An Introduction to Pay as You Earn (PAYE)

Resource 4.4
An Introduction to Pay as You Earn (PAYE)

When your business starts to employ people, you will need to process Pay As You Earn
(PAYE) wage deductions as part of your payroll system. You will be required to make
the correct deductions from your employees' pay, make the necessary payments to HM
Revenue & Customs (HMRC), and maintain an orderly system of pay-related records.
This factsheet explains how to manage the deduction of income tax, National Insurance
Contributions (NICs), and student loans from your employees' pay, as well as paying
statutory payments, such as Statutory Sick Pay (SSP) and Statutory Maternity Pay
(SMP). It tells you what information must be included on pay statements. It also
includes hints and tips and sources of further information.
When do you become an employer?
An employer can be defined as someone who employs an individual under a contract of
employment. In most cases the employment status of a worker is obvious but in some
circumstances it is not clear whether someone who works for you is your employee or if
they are actually a self-employed contractor. HMRC provides guidance on how they
determine a worker's employment status at www.hmrc.gov.uk/employment-status.
If you operate your business as a sole trader or partnership, you and your partners will
be registered as self-employed and you will only become an employer when you employ
your first member of staff. However, if you set up your business as a limited company,
the company becomes an employer when it begins trading, because directors are
employees of the company.
You need to register as a new employer as soon as you know that you will be employing
someone. You can do this by calling the HMRC New Employer Helpline on 0845 607
0143 or by e-mail (www.hmrc.gov.uk/paye/intro/register-email.htm). You need to
provide details about your business including the names and addresses of any partners
or company directors, the nature of the business and its contact details. HMRC will also
need to know who your employees are, when they were employed and details about
how you will operate your payroll system. Go to
www.hmrc.gov.uk/paye/intro/register.htm for more guidance on registering as a new
employer.
What are your statutory obligations?
As an employer you have obligations to your employees and to HMRC. Your main
obligations are:
    • To pay your employees at least the National Minimum Wage (NMW).
    • To provide equal pay to female and male employees who are doing the same
        work.
    • To deduct income tax and NICs from your employees' pay.
    • To deduct student loan contributions from your employees' pay when advised to
        do so.
    • To allow your employees to take paid annual leave.
    • To provide an itemised pay statement to your employees when they are paid.
    • To pay your employees any statutory payments that they are due, for example
        SSP or SMP.
Failure to comply with these requirements can result in financial penalties being imposed
and legal action being taken against you or your business.

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Resource 4.4

The PAYE scheme
Under the PAYE scheme, income tax due for each employee is deducted from the
employee's monthly salary or weekly wage. If PAYE deductions are processed correctly,
employees should have no additional tax to pay to HMRC at the end of the year.
Income tax is payable if an individual's income in a particular tax year exceeds their
personal allowance. The basic personal allowance used for the majority of employees is
£8,105 for the tax year 6 April 2012 to 5 April 2013. When their annual income exceeds
this amount, tax is paid at the following rates:
    • Basic rate of 20% on earnings between £8,106 and £34,370.
    • Higher rate of 40% on earnings over £34,370 and up to £150,000.
    • Additional rate of 50% on income over £150,000.
For example, if an employee earns £18,000 a year (gross) the tax calculation is as
follows:

Under the PAYE scheme, tax deductions are averaged out over the year so that the net
pay received by the employee is the same each month. Using the example given, the
income tax for the month is calculated assuming that the monthly salary paid is one
twelfth of the employee's annual salary so the employee would have an average
monthly income tax deduction of £165.
Income tax codes
Every employee is allocated a tax code by HMRC that takes account of their personal
circumstances relating to tax and is used by their employer to calculate the correct
amount of tax to be deducted from their salary.
A tax code is made up of one letter and several numbers. The number in the tax code
can be multiplied by ten to show the actual personal allowance for that employee. The
letter in the code corresponds to the individual's personal circumstances and the types
of allowances they are entitled to.
For example the letter L is used for all employees entitled to the basic personal
allowance and this is expressed as a tax code 810L. If the employee has underpaid tax
in previous years, and this is now being recovered through the PAYE system, they will
have a lower personal allowance, which could be £3,000. This would be expressed as a
tax code 300L and result in more tax being deducted each time the employee is paid.
In some situations an employee has a negative personal allowance and the tax code K is
then used. This situation might occur where the employee is receiving a range of
taxable benefits such as a company car and private medical insurance. If the employee
is assessed to receive taxable benefits of £9,105 (£1,000 greater than the basic personal
allowance) they would have a tax code K100.
If a new employee has recently left a job they should have been issued with a P45 form
by their previous employer. They should give this form to you to provide you with their
current tax code. If the employee does not have a P45 form you will need to complete a
P46 form and send it to HMRC who will issue you with the appropriate tax code for that

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Resource 4.4
employee. If you are due to pay an employee before you receive notification of their tax
code from HMRC, you should use the 'emergency tax code' of BR. If they have stated on
their P46 what their earnings are in the tax year and you are waiting for confirmation of
this from HMRC you should use 810L on a week 1 or month 1 basis, which applies the
basic personal allowance to their salary payment.
National Insurance
Both employers and employees pay Class 1 NICs. Any employee aged between 16 and
the state retirement age must pay NICs. The amount of an employee's contributions
depends on the level of their salary:
    • 12% of salary between the primary threshold rate and upper earnings limits
        (£146 to £817 per week for the tax year 2012/13).
    • 2% for all pay above the upper earnings limit.
Employers' NICs are charged at a rate of 13.8% of the employee's salary above the
primary threshold rate. Unlike the employee contributions there is no reduction in rate
once the upper earnings limit is passed.
In addition to Class 1 NICs, an employer is also responsible for paying Class 1A NICs on
employee benefits. All benefits provided to employees need to be reported annually to
HMRC on forms P9D and P11D and the total value of taxable benefits provided to all
employees is liable to an additional charge to the employer of 13.8%.

Statutory Sick Pay (SSP)
Employers have to pay SSP to employees who satisfy certain conditions and who have
been sick for at least four consecutive days, including weekends and bank holidays. SSP
is funded by the Government but it is paid by your business and you must then reclaim
this money by deducting it from the regular NICs your business pays to HMRC. For the
employee, SSP is treated as earnings.
SSP may only be recovered by employers under the Percentage Threshold Scheme
(PTS) through which an employer must:
(a) In the month SSP has been paid, establish the business's total gross Class 1 NICs
liability for the tax month across all PAYE records (including employees' and employers'
NICs).
(b) Multiply NICs by a set percentage, currently 13% (rounding down fractions of a
penny).
(c) Calculate the total SSP payments made in that month.
Where the amount at (c) is more than the amount at (b) the difference may be
recovered from HMRC.

Statutory Maternity Pay (SMP), Statutory Paternity Pay (SPP) and Statutory
Adoption Pay (SAP)
SMP works in much the same way as SSP. The employer pays SMP to eligible employees
and most of this can be reclaimed from the Government by way of deductions from the
business's NICs. Employers can (but are not obliged to) add to the amount of SMP paid
to employees, although only the statutory element of SMP is recoverable.
New fathers are entitled to take one or two consecutive weeks of paternity leave after
their child is born. During their paternity leave, most employees are entitled to SPP from
their employers. The rate of SPP is the same as the standard rate of SMP.

