether one or two payrolls are required and whether tax withholding and/or social security is required in respect of each payroll).

Using the example of an Assignee seconded to the UK from the US for 3 years, you may end up with a structure which, in the simple terms, looks like this:

Step 4: Pre-set-up actions

Once you have your payroll structure and (ideally) before setting-up the employee on payroll, you then need to look at each payroll and decide what specific actions are required prior to set-up of the Assignee and operation.

In the example above, this would include:

Using US procedures to reduce US Federal withholding to zero.
Obtaining a Certificate of Coverage from the IRS in order to prove to the UK tax authorities that the employee remains subject to US Social Security (and therefore no UK Social Security is required).

The key aims of this stage are to use in-country payroll protocols to (i) prevent cash flow issues arising from “double withholding” of tax or social security (where possible) and (ii) ensure that the correct documentation (e.g. certificate of coverage in this case) is in place.

This stage may include other actions such as, using the UK as an example, obtaining a “No tax” coding in the case of a UK outbound Assignee who becomes non-UK resident (so that they can be paid on a gross basis from the UK payroll).

Depending on the circumstances, it may also involve obtaining authorisation to claim foreign tax credits via payroll (this is possible in some countries) rather than having to wait until a tax return is filed (thereby helping the Assignee with cash flow).

Whilst I have used a simplified example, this stage can be tricky. For example, in many countries, it is not possible for withholding to be reduced via payroll (and therefore double withholding arises and the employee may have to wait until they file a tax return to correct the position). In other cases, there is no reciprocal social security agreement and so ‘double social security’ can arise.

A little creativity is sometimes required to come up with a solution which is both compliant and satisfies the needs of the employer and the Assignee. Timing is also important. Delays in obtaining the relevant documentation (e.g. obtaining a certificate of coverage) can lead to delays in set-up.

It is partly for this reason that some employers put in place a tax equalisation or tax protection arrangement (i.e. whereby the employer pays the actual tax liabilities and subject the employee to a hypothetical tax).

One of the benefits of such an arrangement is that the employee does not need to worry about double withholding etc.

Step 5: Review and re-work taxable salary

If you got this far, you are doing well! However, there is one final step before setting-up the Assignee on the relevant payroll(s).

Where you have someone paid from one country and withholding is in another, you can't normally simply use the raw payroll data from the paying country. Some re-working may be required. I will explain why.

Let’s use the example of an Assignee being seconded from the US to the UK with the payroll structure in Step 3.

For the UK payroll, at first glance, this may seem like a straightforward case of taking the US taxable gross income and calculating the UK withholding required on this income. The problem with this approach is that the taxable income for US tax purposes will likely be different from the taxable income for UK purposes.

Why? Quite simply because the US and UK calculate taxable income in different ways (i.e. deductions allowable under UK tax rules may not necessarily be allowable under US tax rule). Simply taking a gross salary is likely to lead to an erroneous result too (albeit that there will be an over-withholding in the UK).

Let me give you a simple example (dollar amount used across both US and UK for simplicity).

As you can see from the example above, it is easy to get the UK payroll withholding wrong, either by assuming that you can simply take the US figures or not understanding what is and is not deductible for UK tax purposes.

In this example, only the employee 401(k) is deductible for UK tax purposes but even this can’t be assumed since there are rules to determine when 401(k) contributions are and are not deductible for UK tax purposes.

Once you have reworked the home country pay data, you can then simply set-up a template which translates the home country payroll data and makes it good for use for host country payroll purposes. If you ask them nicely, your colleagues in the home country may even complete the template each month for you!

I would normally suggest getting a tax advisor like me to review the template. Once in place, the template can be used on a go-forward basis to make sure taxable income for the host payroll is right, every time.

Step 6: Payroll set-up and coordination plan

Finally, the Assignee can be set-up on the home and host payroll and you should be ready to go. At this stage, you should figure out what ongoing coordination is needed.

