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The Coalition’s June 2010 Budget announced that the Government wished to consider how the Pay As You Earn (PAYE) system could be improved in order to reduce costs, ensure accurate tax calculations, and make it easier for employers and HMRC (Her Majesty’s Revenue & Customs) to administer.

In all honesty something does need to be done urgently. Recent reports about taxpayers having to pay hundreds, even thousands of pounds in tax which was not collected by their employers because of errors in tax coding by HMRC have highlighted just one of the problems in the system.

The PAYE system was introduced in 1944 and it continues to work well for employees with regular, stable earnings. These days the pattern of an individuals working life has changed and many have more than one job and/or pension at the same time, and the days of working for just one or two employers for your entire working life are long over and even with the advent of computerisation PAYE can, and does, result in overpayment or underpayment of tax where employees have more than one job, or with a pension and a job. Each year around 5 million people have to claim a tax repayment or receive a tax bill because PAYE has not collected the correct amount of tax. Student loan deductions often continue to be made long after the loan has been repaid in full. Also when employees have more than one job, they can overpay NICs (National Insurance Contributions) and have to claim a repayment.

The real problems is that although most employers have to make monthly payments of tax, NIC and other deductions (such as student loan repayments) these are only checked and reconciled at the end of the year. There are all sorts of possible events that might take place during the year to affect the figures, such as changing jobs, having a period of unemployment, delays in getting a P45 when you leave one job so that your new employer can deduct the correct amount of tax etc. and so on.

Consultation

As the first step in considering changes to the system HMRC published a discussion document a few weeks ago, entitled Improving the Operation of Pay As You Earn (PAYE). The document explores options for moving to a system that collects information on PAYE deductions at the time employees are paid instead of at the tax year end. The process is called “Real-time Information” and seems a positive idea. Less so is another option called “Centralised Deductions” which would mean employers sending details of their payroll to HMRC together with the gross sum due for HMRC to calculate the net amount due to the employee and keep the deductions, tax, NIC etc. itself. Lets look more closely at each of these ideas.

Real-Time Information

This initial proposal makes use of the automatic deduction calculations carried out by computerised payroll systems and the ability of most employers to pay their employees electronically.

The “Real-time Information” concept would involve the automatic submission of each employee’s pay and deductions each time the employee is paid electronically. The information would be held by HMRC in a consolidated real-time tax account for each person. For those employers not paying electronically, the annual Employer CD-ROM could be enhanced to submit the information at the time of payment. The changes would require enhancements to payroll software but could, in HMRC’s estimation, be in place by April 2012.

Some of the benefits of Real-time Information, as detailed by HMRC, include:

  • simplify the process for both employers and HMRC by removing or reducing the use of P45s and P46s, as HMRC could detect when a new employee is paid for the first time and then issue the correct tax code;
  • employee’s changing jobs during the tax year would be more likely to pay the correct tax, reducing the need for end-of-year adjustments;
  • if pay and deduction information is submitted throughout the tax year, the year-end reporting requirement would be considerably reduced;
  • real-time income information would help HMRC pay tax credits and DWP (Department of Work & Pensions) pay income-related benefits more accurately; and
  • HMRC would know, at any time, exactly how much tax and NICs are due to be paid over by employers.

Centralised Deductions

Once employers are routinely sending pay and deductions information, the next step would be for each employee’s gross payment figure to be sent to HMRC for each pay-day and for the tax, NICs and other deductions to be calculated centrally. Individuals’ real-time tax accounts would be expanded to include their personal tax allowances and other reliefs. HMRC would also develop a central calculator to work out the correct tax, NICs and student loan repayments from their pay. The make-up to gross would still be the employer’s responsibility but the gross-to-net calculations would be carried out by HMRC. The resulting net pay figures would then be sent into the banking system for employees’ accounts to be credited and the total deductions figures debited from the employers’ accounts.

HMRC’s suggested additional benefits from “Centralised Deductions” include:

  • there would no longer be a need for tax codes as the employer would not be involved in the tax calculations – the actual annual allowances and reliefs would be used;
  • HMRC would be responsible for the accuracy of the calculations and perhaps provide employees with direct access to their consolidated tax account –employer-produced payslips would not show deduction information;
  • individuals completing self-assessment returns could be provided with pre-populated forms showing their employment and pension payments and deductions;
  • employees would consult their employers with questions about amounts and timing of gross payments, statutory payments and third party deductions, but questions about tax and NICs deductions would be the responsibility of HMRC.

The suggested effect on employers is that they would no longer have to:

  • receive information about individuals, calculate and make deductions from payments to them;
  • operate tax codes on 55 million employments;
  • make monthly payments of deductions to HMRC;
  • process forms for people starting or leaving work;
  • reconcile payments across the year and make annual returns to HMRC; or
  • provide employees with an end-of-year P60.

Employers would still be responsible for:

  • determining the pay components that are subject to tax and NICs;
  • determining taxable expenses and payments;
  • some statutory payments (e.g. Statutory Sick Pay); and
  • third party deductions (e.g. trade union subscriptions).

Conclusion

I think there is a good case to be made for using real-time information and for centralised computations of amounts due, but the suggestion that gross pay might flow to a central computer, which would then pass net pay on to employees, is completely unacceptable. Sooner or later (given HMRC’s record probably sooner) the system would break down and some people would not get paid. That would be a major embarrassment for HMRC, and a disaster for the employees affected and for their relationship with their employers.

I also note that there is no mention of Benefits in Kind being included in the system and so it would seem that these would continue to be returned annually in arrears using form P11d as now and this could still cause some quite significant over or underpayment of tax.

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