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If you agree with an employee to pay all or part of their earnings on a 'free of tax' (FOT) basis, you will have to follow special procedures for working out the PAYE tax and National Insurance contributions (NICs) that you will need to pay to HM Revenue & Customs (HMRC).
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Paying an employee on a free of tax basis, means committing to paying them a certain amount of take-home pay. For example, you might agree to pay an employee £1,000 free of tax each month. This means that regardless of changes to the allowances, rates or thresholds that apply to PAYE tax and NICs, your employee will receive the sum of £1,000 each month.
You must ensure that all tax and NICs liabilities are paid. And it is important to note that these PAYE tax and NICs liabilities are not calculated on the basis of the net sum received by the employee, but on the 'true gross pay' represented by that sum. This is explained below.
If you make a 'cash in hand' payment to an employee it also counts as a free of tax payment, so the rules outlined in this guide also apply to it.
If you agree with an employee that part or all of their earnings will be paid free of both PAYE tax and NICs, you should contact HMRC's Employer Helpline for advice.
Find contact details for HMRC's Employer Helpline
If you agree to pay an employee free of tax only, the procedures to follow depend on whether you pay all or part of their earnings in this way.
Unfortunately you can't use the P11 Calculator in HMRC's Basic PAYE Tools package to work out and record free of tax payments. You'll need to do it manually, unless you use commercial payroll software with the necessary functionality.
If you will be paying all of an employee's earnings on a free of tax basis, you must contact your HMRC office. They'll send you a pack containing everything you need to calculate and record PAYE tax and NICs deductions on free of tax payments.
The pack includes a special deductions working sheet - form P11 (FOT) - special tax tables and a leaflet explaining how to calculate true gross pay and complete form P11 (FOT).
If you pay some but not all of an employee's earnings free of tax, you should still record their earnings on a standard form P11. The gross pay figure to enter on form P11 to calculate the PAYE tax and NICs due on the payment is the total of the following two amounts:
You can calculate the true gross pay of the free of tax element using the following steps:
You can find a worked-through example of one of these calculations on page 23 of HMRC's publication CWG2, 'Employer Further Guide to PAYE and NICs' - there's a link to it at the bottom of this guide.
More about completing a paper form P11
If you enter into a free of tax arrangement with an employee it is your responsibility to ensure that the employee understands and agrees to the terms of the agreement.
You must also confirm on your Employer Annual Return that you have made a free of tax payment to an employee.
Download CWG2, 'Employer Further Guide to PAYE and NICs' (PDF 490K)