In the US to UK example above, the UK payroll would need to coordinate with the US payroll in order to ensure timely provision of information between the parties (salary details from the US to the UK, withholding details from the UK to the US).

I would advise getting in place a payroll timetable, covering both home and host country requirements. Then, everybody is clear and on the same page.

You will also need to think about exchange rates and the impact that this may have on tax withholding calculations and, ultimately, the net salary that is delivered to employees. There are several strategies for managing exchange rates which I will cover at a later date.

You've done it! The six steps are completed. You may ask yourself whether it was all worth it...

What happens if you get it wrong?

Unpicking errors in setting up a payroll for Assignees is no fun. You not only have the challenge of trying to claim a refund where tax/social security has been withheld in a country where it is not due but also the potential financial penalties associated with retrospectively settling tax in a country where tax/social security is due but there has been no withholding.

At the heart of this, you will also have an Assignee who may start to wonder why you are messing with their pay.

For example, I dealt with a case (some minor details changed for complete anonymity) whereby a UK employee was working in France for over 3 years on assignment with an indefinite duration. Since the company had no entity in France, the employee was paid via the UK payroll and UK withholding and social security was operated. No tax or social security was paid in France.

Unfortunately - for both the employer and employee - under the tax and social security rules, tax and social security were actually due in France rather than the UK. Step 1 and 2 above had been skipped!

Since the employee was non-UK resident, no tax was due in the UK and, under the EU Social Security rules, social security was due in France rather than the UK (both employee and employer contributions, incidentally).

Sorting this out (i.e. refunds from the UK, tax and social security payments in France) took several months. Of course, at the heart of this was an expatriate employee who had to be ‘managed’ by his employer to make sure that they were not affected.

So, getting it right first time is important from both an employer compliance and employee satisfaction perspective.

Why can’t we just pay and withhold tax and social security in the country in which the employee is working (i.e. one payroll)?

I get asked this a lot. The simple answer is that, normally, you can.

At the start of this article, I referred to a potentially simpler arrangement. This arrangement normally involves employing the individual via a local employment contract in the host country. That is, we forget the traditional 'assignment' model and simply transfer the employee to an overseas employment.

All salary payments are made from the host country and, normally (under the rules in most countries) withholding and social security are only required in the host country (though the position should always be reviewed because there are sometimes nuances and deviations from this norm).

So, you can skip pretty much all the steps (though I would still cast an eye over them to identify any issues) and go straight to setting up the employee on the payroll (like you would any other employee).

Why do we not do this all of the time then? Whilst this is a more straightforward option from a payroll perspective, there are downsides to this approach which can include the following:

The employee is not likely to continue to be eligible to participate in the home country pension scheme.
The employee would normally lose their right to participate in home country benefit schemes.
There are normally some employment law considerations (e.g. continuity of service, the right of return to home employment).
Dealing with remuneration issues can be tricky. For example, should the employee now be paid in accordance with local salary rates (which may be lower than the home country) rather than remaining on a home country package?
Such an arrangement means that there would normally be no possibility of remaining in the home country social security system (potentially leading to a home country ‘state pension’ shortfall, depending on assignment duration).
There can be less security for employees (i.e. where the home country contract is terminated and, in effect, a new employment is started in the host country).
It may be more difficult to ‘get employees back’ (i.e. they decide to remain in the host country on a host country contract).

These things aside, there is an increasing trend of using such “local” arrangements to manage expatriates. Some such arrangements are known as “Local plus” whereby the employee receives a local salary under a local employment in the host country but receives some limited assignment related benefits.

I can see why employers are opting for this. It is more straightforward in some respects (especially in terms of administration) and often less costly. However, as I say, it does have some downsides too.

So, in conclusion, with some planning, payroll for Assignees can work well. However, getting the planning right can be tricky and so work through each step carefully, involving specialists where you need it.

First published September 2017 in HRIS and Payroll Excellence.

Written by:

Lee McIntrye-Hamilton
Partner, Global Mobility & International Employment Tax
Blick Rothenberg
lee.mcintyre-hamilton@blickrothenberg.com