TaxOct 24 2017

PAYE complications: A user's guide

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PAYE complications: A user's guide

Prior to 1944, wages were paid gross and income tax was collected every six or 12 months. From April 1944, employers became responsible for deducting income tax.

To enable employers to calculate the amount of tax to deduct, each employee was issued with a pay-as-you-earn (PAYE) tax code. 

When employees left employment they were provided with their tax code, pay to date and tax paid to date on a P45 form. Employees then passed this to their new employer. 

The basic principle behind PAYE tax codes has remained broadly unchanged.

Standard tax code

The most common tax code for 2017-18 is 1150L. This simply assumes a tax-free allowance of £11,500 (1,150 x 10). A different number such as 800L would be assuming a tax-free allowance of £8,000 (800 x 10). The allowance is then applied cumulatively through the year, as are the basic and higher-rate bands. See Box One

 

Note that all examples assume a rest of UK (non-Scottish) taxpayer.

For those who receive consistent payments, this system works well. For those who receive irregular payments, the correct tax should be paid by the end of the year, but initially it is likely to be overpaid. See Box Two.

 

Emergency tax codes

Emergency tax codes will end in W1, M1 or X, for example 1150M1. These are non-cumulative. 

For those paid monthly it assumes that each month an employee has one-twelfth of the personal allowance, one-twelfth of the basic rate band and one-twelfth of the higher rate band. See Box Three.

 

 

Benefits in kind

Employers can provide non-cash benefits that are taxable: a company car, for example. To enable this tax to be collected, the tax-free allowance will be reduced by the taxable value of the benefit. 

If the taxable value is higher than the tax-free allowance, this will result in a K code and a negative tax-free allowance. See Box Four.

 

 

Second job

An individual with a second job may have a tax code that assumes their personal allowance, basic-rate band and even higher-rate band has been used up by their first source of income. A BR code will deduct basic-rate tax from all income: D0 will deduct higher-rate tax and D1 will deduct additional-rate tax. 

Transferrable tax allowance

Those who have used the transferable tax allowance to transfer some of their personal allowance to their spouse or civil partner will have an N tax code, while those who have received some of their spouse’s or civil partner’s tax allowance will have an M code.

Other tax codes

An NT tax code is used in certain cases where no tax should be deducted: for example, a self-employed musician who is not subject to PAYE. A 0T code is used where no personal allowance is available. 

A T code would be used where HMRC needs to review items with the individual. An S tax code will be added where HMRC has identified the individual as a Scottish taxpayer, for example, 1150L becomes S1150L.

Pension income

Pension income is also paid through the PAYE system and taxed in the same way as employment income – the exception is the state pension, which is paid gross of tax despite it being taxable. 

Any tax due on the state pension is usually taken through the PAYE code applied to other income, such as to a private pension. 

Drawdown income taken as a lump sum or the taxable 75 per cent of an uncrystallised funds pension lump sum (UFPLS) is taxed as income in the same way as other pension income. 

If this is the first payment being made by the pension provider, it will usually result in an emergency, non-cumulative tax code being applied. This can lead to a significant overpayment of tax. See Box Five

 

PAYE tax codes are far from perfect, especially for the increasing number of people, particularly pensioners, who have more than one source of taxable income. 

However, for a system that was introduced three-quarters of a century ago, it has proven to be remarkably resilient.

Phil Warner is head of technical at Hargreaves Lansdown