Arrears of pay
25 April 2019
This article was featured in the May 2019 issue of the magazine.
Justine Riccomini, head of taxation (Scottish Taxes, Employment and ICAS Tax Community), ICAS, explores the tax etc issues
Arrears of pay can accrue in many different circumstances – not just by a failure to meet national minimum wage (NMW) obligations. However, because of the proliferation of NMW-related cases which HM Revenue & Customs (HMRC) is pursuing, resulting in a quarterly naming and shaming list (http://bit.ly/2UlgCr9) and telephone number sized arrears bills in some cases, little wonder that when the term ‘arrears of pay’ is concerned, everyone thinks of NMW.
However, pay arrears most frequently occur when:
an employer or employee discovers that wages or salary paid in an earlier period were less than what they should have been paid under the employee’s contract
backdated pay award is made
the employer’s payroll or human resources systems make an error
equal pay legislation applies, and the employer has to pay arrears.
Liability to income tax
Employment earnings are liable to pay as you earn (PAYE) under section 62 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). It follows that any employment earnings paid in arrears such as NMW allowances, holiday pay etc are thus liable to income tax. Note that arrears of pay are not compensation awards even if ordered to be paid by a tribunal and should never be treated as such – HMRC will not accept that argument.
In terms of basic principles, the timing of the charge to PAYE on taxable earnings is the earlier of when: the payment was received by the employee or worker, or when entitlement arose to it (s. 686 ITEPA). In the case of arrears of pay, the employer will need to consider when entitlement arose.
To illustrate this, in a pay dispute, for example, the employees will receive a pay arrears award based on a contractual, or deemed contractual, entitlement to that pay, which entitles them to receive that money from a given point in past time.
HMRC’s PAYE Manual sets out how to allocate a payment of arrears through payroll in closed tax years (http://bit.ly/2I2uwYp). The guidance explains, in line with the provisions at sections 18 and 686 ITEPA, that whilst legally the liability to tax arises in the tax year the money is earned, lump sum arrears should be subject to PAYE at the time they are actually paid.
There are two settlement procedures, dependent on whether the employer is a ‘large employer’ or not.
Large employers – Large employers (such as a local authority) wishing to settle income tax liabilities, and where large numbers of employees are involved, can settle directly with HMRC under regulation 141 of the Income Tax (Pay As You Earn) Regulations 2003 (‘the Regulations’).
The tax rates used must correspond to the rates in force at the time the employee became ‘entitled’ to the payment. If no Scottish or Welsh rates were in force in the particular year in question, the rates used should be UK rates.
If a large employer does not wish to use this settlement route, it must follow the same procedure as other employers, as follows.
Other employers – An employer that is not a ‘large employer’ should allocate the payments to week 53 of the closed tax year to which the arrears correspond. If this is not possible or the employer does not wish to do this, the payment is taxed in full in the tax year in which received which could result in an employee being taken into a higher tax bracket for that tax year. The employer has a duty to tell the employee this, thereby enabling them to contact HMRC. Employees who contact HMRC in such cases can have their arrears of pay reallocated at the end of the tax year in which the arrears were paid. In some cases, this will lead to cash flow issues for the employee.
I understand from discussions over the years with software providers that there are some software programmes which do not allow employers to process adjustments in closed tax years. If this happens, the HMRC’s Basic Tools can be used instead to cater for this one-off event. Guidance from HMRC can be found here: http://bit.ly/2UytedE, or by using the employer’s helpline (0300 200 3200).
Having established when the entitlement arose, the next most common difficulty many employers encounter is the disparate payroll treatment for income tax and National Insurance contributions (NICs).
...the employer will need to consider when entitlement arose...
The NICs legislation
Class 1 NICs are calculated based on pay periods and any lump sums of pay arrears are deemed for NICs purposes to be received in that pay period. As such, no retrospection is required.
Whilst a lump sum can result in a large one-off NICs charge for that pay period which may result in a cash flow issue, in some cases it can actually save the employee money because NICs are charged at 12% until pay reaches the upper earnings limit (£50,000 for 2019–20). NICs charged on anything over that drops to 2%. HMRC’s guidance can be found at http://bit.ly/2TYbvrB.
In some cases, the NICs will be the only thing processed through the current payroll run because the tax may have been settled directly or put through closed tax years. The employer should understand how to configure the payroll parameters to ensure the lump sum is chargeable to NICs but not to tax. The payment needs to be reported in a full payment submission for that pay period.
Payment in instalments
Employees might agree to sign agreements to receive their arrears of pay in delayed stages if this helps the employer to fund the payments, which would lead to the date on which the monies are paid being delayed. However, just because employees have agreed to receive the arrears in instalments does not necessarily mean that PAYE is not still due: earnings are treated as ‘received’ for assessment purposes, and ‘paid’ for PAYE purposes, on the earlier of the following in accordance with s.18 ITEPA:
when a payment of earnings is actually made or when a payment on account of earnings is made
the time when a person becomes entitled to payment of earnings or a payment on account of earnings.
