What is a ‘free of tax’ payment in the context of P35 reporting, and does it involve PSAs?

Question 2 in the Part 3 Checklist of the P35 Employer Annual Return asks:

“Did you make any ‘free of tax’ payments to an employee? In other words, did you bear any of the tax yourself rather than deduct it from the employee?”

This question can be mistaken by employers, as it is not clearly worded.  The explanation in the E10 ‘Finishing the tax year..’ helpbook is similarly vague, stating that “A ‘free of tax’ payment is a payment where the employer (rather than the employee) bears any tax due.”

These payments are, simply, where the employees are paid a net amount as take-home / cash-in-hand pay rather than a gross amount before the calculation of tax and National Insurance.  Whilst simple for the employee, the employer has to ensure that the correct tax and National Insurance liabilities are accounted for in the payroll and paid over to HMRC.  The calculation of this liability will depend on whether the employer is making payments that are just free of tax or are free of tax and NI.

Employers must not use this arrangement unless they have contacted their tax office and received instructions on how to handle the grossing-up process.  For employers handling such payments manually, the tax office can provide special P11 (FOT) working sheets, FOT tax tables (Tables G), and FOT1 guidance notes.

Some commercial payroll software will perform the necessary calculations, however, the overriding obligation to contact HMRC remains.  This is so that when they see the ‘Yes’ box ticked that free of tax payments were made, HMRC are already aware that this method of paying wages is used.  If they have not been contacted, the ‘Yes’ tick may prompt HMRC to investigate and query the payments being made.

HMRC provide good guidance on their Website which links to other guidance such as the CWG2 Employer’s Further Guide to PAYE and NICs and HMRC contact details.

Returning to the original question, this question on the P35 does not relate to PAYE Settlement Agreements (PSAs), even though the employer is bearing the employee’s tax liability on the payments and thereby avoiding having to handle the tax and NICs liabilities through the payroll.  If the only way in which an employer is bearing an employee’s tax is a PSA, question 2 should be answered NO.