When paying PAYE earlier might be beneficial
There are special rules that determine when an employee is deemed to be paid for tax purposes. Basically, the legislation seeks to ensure that PAYE is applied as soon as is reasonably possible. Or, according to HMRC, as soon as the employee is able to benefit from their salary.
The rules for general earnings, e.g a bonus or salary, and when they are deemed to be paid, are contained within s.18 Income Tax (Earnings and Pensions) Act 2003. HMRC’s interpretation of the legislation is set out in their Employment Income Manual 42260. For ordinary employees it is the earlier of:
1. when a payment of earnings is actually made, or when a payment on account of earnings is made; or
2. the time when a person becomes entitled to payment of earnings, or a payment on account of earnings.
Even if a payment is not made therefore, nevertheless PAYE is required to be operated once an employee is entitled to be paid.
The rules for directors become more complex because HMRC argue that they have more control over how payments can be made. Therefore it is necessary to consider arrangements that go beyond the norm. So, for directors, earnings are deemed to be paid on the earliest of (1) & (2) as above plus:
3. the date when earnings are credited in the company’s accounts or records;
4. where the amount of the earnings is determined before the end of the period to which they relate, the date that period ends;
5. where the amount of earnings is determined after the end of the period to which they relate the date the amount is determined.
It is commonplace for companies to make provisions in their accounts for future expenses, known as accruals, e.g a forthcoming telephone bill, where the company has made calls and had the use of a landline but the invoice has not been presented until after the company’s year end. Such accruals are allowable for corporation tax purposes because the obligation to pay arises immediately when the telephone is used, without having to wait for the invoice.
It is therefore possible for a company to obtain a tax reduction earlier but account for PAYE later. However, what if the company wants to bring forward the PAYE payment and have the director’s earnings taxed earlier?
Mike is the sole director of his own PSC, Go It Alone Ltd. Whilst the business is profitable, its cashflow is poor due to its dependency on one particularly large contract. Go It Alone Ltd has fixed Mike’s salary and a bonus, based on the company’s profits for the year, which have been excellent. The bonus, however, is contingent upon a large sales invoice being settled in full. The timing of the payment of the bonus is therefore uncertain as it is based on a future event and, as such, PAYE is not due immediately but rather when the criteria are fulfilled. Mike has made sufficient personal pension contributions to ensure that the bonus does not plunge him into the higher rate tax band.
With the 5th April fast approaching, the invoice has still not been paid and whilst Mike is confident that it will be paid he is concerned that his bonus won’t be paid until after the end of the tax year, thereby scuppering his own personal tax planning.
Mike informs his accountant that his company is prepared to pay the PAYE before its sale invoice is remitted even though Go It Alone Ltd does not have the money to pay Mike’s net bonus as well. By virtue of reference to the triggers for when earnings are deemed to be paid (as discussed above), Mike’s accountant recommends that the bonus is credited in the company’s books and records. It is not necessary for the company to physically pay Mike but instead, the net bonus can be credited to Mike’s director’s loan account so that he can draw on it at a later date.
At the point the expense has been accounted for as earnings, Mike will be deemed to have received payment and PAYE will become due, ensuring that he is taxed on the bonus in the tax year he had planned for.
In the above circumstances, where the board’s original plans to pay the bonus are changed, then this should be properly sanctioned and a Board Minute recorded.