Further guidance from HMRC on tax relief restrictions on employer-supported childcare

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The following notes appeared originally in a newsletter in March 2010.  They have been updated in line with newly published HMRC guidance for employers and employees.

In September 2009, the Prime Minister, Gordon Brown, announced that the tax exemption for childcare vouchers would be phased out from 2011.  Following widespread dissent, this decision was reversed in December 2009 and, instead, it was announced that, still from April 2011, the tax relief on childcare vouchers would be restricted to the basic rate of tax.

Some details of this tax relief restriction were published in February 2010 in an HMRC document entitled Reform of the Tax Treatment of Employer-Supported Childcare.  Unfortunately, a number of significant issues were not addressed in that document, some of which still require clarification.  However, more information was published by HMRC on 27 October in two somewhat disjointed FAQ documents – one for employers, another for employees.  The changes will require amendments to both primary and secondary legislation but no draft text has yet been made available.  As a result, only HMRC’s guidance is currently available to explain how the tax relief restrictions will be administered by employers.

With regard to the Government’s objective in restricting the available tax relief further, the new guidance states:

“Under current arrangements, employees on higher earnings receive a greater tax saving than those who pay tax at the basic rate.  The purpose of the change is to even out the amount of tax saving available for all employees regardless of the tax rate that the individual pays.”

Readers will be able to decide whether this objective is fully achieved when considering the worked examples provided later in this article.

There are three separate tax and NICs exemptions covering childcare provision in the Income Tax (Earnings and Pensions) Act 2003 and the equivalent social security legislation:

1. Employer-provided childcare, i.e. workplace nurseries, is fully exempt from tax and NICs if the defined conditions are met.
2. The provision of employer-contracted childcare, i.e. where the employer provides access to childcare by contracting with registered childcare providers, is exempt from tax and NICs on the first £55 per week.
3. The provision of childcare vouchers for qualifying childcare is also exempt from tax and NICs on the first £55 per week.

The first of these methods of providing childcare is not affected in any way by the tax restriction.  Employers are encouraged to continue to increase the overall availability of childcare by making in-house provision.  Only the second and third methods of providing childcare are affected by the restrictions and, together, they are known as “employer-supported childcare” to distinguish them from “employer-provided childcare”.  Employees are only entitled to one £55 exemption for “employer-supported childcare” in respect of the same tax week, either employer-contracted childcare or childcare vouchers.

The statutory tax and NICs exemptions are defined in the context of the provision of employer-supported childcare, financed by employers as a fringe benefit for their employees.  HMRC calls this way of providing childcare as a “salary plus” arrangement.  However, it is more common to find them provided under

• self-financing “salary sacrifice” schemes, where the employer’s costs are met by voluntary reductions in the salaries of the employees concerned
• flexible benefits schemes, where employees may choose between a range of benefits, including employer-supported childcare, and offset them against each other.

For the purposes of these new tax relief restrictions, it does not matter how the employer-supported childcare is provided.  If it is provided in such a way that it benefits from the £55 tax exemption, employers must operate the new restrictions.

Statutory conditions for tax exemption

At this point, it is worth restating the conditions that must be met in order for employees to qualify for the tax exemption, whether under the current rules or under the new rules from April 2011.

The provision of employer-contracted childcare is exempt from tax up to the weekly limit if:

1. the child
   1. is a child or stepchild of the employee and is maintained (wholly or partly) at the employee’s expense, or
   2. is resident with the employee and is a person in respect of whom the employee has parental responsibility,
2. the care is qualifying child care, and
3. the care is provided under a scheme that is open
   1. to the employer’s employees generally, or
   2. generally to those at a particular location.

The provision of childcare vouchers is exempt from tax up to the weekly limit if:

1. the voucher is provided to enable an employee to obtain care for a child who
   1. is a child or stepchild of the employee and is maintained (wholly or partly) at the employee’s expense, or
   2. is resident with the employee and is a person in respect of whom the employee has parental responsibility,
2. the voucher can only be used to obtain qualifying child care, and
3. the vouchers are provided under a scheme that is open—
   1. to the employer’s employees generally, or
   2. generally to those at a particular location.

The most critical of these conditions, in both cases, is the requirement for the scheme under which the childcare or the vouchers are provided to be open to employees “generally”.  If that condition is not met, none of the childcare or vouchers provided to any employees qualifies for tax relief.

