In order to appreciate the solution, we must first understand the problem. Many businesses use the services of individuals who are treated as self-employed. They also have employees. The key difference is that in the case of an employee, the business is responsible for operating the Pay As You Earn (PAYE) system to deduct tax and national insurance contributions from the wages paid to the employee.
The employer also has to pay employer’s national insurance contributions. The amounts deducted are paid over to HMRC on a monthly basis, on the 19th day of the following month, so for the April 2008 tax month (which, confusingly, ends on 5 May 2008), the tax and national insurance have to be paid over by 19 May 2008.
In the case of self-employed individuals, the position is much simpler. The individual presents his invoice for work done and this is paid with no deductions for tax. The individual is responsible for declaring his income and paying tax (and national insurance) on it through the self-assessment system of annual tax returns.
The problem comes when an individual has been treated as self-employed when he should have been paid under deduction of tax as an employee. This can happen for a number of more or less respectable reasons, ranging from the “employer” trying to dodge his responsibilities under employment legislation to a genuine misunderstanding of the situation.
In most cases, this comes to light during an “Employer Compliance Review” by HMRC, and the usual policy is to expect the employer to make good the tax and NIC that should have been deducted from the payments made, typically for the last six years if the individual has been “employed” for that long.
It gets worse. Because tax should have been deducted from the payments made to the individual concerned, HMRC take the view that the amounts paid to him were net of income tax (for the sake of clarity, we will ignore the NIC situation for the rest of this article, as the important change relates to income tax).
This means that for every £100 paid to an individual liable to income tax at the basic rate, the tax due is not £22 (being the 2007/08 basic rate of 22% on £100). Instead, it is £28, because £100 net of basic rate tax is equivalent to £128 gross. £128 times 22% is £28.
In the case of an individual paying tax at 40%, the tax due on a net payment of £100 after this “grossing-up” procedure is a stonking £67.
Of course, the missing piece of the jigsaw is the tax the individual has already paid through his self assessment returns. In the past, provided the “employee” agreed, this tax could be informally offset against the PAYE tax due from the employer. This would not cover the whole liability, of course, precisely because the individual concerned was paying tax on the net sum received (£100 in our example, so £22 or £40 depending on the rate of tax he paid), but it did go some way towards softening the blow for the employer.
Then came the case of Demibourne v Revenue and Customs Commissioners, which highlighted the fact that HMRC did not in fact have the power to do this offsetting. Instead, the employer had to pay the tax in full, and the “employee” got a nice hefty repayment of all the tax he had paid under self assessment for the same period. Apart from being unfair, particularly in cases where both sides had been perfectly happy with the “self-employed” arrangement, this also provided a very strong incentive for those workers whose status was being reviewed by HMRC to agree that they were in fact employees.
The PAYE regulations have now been amended so that in cases where settlements are being agreed after 5th April 2008, including those involving earlier years, HMRC now do have the power to offset the “self-employed” tax paid by the individual against the employer’s liability.
This is good news for employers, though it does not mean they can relax about the question of whether a particular worker is self-employed or an employee. A PAYE settlement will still be an expensive experience, for the reasons described above, even though the new regulations mean that at least some of the tax will have already been paid by the employee.
James Bailey
