PAYE for special types of pay
In this section:
- Paying an employee on a 'free of tax' basis
- Tips, gratuities and service charges and PAYE
- PAYE for shares and other non-cash payments
- Incentive awards and PAYE
- Holiday pay and PAYE
Paying an employee on a 'free of tax' basis
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 (Pay As You Earn) tax and National Insurance contributions (NICs) owed to us.
Free of tax payments and true gross pay
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.
It is your responsibility to ensure that all the associated 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.
Making payments that are free of both PAYE tax and NICs
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 us for advice. We will let you know how to proceed.
The number to use is our Employer Helpline on Tel 08457 143 143. This is open from 8.00 am to 8.00 pm, Monday to Friday and 8.00 am to 5.00 pm on Saturday and Sunday.
Making payments that are free of PAYE tax but not of NICs
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 integrated P11 Calculator on our Employer CD-Rom 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.
All of an employee's earnings paid free of tax
If you will be paying all of an employee's earnings on a free of tax basis, contact the Employer Helpline for a pack we have put together containing everything you need to calculate and record PAYE tax and NICs deductions on free of tax payments.
This 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.
Part of an employee's earnings paid free of tax
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:
- the 'true gross pay' of the free of tax element of the earnings
- the actual gross pay of the part of the earnings that haven't been paid free of tax
You can calculate the true gross pay of the free of tax element using the following steps:
- Multiply the free of tax pay by 100
- Subtract the employee's tax rate figure (this is 20 or 40) from 100
- Divide the answer to (1) by the answer to (2)
You can find a worked-through example of one of these calculations on page 23 of our publication 'Employer Further Guide to PAYE and NICs' (CWG2) - there's a link to it at the bottom of this guide.
More about completing a paper form P11
Other responsibilities if you make 'free of tax' payments
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 record on form P35 in your Employer Annual Return that you have made a free of tax payment to an employee. You do this in Question 2 of Section 3.
More about completing form P35
Read our publication 'Employer Further Guide to PAYE and NICs' (CWG2) (PDF 462K)