Employees affected by the new restrictions

The new restrictions apply only to employees who join the childcare or voucher scheme on or after 6 April 2011.  These include:

• employees who join the scheme for the first time
• employees who apply to join the scheme before 6 April 2011 but who do not meet the qualifying conditions until 6 April 2011 or later
• employees who have left the scheme in the past and who rejoin
• employees who cease to meet the qualifying conditions but who rejoin when they qualify again
• new employees joining the scheme, even if they have participated in a scheme with their previous employer with the same scheme provider.

Employees who stop receiving childcare or vouchers temporarily are not treated as leaving the scheme, as long as the break is for no longer than twelve months.  Examples of such temporary periods are:

• parents working during term-time who care for their children personally during school holidays
• employees taking maternity, adoption or additional paternity leave
• employees on long-term sick leave
• employees taking a career break

Conversely, employees who are not affected by the new restrictions are those who are already scheme members on 5 April 2011.  For as long as they remain scheme members and meet the qualifying conditions, the restrictions that apply during 2010/11 continue to apply to them.  To be a scheme member, an employee must meet the qualifying conditions and have applied for membership on or before 5 April 2011, even if the childcare or vouchers are first provided after that date.  Continuous membership is not affected by

• a requirement for employees to renew their scheme agreement each year
• changes in the value of the childcare or vouchers they receive
• a change in employer due to a business merger, reorganisation or TUPE transfer
• a change in the third-party voucher scheme provider.

Tax restrictions for existing scheme members

Employees who are not affected by the new restrictions continue to benefit from the £55 weekly exempt amount.  This is equivalent to £243 per month.  (There are 53 weeks in a tax year for the purposes of employer-supported childcare.)

If the value of the employer-contracted childcare provided exceeds the weekly or monthly exempt amount, the excess must be reported on the employee’s P11D at the year end and the employer must pay the relevant amount of Class 1A NICs.

If the value of childcare vouchers provided exceeds the weekly or monthly exempt amount, the excess must be:

• added to the employee’s gross pay in that particular week or month for NICs purposes, and
• reported on the employee’s P11D/P9D Return at the year end.

Tax and NICs liabilities, if any, are determined in each pay/earnings period.  If a liability occurs in one pay period it cannot be offset against periods where no liability arises.  These are the existing procedures and they are not changing at all for existing scheme members.

Where employees receive variable values of childcare vouchers in each pay period and some of them exceed the weekly or monthly limit, special rules apply for calculating the amount that must be reported for NICs purposes.

Basic earnings assessment for new scheme members from April 2011

Instead of the single £55 exempt amount that applies for existing scheme members, new scheme member from 6 April 2011 will have an exempt amount that relates to their marginal rate of tax.  The restrictions are aimed at employees who pay tax at the higher 40% rate or the additional 50% rate.  The effect of the restrictions is to ensure that such higher-paid employees do not receive more from the tax exemption in actual monetary terms than employees who pay tax only at the basic 20% rate.

To achieve this, the weekly exempt amount is

• £55 for employees whose marginal rate of tax is 20%
• £28 for employees whose marginal rate of tax is 40%
• £22 for employees whose marginal rate of tax is 50%.

A basic rate employee receiving vouchers worth £55 has tax relief of £11.  The lower weekly limits for 40% and 50% taxpayers ensure that they also have tax relief of approximately £11 (40% of £28 = £11.20, 50% of £22 = £11).

The decision as to which weekly exempt amount applies to new scheme members is made by the employer.  This is the principal administrative problem with the new tax restrictions.  An employee’s marginal rate of tax can only be correctly determined after the end of a tax year, when the employee’s total earnings for the year are known.  However, which of the three exempt amounts to apply to any employee has to be decided in advance, at the start of the tax year.  To do this, employers must carry out an entirely artificial calculation to estimate the employee’s earnings for the year – at the very start of the year, or when an employee first applies to join a scheme.  It is called a “basic earnings assessment”.  The only positive aspect of the assessment procedure described below is that the employer’s estimate will usually be less than the employee’s final total earnings for the year and, as a result, the estimate will be in the employee’s favour.

Once calculated, the basic earnings assessment is fixed for the remainder of the tax year and used throughout the year to determine any tax and NICs liabilities.

There are no exceptions to this requirement to perform a basic earnings assessment when an employee joins an employer-supported childcare scheme, even in businesses and business sectors with a high turnover.

The basic earnings assessment includes any of the following payments to which the employee is contractually entitled.  The list is not exhaustive.

