Further changes involving the use of tax code 0T! (Part 3)

Friday, November 12th, 2010

There is nothing specifically to report yet on the issues we have raised about the proposed use of tax code 0T in the P46 box C situation.  However, HMRC has now announced two further uses for the code from April 2011, both of which are equally inappropriate.

The announcement was made first in HMRC’s weekly informal newsletter and was followed by more detail in an email sent to payroll software developers.

The first announcement states that, from April 2011, the PAYE Regulations will be amended as follows:

Code 0T will become the default code in the following circumstances:

  • P46 box C, where the employee has not completed or signed section 1 of the form in time for the first pay day
  • To be operated on standard payments after the employee leaves employment
  • For P46(Pen) where an employee starts to receive a pension whilst still being employed by the same employer.

The first point confirms what we said in last week’s newsletter – that whoever is deciding these significant policy changes is hopelessly confusing two entirely separate issues.  Code BR is currently used in two distinctly different P46 situations; one where the employee checks box C, the other where no box is checked (strictly where the employee completes the form but does not sign it).  Tax code 0T is more effective than BR where no box is checked but, for reasons we have already covered, code 0T is scarcely better than BR at tackling the under-deduction of tax where box C is checked.

The email from the Software Developers Support Team (SDST) provides some additional explanation about the second and third points of the announcement, although some of it is inaccurate.  It states:

SDST have been made aware of some amendments to the PAYE Regulations which will come into effect from 6th April 2011.  These amendments involve changing the PAYE tax code HMRC authorises the employer to operate in some situations.  There are two changes and these are as follows:

An employer makes a payment to an individual after leaving their employment

Currently the guidance says you have to deduct tax at BR on any payments made to an employee after the employment has ceased, if they have not been included in their form P45. If the individual is liable to tax at the higher or additional rate however this will result in an underpayment that we would have to collect from the employee. From April 2011 we will be changing the code we authorise you to operate from BR to 0T. Code 0T will ensure that tax is deducted from payments at the basic, higher and if appropriate the additional rate of tax.

An employer continues to make payments to an individual as an employee and then begins paying them a pension.

It is becoming commonplace for employees to begin receiving occupational pension payments whilst continuing in employment with their existing employer. In this event the current guidance instructs you to continue using the same tax code against the individual’s employment income until we issue a new code. We also tell you to operate the same tax code against the pension payments on a Week1/Month 1 basis. This can result in the employee receiving more personal allowances than they should and an underpayment of tax arising at the tax year end. To remedy this, from April 2011 the authorised code to be operated against the occupational pension receipts will be changed to code 0T where the employee continues to work for you.

These changes will be included in the CWG2 Employers Further Guide to PAYE and NICs. The 2011 version of these helpbooks will be published online in February 2011.

Payments made on termination

The second situation relates to payments that are made after an employee leaves and after the termination P45 has been issued.  The first announcement refers specifically to “standard payments” which, according to CWG2 pages 15 and 96, are final payments of salary or wages, holiday pay, week-in-hand payments, bonuses, arrears, SMP, SAP, SPP, etc.  They do not include special additional one-off termination payments such as redundancy pay, pay in lieu of notice, etc.  However, the SDST email does not distinguish between standard payments and one-off termination payments.

The current requirement is for standard payments to be taxed using BR W1/M1 at the tax week or month in which the payment is made.  (See CWG2 page 15)  The effect is that tax is deducted at 20%, whatever the tax week or month.

HMRC’s announcement is that, from April 2011, tax code 0T will be used instead of BR in this situation.  Unfortunately, neither of the two HMRC documents states whether the code will be used cumulatively or non-cumulatively.  Because it is not stated, the inference is that HMRC intends it to be used cumulatively.  If that were the case, the tax calculation would have to be made at the tax week or month in which the payment is made, with the effect that the employee’s correct tax code at termination would be replaced with code 0T retrospectively for the whole tax year to date.

