PAYROLL INSIGHT
The payroll treatment of back-pay
Though commonplace for back-pay (arrears of pay) to become payable, the treatment for purposes of income tax under PAYE, for Class 1 NICs and for automatic enrolment differ according to the circumstances . Mike Nicholas outlines the rules
W here wages or salary paid in an earlier period were less than what should have been paid under the terms of the employment agreement, the employer usually calculates the arrears of pay and makes payment in a lump sum. Such arrears may arise where there is a backdated pay increase, or HM Revenue & Customs (HMRC) identifies non-payment of the national minimum wage (NMW) or an award of equal pay occurs. The payroll treatment of such arrears needs to be carefully managed to ensure both compliance with the law and that the employee does not lose out. Income tax and NICs For income tax purposes, arrears of pay are ‘earnings’ within the meaning provided by section 62 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). Note that awards in respect of claims under the Equal Pay Act 2010 are arrears of pay (and thus ‘earnings’) irrespective of whether the employer settles or a Tribunal decides. Some employers mistakenly describe such awards as ‘compensation’
(A slightly different set of rules apply to company directors.) The time when payment of the arrears is made, or when entitlement to them arises, may be in the same or a later tax year to which the arrears refer. For example, in May 2018 an employee is awarded a pay increase backdated to March 2017. The arrears of pay are paid in June 2018. The full amount is treated as taxable in the 2018–19 tax year and PAYE should be operated in June 2018. It can happen that payment of earnings is made after the date the employee was entitled to payment. In that situation the employee is deemed to have been paid on the day they were entitled to be paid. However, if employees have effectively waived their rights to receive earnings before the date when entitlement arises they are not treated as having ‘received’ earnings. The PAYE situation, however, is somewhat different for arrears of pay arising under either NMW legislation – which includes the national living wage – or equal pay legislation. This is because the National Minimum Wage Act 1998
to avoid treating the arrears of pay as earnings. If the arrears of pay arise because of a backdated pay award, the usual ‘earlier of’ rule will apply for pay as you earn (PAYE) purposes. Section 18 ITEPA specifies that general earnings consisting of money are to be treated as received at the earlier of the time when: ● payment is made of or on account of the earnings (Rule 1), or ● a person becomes entitled to payment of or on account of the earnings (Rule 2). When a person becomes entitled to payment of earnings is not necessarily the same as the date on which an employee acquires a right to be paid. ...subject to income tax in the tax years when the employee was entitled to the earnings...
| Professional in Payroll, Pensions and Reward | November 2017 | Issue 35 20
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