• the current basic pay/salary as stated in the employee’s contract of employment (and, where a salary sacrifice is involved, this is the lower, post-sacrifice salary)
• the amounts of any contractual or guaranteed bonuses
• the amounts of any London weighting or other regional allowances
• the reportable value of any taxable benefits – including the value of the employer-contracted childcare or childcare vouchers to be provided
• the amount of any shift allowances.

All of these pay items are payments that, on the basis of the employee’s contract, can be estimated with reasonable accuracy

• for the whole of the coming tax year in the case of an existing scheme member or
• for the rest of the current tax year when an employee joins the scheme during the year, or when an existing scheme member returns from a temporary break and was not receiving normal contractual pay at the start of the tax year.

The assessment should not be based on payments that have been made in the past, either in the present employment (e.g. on the previous year’s P60) or with a previous employer (as quoted on a P45).  The assessment looks ahead to the whole of the coming tax year and is made on the basis of the employee’s current contractual circumstances.  It would be appropriate, however, for an employer to listen to any views an employee has about the assessment in case there are other factors that the employer should take into consideration or ignored.

Payments that may be made during the year or that cannot be determined at the start of the tax year are not included in the assessment.  Such payments include:

• performance-related or discretionary bonuses
• overtime payments.

The resulting total from the basic earnings assessment should also be reduced by the amount of any deductions that will be made before tax during the year under the net pay arrangement, i.e. pension contributions to occupational pension schemes, payroll giving donations and payments to purchase partnership shares under Share Incentive Plans.

Where employees join a scheme mid-year, the result of the assessment, which should represent the earnings expected in the rest of the tax year, should be “grossed up” in order to obtain an annual figure.

The resulting total from the assessment applies for the whole of the tax year.  It is based on the employee’s circumstances at the time it is calculated and may not be changed during that tax year to reflect any changes in the employee’s earnings.  A new assessment is carried out at the start of the next tax year, based on the employee’s circumstances at the start of that tax year.

Consequently, it would not be inconsistent or incorrect for an employee to be entitled to an exempt amount of £55 per week for the whole tax year based on an assessment of earnings at the start of the tax year but, later in the year, to start paying tax at 40% due to a promotion.

The way in which each employee’s basic earnings assessment was determined becomes a part of the employer’s payroll records and they must be retained and produced in the event of a compliance check.  There is no defined format for the records – they must contain enough information to show how each assessment was calculated.

Using the basic earnings assessment to determine the exempt amount

Having determined each employee’s basic earnings assessment, the next step provides a further administrative problem.  The estimated annual earnings are compared with the tax thresholds that identify the employee’s marginal rate of tax.  However, to do so, the employee’s tax code must be taken into consideration.  At this point, HMRC’s new guidance becomes very vague.  Despite using a heading that suggests that an employee’s tax free pay for the year is used when calculating the basic earnings assessment, it appears from the brief explanation that that is not the case.  Rather, the tax thresholds will have to be determined for each employee, taking into consideration the employee’s tax code.

For example, using the 2010/11 personal allowance of £6,475, and the 2010/11 tax thresholds, namely the basic rate limit of £37,400 and the higher rate limit of £150,000, an employee with a tax code of 647L would have an exempt amount of

• £55 pw/£243 pm if the assessed earnings are less than £43,875 (i.e. £6,475 + £37,400)
• £28 pw/£124 pm if the assessed earnings are between £43,875 and £150,000 (on the basis that the personal allowance has been lost at the higher rate limit)
• £22 pw/£97 pm if the assessed earnings exceed £150,000.

None of that is clear in HMRC’s guidance.  There is also no explanation of what happens if an employee’s tax code is wrong, or if it changes during the year.  However, having decided on an employee’s marginal rate of tax in this way, the appropriate exempt amount will be used to determine how much, if any, of the value of the employer-contracted childcare or childcare vouchers has to be reported for tax and NICs.

If the value of the employer-contracted childcare provided exceeds the appropriate weekly or monthly exempt amount, the excess must be reported on the employee’s P11D at the year end and the employer must pay the relevant amount of Class 1A NICs.

If the value of childcare vouchers provided exceeds the appropriate weekly or monthly exempt amount, the excess must be:

• added to the employee’s gross pay in that particular week or month for NICs purposes, and
• reported on the employee’s P11D/P9D Return at the year end.

Errors in calculating the basic earnings assessment

Even though it does not reflect an employee’s actual earnings in a tax year, an assessment that was based on the best information available at the time will be treated by HMRC as correct for P11D reporting purposes.

