Pay as you earn
The pay as you earn or PAYE system is how companies in the UK pay tax contributions for each of their employees. Companies only pay their own employees this way. Contractors handle their own tax obligations. However, contractors with a service company can pay themselves through PAYE as well.
PAYE tax is made of 3 separate amounts relating to an employee:
- employer's National Insurance
- employee's National Insurance
- employee's income tax
All of these amounts are calculated from the employee's gross wage. The 2 employee contributions subtracted from the gross wage give the net wage.
Net wage = Gross wage - ( income tax + National Insurance )
The net wage is the amount the employer pays to the employee.
Note that the full cost of employment to the employer is the gross wage plus the employer's National Insurance contribution. This is an often ignored cost of employment that makes contractors appear more expensive than employees.
Some development companies refer to employess on a fixed term or temporary contract as contractors. However, they still pay such employees through their PAYE scheme which is not a valid option for contractors as we use the term here (that is, if they are working under a contract for services rather than a contract of service.)
Contractors that are self-employed, make all national insurance and income tax payments themselves. They normally pay class 2 national insurance contributions to the revenue by monthly direct debit. And at the end of the year, they calculate and pay their income tax by filling out a self-assessment tax return.
Contractors using PAYE
Although PAYE is only used for employees, there are ways a contractor can be paid this way without becoming an employee of the development company.
Contractors with a service company can employ themselves and pay themselves through PAYE. The system runs like any other company except for small differences in national insurance if the contractor is also a director.
Other kinds of intermediary can sit between the contractor and the developer:
- umbrella company
- managed company
In each case, if the contractors are employed by the intermediary they will be paid through PAYE in the usual way.
How it works
Only contractors employing themselves through their own company need to deal with details of running a PAYE system.
Employers collect PAYE contributions for all of their employees and make a single payment to the Revenue. Payments are monthly and cover contributions from wages paid in the period from the 5th of a month to the 5th of the next. It must reach the Revenue by the 22nd of the month.
The revenue provide an unfeasibly large and impractical worksheet on which work out all the amounts throughout the year.
Although the instructions for working out these amounts and filling out the various forms are convoluted and confusing, the actual requirements and calculations are trivial. Tax doesn't have to be taxing... but we do our best. The instructions are available from the revenue in form E13. Edited highlights follow:
You get a certain amount of your pay tax free. This is known as your allowance. For the 2006-2007 tax year, a typical employee can earn £5,035 before paying any income tax. There are different allowances depending on the employee's circumstances and the limits update at the beginning of the tax year.
Above that, tax applies in bands. The band rates are called: starting rate, basic rate, and higher rate. Currently the rates are: 10%, 22%, and 40% respectively. The tax bands are the same for all employees. Each band's limit also updates at the beginning of the tax year.
The rates are cumulative in that an employee earning enough to pay some higher rate tax also pays the maximum basic rate and starting rate tax. But the bands are exclusive so each rate only applies to the amount in its band; not the whole wage.
To work out how much tax you pay in each band, take the amount falling within each band and apply its rate. The total income tax for the year is the sum of the tax in each band.
However, this is not how the tax is calculated for PAYE. Instead you are given a tax code. This code is used in combination with tables to approximate the above calculation. This approach also breaks up the amounts into weekly or monthly payments. It also absorbs some of the fluctuations if an employee's wage changes significantly during the year. The last payment of the tax year (or of the employment) is calculated differently to correct any accumulated errors.
The tax tables themselves are available on the revenue site. Here are the most common tables:
Like income tax there are various allowances before you have to start paying NI contributions. Again you can use tax tables to enter the values or calculate them using a percentage. To find out which table to use, follow the flow chart on p31 of E13. Again, the most usual table is table A in leaflet CA38.
- for the period 6 April 2005 - 5 April 2006
- for the period 6 April 2006 - 5 April 2007
- for the period 6 April 2007 - 5 April 2008
To calculate the amounts you need to find 3 values: the lower earnings limit LEL, the earnings threshold ET, and the upper earnings limit UEL. These values are given on p4-5 of leaflet E12. For those who use table A the values are as follows for 2006-2007:
- LEL: £84 per week, £364 per month, £4,368 per year
- ET: £97 per week, £420 per month, £5,035 per year
- UEL: £645 per week, £2,795 per month, £33,540 per year
The rate of tax you pay between each of these limits depends on your tax table. You don't pay anything up to the LEL. Above that, the percentages for tax table A are:
A director's NIC is worked out annually. Although you can pay monthly like an employee if you prefer. You then have to adjust the last month to account for any differences. Unless you happened to start your company at the beginning of the tax year, your earnings period for your first year will be less that 1 year, so you need to work out your pro rata LEL, ET, and UEL. Page 40 of CA40 gives a table for these values depending on which tax week you became a director.
Once calculated, you pay the sum of NICs and income tax for all employees to HMRC every month. For our example employee on £45,000, the total payments for the year 2006-2007 come to £50,116 of which £18,101 goes to the revenue as PAYE income tax and NICs, leaving £32,015 as the employee's net wage.
Each employee has a statutory right to a pay statement that shows any pay deductions. The pay statement is required to show the following:
- gross pay
- itemised deductions
- net pay
After the end of the tax year (April 4th) HMRC requires you to send a form which summarises your payments for the year. You have until May 19th to send it. You can now do this online and for the year 2006-2007 you will get a £150 tax free payment if you do.