The tax law relating to employment income is contained in the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003).
Employment income consists of general earnings and specific employment income. An ‘employment’ in this context includes any employment under a contract of services as well as apprenticeships and services for the Crown. Employments also cover ‘office holders’ such as directors.
The distinction between general earnings and specific employment income is important for people who are not resident, or not ordinarily resident, or not domiciled in the United Kingdom for tax purposes. There are special tax rules which apply to general earnings but do not apply to specific employment income.
For tax purposes, general earnings means payments made to the employee as a reward for services rendered. It consists of remuneration paid in normal monetary form (cash) as well as certain non-monetary rewards such as taxable benefits.
Specific employment income includes payments and benefits on termination of employment, payments and benefits in respect of non-approved pension schemes and share related income (share options).
For a payment to be treated as being from employment it must be made in return for services (past, present or future). There is a significant body of case law to determine the existence of an emolument of an employment.
In Hamblett v Godfrey (1987) the courts disagreed that the compensation paid by the employer to the employee for agreeing to give up her rights to join a trade union was not an emolument. It was decided that the right to join a trade union was part of being an employee and it was closely linked to the employer-employee relationship so it has to be treated as an emolument.
Another interesting case is Shilton v Wilmshurst (1991) where the footballer Peter Shilton was transferred from one football club to another. The ‘old employer’ paid Mr Shilton to agree the transfer. The courts decided that the income was an inducement to remain or become an employee and it was not a termination payment (payment being tax free up to £30,000), so the full amount was taxable.
Another controversial issue when it comes to employment is to decide whether someone is employed or self-employed, because if an employer wrongly treats an employee as self-employed, the employer is liable for the PAYE and NIC with limited rights to recover the cost from the employee.
The tax legislation itself does not tell us whether a worker is employed or self-employed so the distinction between the two is based on case law and HMRC practice. The most common tests used to determine employment status is the MICE test:
Other criteria that HMRC might apply in determining the employment status are the number of paymasters or the degree of financial risk taken by the worker.
Three of the leading cases on this area are:
Most agency workers are required to be treated as employees. The agency is usually responsible for the operation of PAYE; the client is only responsible if the payment is directly to the worker.
HMRC detected an increase in the number of individuals who were providing employment services through the medium of an intermediary company in order to avoid PAYE and NI. Special rules known as the IR35 rules were introduced with effect from 6 April 2000.
The legislation will only apply in situations where the worker would be treated as an employee of the client if the intermediary company did not exist. All employers have to state now in their annual P35 form whether or not the IR35 rules apply to any workers on the return.
Managed service companies (MSC) are service companies that are IR35 compliant but manage to avoid PAYE and NI in a different way. A MSC is managed by a scheme provider and has the structure of a company. The contractors are non-director shareholders of the company. The MSC pays the contractor a low salary plus dividends on his share. From 6 April 2007 the government introduced legislation relating to MSCs. The consequence of this legislation is that MSCs will treat all payments received by workers providing their services through such companies as income subject to PAYE and NIC.
Benefits means non-cash remuneration and many employees receive them as part of a remuneration package. Some of the benefits are taxable and some are not.
ACCA provides guidance notes (which can be customised and sent to clients) dealing with the tax treatment of certain benefits in kind. The guides are free to use by members.
All employees are taxable on: cash vouchers, non-cash vouchers, credit tokens and living accommodation. All other benefits only arise on employees paid over £8,500pa, or directors where a benefit is provided to the employee or a relative or a member of his household by reason of his employment. The general rule is that employees paid under £8,500pa are assessable on the second hand value of the benefit but directors and employees paid over £8,500pa are assessable on the cost to the employer of providing the benefit.
Guidance on how to measure the benefit is given in section s204 ITEPA 2003 being ‘the expense incurred in or in connection with the provision of the benefit’.
The House of Lords in Pepper v Hart decided that the marginal cost method as opposed to the average cost method should be used to identify the cost to the employer of providing the benefit.