If, however, the employer’s initial assessment is incorrect because of a failure to use relevant available information and more tax relief is given than the employee is entitled to, amounts in excess of the correct weekly limit must be reported on form P11D or P9D, as appropriate.  Alternatively, HMRC will assess the employee for any additional tax due.

If the assessment is wrong for tax purposes, it will also be wrong for NICs purposes.  HMRC’s guidance makes no mention of how any Class 1 NICs that have been overpaid or underpaid by employee and employer on childcare vouchers are corrected if the initial assessment is incorrect.

Transitional provisions

Curiously there aren’t any transitional arrangements.  Generally when a tax advantage is removed, tax avoidance measures follow closely.  Is it possible for employees paying higher rates of tax to avoid the restrictions?  Yes – by joining an employer-supported childcare scheme before 6 April 2011.   There is a catch of course – the first of the three conditions for both employer-contracted childcare and childcare vouchers require them to have a child who can benefit from the childcare.

HMRC’s guidance is very clear on this.  Can an employee join the employer’s scheme before her, or his, baby is born?  “No – you must be a parent or have parental responsibility for a child at the time you join your employer’s scheme.”

The statutory definition in the case of employer-contracted childcare is also clear – and obvious.  The tax liability on the benefit arises at the time the childcare is provided, so there must be a child to enjoy the childcare.  But, childcare vouchers do not have to be used immediately.  In response to a question we asked, HMRC stated:

“Parents can receive childcare vouchers before they incur childcare costs which can then be redeemed at a later date.  If the employer permits this within the scheme which is offered to all its employees, it does not contravene any HMRC requirements.”

However, do childcare vouchers qualify for the tax exemption if they are obtained even before the child who will benefit from them is born?  In the case of childcare vouchers, the wording of the first condition is not explicit.  It says that the voucher “is provided to enable an employee to obtain care for a child who (a) is a child…, or (b) is resident with the employee…”  Does this mean that there must be a child at the time the voucher is provided or at the time the voucher is used?  Although the wording is unclear, it must logically mean that there must be a child when the voucher is provided as it is at that point that the tax liability arises.  In answer to our question on this subject, HMRC replied:

“Entitlement to the exemptions for childcare vouchers does require an employee to be a parent or have parental responsibility for a child at the time the voucher is issued. The vouchers themselves may however be used at a later date.”

There is, therefore, nothing to prevent higher-paid employees entering into a childcare voucher scheme before 6 April 2011 to avoid losing tax relief at their full marginal rate – but only if they are already a parent or have parental responsibility.

Effect of the NICs exemption

If the conditions for the tax exemption are met, there is a corresponding NICs exemption.  Where the exempt weekly limit is exceeded, the excess amount is liable for Class 1A NICs in the case of employer-contracted childcare, or for Class 1 NICs in the case of childcare vouchers.

Although HMRC’s document includes a passing reference to relief from NICs, it does not, surprisingly, consider the effect of the NICs exemption for these benefits.  The objective of introducing the £28 and £22 weekly limits is to equalise tax relief across all employees.  But the NICs relief available for childcare vouchers is far from equal.  Assuming that the basic tax rate in 2011 is 20%, the standard employee Class 1 NICs rate is 12%, and the top employee Class 1 NICs rate is 2%:

• if an employee liable for basic rate tax is provided with a £55 childcare voucher, there is tax relief of £11 (20% of £55) but also Class 1 NICs relief of £6.60 (12% of £55) – £17.60 in all.
• if an employee liable for higher rate tax is provided with a £28 childcare voucher, there is tax relief of £11.20 (40% of £28) but (because earnings exceed the NICs upper earnings limit) also Class 1 NICs relief of £0.56 (2% of £28) – £11.76 in all.
• if an employee liable for additional rate tax is provided with a £22 childcare voucher there is tax relief of £11 (50% of £22) but (again because earnings exceed the NICs upper earnings limit) also Class 1 NICs relief of £0.44 (2% of £22) – £11.44 in all.

The Government’s objective, as stated in HMRC’s document, is to “even out the amount of tax saving available for all employees regardless of the tax rate that the individual pays”.  That is true in the case of tax relief for childcare vouchers but not in the case of NICs.

Further information:

Changes to employer supported childcare – Employer Q&A

Changes to employer supported childcare – Employee Q&A

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This entry was posted on Thursday, November 4th, 2010 at 17:31 and is filed under Childcare, Compliance, Maternity / Paternity / Adoption Pay & Leave, P45 / P46, PAYE, Pensions, SSP, Statutory and Other Payments and Deductions, Statutory Sick Pay (SSP). You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.