PAYE: right and wrong
In early September 2010, there was major press coverage on the errors and failing of PAYE and Tax Codes. Although there may be some mistakes with the implementation of the new system from HMRC from the former 12 COP databases to the new single NPS technology, it is not correct that PAYE was necessarily being operated wrongly.
PAYE, invented in the 1940’s has been in operation for many years, passing the liability for collecting tax from the then Inland Revenue to Employers.
The major issue with incorrect tax codes at the beginning of the tax year was a fundamental flaw in the logic design of the new NPS system in the handling of multiple employments combined with a historic misunderstanding by employers of their obligations to correctly notify new starters and leavers of a PAYE reference scheme as opposed to a Corporate entity or employer.
This difficulty was exacerbated by a fundamental design mistake, the use of the Works Numbers. HMRC rules formerly placed the control of the employer's reference for interchange and record creation in the hands of the employer to do what they like with it and only update electronically for New Starter records (P45 and P46) and also when an employer requested a special process called the Works Number Update (WNU). The design flaw was the HMRC decision to match NPS P14 records to works numbers and create secondary employment records where they didn’t tie up. Never before had HMRC undertaken such a bizarre activity. However, they have taken extensive measures to correct these errors and have mostly been successful.
So, the recent press coverage has lambasted errors in the PAYE system. The reality is that in many cases the PAYE system and employers have actually done what the law requires.
So should PAYE deduct the correct amount of Income Tax? The reality is no - PAYE will deduct the correct amount to be deducted through pay, but the issue is that the employee liability is not based on that, it is based on annual allowances and a tax year (6th April to 5th April) earnings period which can in many cases be two completely different things. Much of PAYE is estimated and therefore will require corrections known as rebates and underpayments.
So what is the recent issue primarily about? The answer is timing. The normal annual event of balancing the values and getting to the correct annual amounts was a year or two late.
Therefore the correct operation of PAYE is often wrong in relation to the Income Tax actually owed. Why?
- Many employees start work on the basis of a P46 form or by providing nothing. The tax code applied is BR which deducts 20%. Although this is right in law, it’s a guess which actually results ultimately in the wrong amount of Income Tax.
- Many tax codes are issued on a Week 1 / Month 1 basis especially in an effort to adjust and recover underpayments or reflect overpayments and therefore again work on the basis of a guess. So what is right is actually wrong.
- Benefits in Kind are reported in July after the end of the tax year. For new starters, these will not be known to HMRC in most cases. Therefore what is right in the operation of PAYE is wrong.
- Once P11D information is processed and caught up with, then HMRC assumes that the benefit in kind will continue into the future, even if it doesn’t. So one-off benefits are taxed into future years. HMRC have their reasons for doing this, I’m not sure its right, but often the end result is wrong.
- If P11D benefit in kind items are taxed in future years on a correct assumption that the benefit continues, the value of the benefit often changes. So although it may be right on the assumed amount, on the correct amount it is often wrong.
- Where employers have not started taxing Benefits at Source because no more P11D amounts are due as the tax has already been paid, then HMRC may have made assumptions which they thought were right, but now are wrong and the employee has paid twice.
- There is presently no means to deduct the additional 50% rate of tax from very high paid employees. Often they will be operated as BR or even D0, or may even have received free pay when they are not entitled to any. Either way the right operation of PAYE is actually wrong.
- Assumptions in free pay allocated in tax codes may be made for items such as business expenses, charitable giving, company car, etc., which are all estimates and maybe other values which result from former years' Self Assessment submission. So the employer and HMRC operated what was the right tax code but the end result is actually wrong.
The reality is that PAYE is all a big guess, and the guesses are often governed by law which promotes the guessing. But a guess is just a guess and will result in differences which we sometimes call errors. Therefore, although the employer and HMRC may have done, throughout the year, what is right, ultimately, for full annual Income Tax assessment it is wrong.