What is PAYE and How Does it Work?

If your business has expanded to the point where you’re thinking about hiring someone, it’s important to do some research about payroll – if there’s one thing small businesses are notorious for, it’s payroll errors, so it’s best to avoid them as much as possible. Payroll can get complicated quickly, and employment law in many countries will require you to deduct income tax using a PAYE, or Pay As You Earn, system. If you’ve never heard the term before, here’s a brief intro to how it works and what it means for your business.

1. What is PAYE?
2. How PAYE Works
3. Exemptions from PAYE
4. Reporting to your Tax Authority

What is PAYE?

A pay as you earn system is a method of paying income tax in which the employer deducts the income tax from an employee’s pay each pay period, and remits it to the government on their behalf. You may have noticed these deductions on pay slips from past jobs you’ve held; it’s a way for the employee to pay income tax throughout the year, rather than in one lump sum when taxes are assessed. However, it is your responsibility as the employer to deduct the taxes accurately and pay them on time, even though it’s the employee’s taxes which are being paid.

Many countries use the PAYE system, including the UK, South Africa, New Zealand, and Australia. North America has similar systems in place as well, but they all have slight differences. It’s often a good idea to seek help with payroll taxes until you gain confidence in your knowledge of payroll law, but it’s also a good idea to make sure you’re familiar with the process so you’ll be able to spot any issues that arise.

How PAYE Works

When it’s time to take on an employee, you’ll have to register as an employer with the government. In the UK, you will need your employee’s national insurance number and their tax code, which will determine how much you should deduct from their wages. PAYE can also include other deductions such as benefit plans, insurance offered by the employer, and student loan payments on top of federal taxes.

In the UK, if the tax office doesn’t have enough information to assess deductions for the entire year, they may give you an emergency tax code which only uses the basic personal allowance as the basis for how much tax to deduct. Once you get a proper PAYE code, you will be able to make necessary adjustments, including paying the employee back for overpaid tax or deducting additional tax, depending on the circumstances. If your employee suspects they have overpaid taxes over the year, they can file a return to claim the money back – however, its best to be as accurate as possible, since large tax refunds will reflect badly on your ability accurately handle payroll.

You’ll also need to generate a pay slip each time you pay an employee as an official record of wages earned and deductions subtracted from those wages – so the pay slip should have the employee’s gross income, a list of deductions, and their net income (take home pay). Pay slips are important records for both the employee and the employer, and you will need them if your business gets audited.

Exemptions from PAYE

PAYE deductions need to be made from all income, including things such as bonuses, maternity leave, and sick leave payments, but it’s important to note that there are some times when you won’t need to deduct tax. This will vary by country, but usually there is a specific amount of money a person must earn annually before they can be taxed – for example, in the
UK, someone can earn up to £12,500 of tax-free income as of 2019 before they must pay taxes. This number changes every year and can vary with individual circumstances – married people and those with disabilities may be entitled to more tax-free income, so it’s important to assess this on an individual basis. In Canada, indigenous people who work on a reserve do not have to pay taxes, but income earned off the reserve is taxed.

Independent contractors and freelancers you hire aren’t technically your employees, and will need to take care of their own taxes – so there is no need to deduct taxes from their invoices, even if they do work for you on a regular basis. If you’re unsure, however, make sure to do a little research online to figure out whether or not the person in question qualifies as an independent contractor or freelancer, since this definition can get murky. If you hire someone as a contractor but have the same expectations of them as you would for an employee, you may be misclassifying them, putting yourself at risk for tax penalties later on.

Reporting to your Tax Authority

All employers in the UK must report employee incomes and witholding amounts to the UK Revenue Authority as they occur – on or before each payday. You will need to calculate how much tax and national insurance you owe each month, and pay these taxes monthly or quarterly if you are a small business.

Employers also must report changes in an employee’s circumstances which may affect their taxable income – if an employee gets married, for example, or if they develop a disability, you’ll have to update your records to reflect this. Make sure you or your HR department checks in with longer term employees periodically to update this information. Usually incorporating this check up as part of their annual performance review is a good idea, so all of their information remains up to date.

Conclusion

Even if you get help with payroll to start with, it’s your responsibility as the employer to make sure the correct taxes have been deducted and remitted the tax authority, and all PAYE records have been kept in the event of an audit. If you’re tackling payroll yourself, it’s important to get a good handle on what you are doing up front to avoid complicated tax issues later. Managing payroll properly is the first step towards managing employees properly, and it’s the first one you should take before a new hire walks through your door.