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Resource 4.4
Adoptive parents are entitled to up to 26 weeks' ordinary adoption leave and up to a
further 26 weeks' additional adoption leave. During their adoption leave, most adopters
are entitled to SAP from their employers. SAP is paid for up to 39 weeks at the same
rate as SMP.
The standard recovery rate for SMP, SPP and SAP is 92% of these payments. However,
if you are classed as a small employer you will be able to recover 103%. To qualify, your
total gross Class 1 NICs for the previous tax year must be less than the threshold, which
at present is £45,000.
Student loan deductions
The majority of graduates borrow money through the Government's student loan
scheme and only start to repay the loan once they are earning more than £15,795 per
year. When notified by HMRC or via a P45, employers are required to make student loan
deductions from an employee's pay.
The rate of deduction is 9% and deductions are made on a non-cumulative basis. For
more information, together with deduction tables and further advice, go to
www.hmrc.gov.uk/helpsheets/e17.pdf.
Salary sacrifice schemes
Salary sacrifice is where an employee chooses to receive a benefit in return for forgoing
part of their salary. Typical benefits include gym memberships, travel passes and
childcare vouchers. Businesses providing benefits to employees under salary sacrifice
arrangements must ensure they deduct the right amount of tax and NICs for both the
cash component of their salary and any non-cash elements. For more information go to
www.hmrc.gov.uk/paye/payroll/special-pay/salary-sacrifice.htm.
The PAYE requirements on non-cash benefits differ according to the type of benefit.
HMRC provides an online A to Z detailing various types of benefits and their PAYE
requirements at www.hmrc.gov.uk/paye/exb/a-z/a/index.htm.
Pay statements
All employees are entitled to receive a written pay statement or payslip, either on or
before their pay day. The minimum requirements of a payslip are that it should show:
    • The gross amount of pay.
    • The amounts and reasons for any variable and fixed deductions made such as
       income tax, NICs, statutory payments and student loan reductions.
    • The net amount to be paid.
    • If part payments are made, a breakdown of each payment.
Paying PAYE deductions to HMRC
Employers have full responsibility for processing the correct deductions from their
employees' pay and for paying those deductions, plus the employer's NICs, to HMRC.
Payments to HMRC must be made by the 19th of the month following the month in
which the employees were paid. If payment is made by Bacs, the money must be
received by HMRC by the 22nd of the month.
From May 2010 new penalties were introduced by HMRC for late payment of PAYE. If
payments are late more than once in a tax year, a penalty of a percentage of the
amount due will be charged. For further information go to
www.hmrc.gov.uk/paye/problems-inspections/late-payments.htm.
If your combined bill for PAYE and NI contributions is less than £1,500 per month you
qualify as a 'small employer', and are entitled to make payments quarterly.

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Resource 4.4
PAYE annual returns
You are required to submit annual returns to HMRC in the form of an end of year
summary of the total pay and deductions for each employee (P14 forms) and an
Employer's Annual Return (P35 form). These forms allow a check to be made between
the deductions that have been recorded and the amount actually paid to HMRC. Almost
all employers must now file their Employer Annual Return online. Go to
www.hmrc.gov.uk/paye/payroll/year-end/annual-return.htm for further information.
At the end of each year you will also need to give every employee a summary of their
pay and deductions for the year (P60), which they need to keep as evidence of tax and
NI paid.
PAYE inspections
HMRC undertakes regular inspection visits to businesses to ensure that they are keeping
the correct records and complying with their legal obligations. They will review your
business's pay records, as well as information relating to the payment of expenses and
their correct disclosure on the annual return forms. The frequency of such visits will
depend on:
    • How long you have been trading - you will usually have an inspection within the
       first two years of operating as an employer.
    • Whether your record of making payments and returns is timely and accurate.
    • The type of business you run - businesses dealing in cash, employing casual
       labour or contractors are considered as higher risk and warrant more frequent
       visits.
If any discrepancies are discovered during an inspection, HMRC can calculate lost
income tax and NICs for a period of up to six years. This period can be extended if they
suspect deliberate evasion and they can also charge additional financial penalties.
Hints and tips
    • Make sure that you maintain accurate and up-to-date pay records and keep them
       for six years.
    • Ensure that any deductions you make from your employees' pay are either legally
       required (PAYE & NI), are part of the employee's contract, or have been agreed
       in writing.
    • Employees have the right to take you to an employment tribunal if you do not
       provide them with an itemised payslip.

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