If, however, code 0T is applied on a W1/M1 basis, the tax on the whole of the additional payment is calculated using the 20%, 40% and 50% rates as appropriate and, the higher the payment, the greater the tax deduction.  For example, using 2010/11 tax thresholds:

If the payment for a monthly-paid employee is:

  • £2,000, the tax using
    • BR M1 would be £400
    • 0T M1 would also be £400 (with tax calculated only at 20%)
  • £5,000, the tax using
    • BR M1 would be £1,000
    • 0T M1 would be £1,376.66 (with tax calculated at 20% and 40%)
  • £10,000, the tax using
    • BR M1 would be £2,000
    • 0T M1 would be £3,376.66 (with tax calculated at 20% and 40%)
  • £20,000, the tax using
    • BR M1 would be £4,000
    • 0T M1 would be £8,126.66 (with tax calculated at 20%, 40% and 50%)

It is clear that code 0T W1/M1 is more effective at deducting tax on higher payments than BR, but not as effective, or as accurate, as if the employer uses D0 and D1 according to the employee’s marginal rate of tax.  Using the figures in the examples above:

  • if code D0 (40%) were used for the £10,000 payment, the correct deduction of £4,000 would be made instead of £3,376.66.
  • if code D1 (50%) were used for the £20,000 payment, the correct deduction of £10,000 would be made instead of £8,126.66.

In the case of these standard payments made after the employee leaves, the employer is in possession of all the facts necessary to decide whether to apply tax code D0 or D1 to the payment.  This is not the case in the P46 box C situation, which is why we have suggested that D0 or D1 in that situation should only be applied with the employee’s authority.  But our recommendation, in the case of standard payments, is that the employer should be able to decide whether to apply code BR (or 0T), D0 or D1, as appropriate, in order for the tax deduction to be as accurate as possible.

No mention is made by HMRC in these documents to one-off termination payments, such as redundancy pay, pay in lieu of notice, lump sum retirement payments, etc., to which the same rules apply when made after termination and after the P45 has been issued.  Such payments may or may not be subject to tax depending on whether they qualify for the £30,000 tax exemption, but payments that are taxable suffer from exactly the same problem – they are currently taxed using tax code BR W1/M1.    Because the employer knows that the employee’s marginal rate of tax is 40% or 50%, it is customary for the employer, when writing to employees to explain the payment and the deduction, to remind them that HMRC will require payment of the additional tax at a future date.  It may be, of course, that many employers prefer the current approach as it gives redundant employees, for example, more money initially and, if they do not find work immediately, the tax may not have to be repaid anyway.

Employee paid a salary and a pension by the same employer

The third situation arises where an employer starts to pay a pension to an employee who is continuing to work for that employer.  The employee is receiving a wage or salary and, at the same time, is receiving a pension from the employer’s pension scheme.  In this situation, which is effectively the same as the P46 box C situation, the employer advises HMRC using form P46(Pen) and, until HMRC sends new coding notices, calculates tax using

  • the employee’s existing tax code for the wage or salary, and
  • code BR on a W1/M1 basis for the pension payments.

This guidance appears on page 22 of CWG2.  HMRC’s email to software developers incorrectly states that the employee’s existing tax code from the employment should be used for the pension payments, but on a W1/M1 basis.

HMRC’s announcement is that, from April 2011, tax code 0T will be used instead of BR to calculate tax on the pension payments until a coding notice is issued.  Again, neither of HMRC’s documents states specifically that code 0T would be used on a W1/M1 basis, but presumably this would be the case.

If the employee’s marginal rate of tax in the employment is 40% or 50%, the proper tax code to use for the pension payments is D0 or D1.  If code 0T is used, the tax deductions will be inaccurate.  Even so, whether or not code 0T as the only option is the best approach in this situation depends principally on how long it takes for the correct coding notices to be issued.  If HMRC cannot issue coding notices promptly for both the employment payments and the pension payments, it would be better, for all of the reasons given above, for employers to apply code BR (or 0T), D0 or D1.  As in the case of standard payments made after an employee leaves, the employer knows the employee’s marginal rate of tax and should be capable of applying the appropriate code.

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