As a result of the above decision, where an employee is using goods and services manufactured or provided by the employer, the marginal cost is effectively zero so that gives rise to a nil taxable benefit.
Some of the most familiar tax exempt benefits are:
Under normal circumstances, expenses reimbursed to an employee will be treated as earnings and entered on form P11D. The employee will then claim the relief under S337 via the self-assessment tax return.
A dispensation is a notice provided by HMRC to an employer agreeing that certain genuine business expenses reimbursed by the employer to the employee should not be included on a P11D form. Employers must apply to their local tax office for a particular type of expense to be included on a dispensation; any items not covered (or not approved by HMRC) must be reflected on the P11D.
PSAs are used by employers to settle the tax (on behalf of an employee) on minor or irregular benefits or where it would be impractical to apply PAYE. PSAs should not be used for settling the tax liability on major benefits such as company cars or low interest loans. If tax on a particular benefit is included on a PSA, that benefit does not then have to be entered on the P11D. Once HMRC agrees the items included on a PSA they will negotiate the tax and NIC liability with the employer and the employer will pay the tax on a grossed up basis.
Employees on secondment to the UK
An employee who attends a temporary workplace for a period of up to 24 months can obtain relief for the cost of travel to and from that workplace. The amount of relief may include the cost of accommodation and subsistence attributable to attendance at that workplace.
In some cases there may be a change in circumstances that leads to a change in the expected length of the secondment. The workplace will be a temporary workplace during any time in which the reasonable expectation is that the secondment will be for a period that does not exceed 24 months. The workplace ceased to be a temporary workplace from the time the employee breaches the 24 months rule or, if earlier, from the time he becomes aware that the secondment is likely to exceed 24 months.
Tax equalisation takes various forms and is therefore difficult to define precisely. The term is generally used to describe the arrangement between an employer and a foreign national employee who comes to work in the UK. This usually means that the employer undertakes to meet on the employee's behalf any additional tax payable above the tax that the employee would have paid in his home country.
The tax treatment follows section 25 and 27 of ITEPA 2003.
An employee resident but not ordinarily resident in the UK is chargeable to UK tax on earnings in respect of duties performed in the UK (UK-based earnings). Foreign earnings are taxed to the extent that they are remitted to the UK.
Where the duties of a single employment are performed both in and outside the UK, an apportionment is required to determine how much of the earnings are attributable to UK duties and therefore liable to tax as UK-based earnings (section 25) and how much of the earnings are attributable to non UK duties and therefore taxable on remittance basis (section 26). HMRC accepts time apportionment based on the number of days worked abroad as an acceptable apportionment basis, except where this would clearly be inappropriate.
In addition to salaries and benefits, employers may also provide their employees with the benefit of tax equalisation (payment of extra tax due by the employee for the reason of being present in a foreign country). That payment will itself represent earnings wholly chargeable to UK tax.
If an employer reimburses the personal tax liability arising on non employment income such as bank interest, dividends or capital gains, then those payments are treated as earnings and apportioned based on the time spent in the UK.
Therefore there can be significant practical difficulties in identifying whether earnings relate solely to UK or non-UK duties. In most cases, HMRC would not generally dispute time apportionment on the basis of working days. If any earnings were allocated solely to non-UK duties, evidence should be available to justify the attribution in the event of an HMRC enquiry.
Some tax-equalised employees are not resident in the UK. They may perform substantive duties of their employment in this country. Unless the specific terms of a double taxation agreement confer an exemption from UK tax on UK source employment income, such employees will be liable to UK tax on earnings in respect of duties performed in the UK. Earnings for duties performed outside the UK will fall outside of the charge to UK tax on employment income. HMRC adopts the same approach to tax equalisation for non-resident employees as for those resident but not ordinarily resident.
Our website provides more guidance on IR35, Disguised Remuneration, Employment Manual update, Benefits in Kind as well as information on case law.