What is non-residential payroll?

Processing payroll for employees in different countries is a real challenge for businesses, which is why many organizations opt to outsource payroll to a local payroll provider after setting up a legal entity under which the employees are hired.

However, setting up and managing payroll in a different market doesn’t always require setting up a legal entity. A non-residential payroll is a way of managing payroll for employees in a different country without a local legal entity. 

But what exactly is a non-residential payroll? How does it work? And what are the challenges and limitations of this payroll model?

Non-residential payroll is when a business runs payroll for employees in a different country under the status of a non-resident employer, also known as Foreign Employer (FE). A non-resident employer is an organization that operates in a foreign market without having a permanent establishment in said country, which means that there is no legal entity.

In a traditional understanding, a non-resident employer works with non-resident employees. Whether or not it is possible to hire new employees in the target market and process payroll as a non-resident employer depends on many different factors, including the scope of the existing tax treaties between the target-market country and the country where the foreign business has its headquarters.

A resident payroll is a payroll that is run by an organization that is officially registered and has a legal entity in the country where the payroll is processed. A non-resident payroll, on the other hand, is a payroll that is processed by a foreign organization that has no official address nor a legal entity in the payroll country where the employees are based.

Depending on the tax treaty between the employer’s domestic country and the target country, non-resident employers may be freed from the obligation to withhold payroll taxes from wages and salaries paid to qualifying non-resident employees. 

When hiring local employees, however, the business needs to set up a non-residential payroll to fulfill its withholding obligations. The set-up process for non-residential payroll mainly includes:

• Registration as a non-resident employer with the local authorities in the target country, which is usually done in the form of a special-purpose entity

• Registration of the local employees with the necessary tax and social security authorities

• Setting up the necessary payroll processes and infrastructure to issue payments to local employees and authorities

• Contracting a local payroll service provider for tax representation and legal advice—if needed

Setting up and running a non-residential payroll allows businesses to save a lot of time and money compared to establishing a local legal entity. However, there are several challenges and limitations linked to the non-resident employer model. They include:

• Permanent establishment risk: Registering as a non-resident employer is not possible for businesses that intend to hire a large number of employees in the target market or want to engage in revenue-generating activities since this could lead to the business being classified as a permanent establishment, thus becoming liable for paying corporate income tax.

• Geographic limitations: The option of registering as a non-resident employer without permanent establishment is usually only feasible in cases where there is a tax treaty in place between the employer’s domestic country and the target country or in a geographic region that is characterized by an advanced level of cooperation between countries (e. g. within the European Union).

• Compliance concerns: Processing payroll in a foreign country as a non-resident employer exposes the business to several compliance risks. In order to mitigate risks and ensure payroll compliance throughout the entire process, foreign organizations need in-depth local payroll and tax knowledge.

• Difficult tax reporting: Currency conversions (e. g. if employee wages are paid in different currencies) can affect tax reporting which then becomes more difficult. Liaising with local tax authorities can also be more complicated and time-consuming than usual due to language barriers.

If registering as a non-resident employer isn’t possible, there are two alternative ways for a foreign organization to hire employees and process payroll in a new market. These alternative options are:

Setting up a local legal entity

There’s always the possibility of taking the traditional route which is establishing a local legal entity under which the employees are then hired and which serves as the official employer for payroll purposes.

Pros:

• Fully operational with regard to business activities

• Legal status is clear

• No limitations regarding the number of local employees that can be hired

Cons:

• High cost

• Time-consuming process

• Support from a local payroll provider may still be required

Employer of Record

Using an Employer of Record (EOR) is a popular way to hire talent abroad without opening an entity. An Employer of Record is a service provider that specializes in hiring employees on behalf of a client business. Since the EOR becomes the employee’s officially registered employer, the client business doesn’t have to open up a legal entity in the employee’s country of residence. The services of an EOR range from processing payroll to fulfilling other administrative tasks like employee registration as well as general HR tasks.

Pros:

• No legal entity needed

• Quick set-up process

• Covers payroll processing as well as other HR and administrative tasks

• Mitigates compliance risks

Cons:

• Not suitable for hiring a large number of employees

• No complete protection against permanent establishment risks