For company directors it’s slightly different:
the date when earnings are credited in the company’s accounts or records
where the amount of the earnings is determined before the end of the period to which they relate, the date that period ends
where the amount of the earnings is determined after the end of the period to which they relate, the date the amount is determined.
HMRC guidance on this can be found at http://bit.ly/2Vt6I3i.
If an employer is experiencing any difficulty in paying the PAYE to HMRC, they should contact HMRC immediately to discuss time to pay arrangements.
What constitutes pay arrears
Police housing payment arrears – The case of White v Inland Revenue Commissioners concerned arrears of police housing allowance. Mr White was a police officer who commenced working three days after the allowance was abolished; however, he had been given material about the allowance before joining the police and thought it would be a part of his remuneration.
Mr White complained that he had only taken the role because he was anticipating this payment in addition to his earnings as an officer. He was initially awarded a payment but there was a dispute about how the payments should be allocated to which tax years. Eventually it was decided that he was not ‘entitled’ to arrears for some of the years he claimed for, and that any earnings he had accrued entitlement to should be attributed to the year in which they were deemed to have been earned, in accordance with what is now section 18 ITEPA.
Tronc scheme NMW arrears – The case of Annabel’s (Berkeley Square) Ltd and others v Revenue and Customs Commissioners concerned whether payments from a tronc scheme represented earnings for NMW purposes. In the case of each worker, the ‘basic wage’ was lower than the NMW and ‘topped up’ by tips by way of a tronc scheme. HMRC took the view that the employers were not satisfying their obligations to pay the NMW, and issued enforcement notices under section 19 of the National Minimum Wage Act 1998. The employer appealed those notices.
Were the payments from the tronc scheme ‘money payments paid by the employer’ and thus counting towards pay for NMW purposes by virtue of regulation 30 of the National Minimum Wage Regulations 1999?
The Court of Appeal held that a payment to an employee by a tronc master was not a payment by the employer and HMRC won the right to claim NMW arrears of pay.
Unpaid holiday pay arrears – A number of cases of pay arrears are in connection with holiday pay and have been heard in the Employment Appeal Tribunal (EAT). Fulton v Bear Scotland Ltd and others; Woods and others v Hertel (UK) Ltd; and Law and others v Amec Group Ltd, all lost at EAT after the employment tribunal decision that payments for non-guaranteed overtime were part of normal remuneration and were to be included as such in the calculation of holiday leave taken under regulation 13 of the Working Time Regulations 1998.
... Pension Regulator’s website has detailed guidance ...
Pension contribution arrears – links to NMW
NMW arrears can also give rise to pension contribution arrears. Where these are identified it may be necessary under automatic enrolment legislation to place the employee into a workplace pension scheme with backdated contributions calculated. The Pensions Regulators website has detailed guidance to help employers/advisers dealing with pay arrears.
Interest and penalties
HMRC reserves the right to charge interest on late payments of PAYE income tax. Depending on the case, HMRC may or may not decide to take action using its charging powers. Interest is usually chargeable from 19 April following the tax year in which the PAYE should have been paid.
As far as penalties goes, it is within HMRC’s powers under schedule 56 of the Finance Act 2009 to issue penalties for late returns. Under real time information (RTI) there are risk-assessed penalties covering PAYE, class 1 NICs, construction industry scheme and student loan deductions based on the number of late payments in a tax year. Penalties for incorrect returns are dealt with under schedule 55 based on the number of employees with a surcharge if the failure continues for more than three months.
No penalties would be likely to apply if the employer has declared and paid the PAYE/NICs in the periods corresponding to when the earnings arrears were treated as ‘received’ under RTI, as the employer will have complied with the requirements as set down in the Regulations.
However, if the employer subsequently fails to report or pay the PAYE on the arrears on time, penalties may apply under the above provisions.
Employers and advisers should be aware that making payments of arrears will be likely to have a knock-on effect in other areas of the employees’ lives – to the extent that some may question why they received them in the first place. State welfare benefits and tax credits are particularly prominent and in terms of these it is important that the employees understand they need to inform the Department for Work and Pensions and HMRC that they have received a pay arrears award. If their benefits and tax credits are affected, they may find themselves subject to recovery proceedings, fines and penalties. Debt agencies and local authorities may also need to know if an employee received a pay award.
Payments of pay arrears are something of an administrative nuisance. The disparity in treatment between income tax (PAYE) and NICs does little to simplify the tasks which an employer must overcome to correct pay retrospectively.
Unfortunately matters are made even more complicated because there is more than one government department involved due to the mix of legislation covering employment law and tax law. Sometimes this leads to confusion, duplication and certain aspects falling through the gaps between the agencies.
Employers that have to pay arrears of awards should prepare to utilise additional resources to ensure they tread carefully through the maze.