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When are tips taxable?

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11th Sep 2015
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With the news of big chain restaurants deducting an admin fee from staff's tips, Stuart Masters investigates whether the Treasury takes its share as well. 

You may be surprised to learn complex rules are in place to collect income tax and national insurance contributions (NIC) from tips you pay.  The relevant legislation dealing with the taxation of tips is contained within The Income Tax (Pay As You Earn) Regulations 2003.

Many entrepreneurs new to the hospitality sector may assume income tax and NIC are not payable on tips their staff receive. However this is a costly assumption when HMRC investigates your business for underpayment of income tax and NIC relating to tips for the government’s official guidelines on the taxation of tips.

Service charges

A ‘service charge’ is a compulsory charge over the price of goods or services.  A service charge is added to the bill before being presented to the customer.  In contrast, tips are classed as ‘uncalled for and spontaneous payments offered by a customer either in cash, as part of a cheque payment, or as a specific gratuity on a credit/debit card payment.’

If an employee receives a percentage of the service charge in his or her wages, the employer must always deduct PAYE and NIC on these earnings without exception. Unlike tips, employers must also charge VAT on service charges when their business is registered for VAT.

Introducing the ‘tronc’ system

Staff may have agreed to place all tip earnings into a pot know as a 'tronc.' The word ‘tronc’ is French for 'collection box'.  Tips placed in a tronc are later redistributed amongst staff members according to an agreed ratio.  The person who administers this system is known as a 'troncmaster'.  The troncmaster is typically a member of staff but never a director or business owner.

HMRC defines a troncmaster as 'a person, other than the employer, responsible for arrangements to share tips amongst employees.'  Since the employer does not directly handle this money, tip earnings are not subject to NIC.  However, employees in receipt of tips via a tronc are still liable to pay income tax on these earnings.  The tronc must be formally registered with HMRC. The employer is under duty to tell HMRC of the existence of a tronc. PAYE is then set up in the troncmaster's name. The troncmaster is personally liable for failing to comply with HMRC rules.  However, the troncmaster may use his or her employer's payroll to operate PAYE on tips.  

If the tronc is administered by the employer, the employer must also deduct PAYE tax and NIC on tip earnings. To avoid this responsibility, the employer must not influence in any shape or form how the tronc is administered.

If an employer permits the use of a tronc but wishes to avoid the onus of NIC deductions, they are well advised to obtain written instructions from their employees on how the tronc is to be distributed amongst them.

HMRC rules on tronc payments

In order avoid NIC on tips, the amount paid to an employee by way of tronc must be 'of a gratuity' or 'in respect of a gratuity'.   HMRC says two conditions must be met in order to meet this requirement:

  • The troncmaster is allocating money that originally was not paid to the employer and the employer does not pay the money directly or indirectly to their employees
  • The employer does not determine, directly or indirectly, the allocation of those tips

The slightest involvement on the employer’s behalf will thus likely expose tronc payments to NIC.

Tips collected and then paid by the employer

Many customers prefer to pay for goods and services using their credit or debit card.  Restaurants also allow their customers the ability to pay tips by means other than using cash.  At the end of the month the restaurant will add tip earnings to their employees’ wages.

In this situation HMRC requires employers to deduct both PAYE and NIC from these earnings.    This is the case even where these earnings are not formally processed through the employer’s payroll system e.g. where an employer collects cash tips and distributes these earnings to back-of-house and kitchen staff.

Tips paid direct to employees

When tips are paid directly to staff (i.e. 'left on the table'), then each employee must separately declare these earnings to HMRC.  HMRC deals with these payments by making an adjustment to the employee's tax code.  Since the employer does not administer these earnings they will not attract NIC provided two conditions are met.

  • Tips are not paid, directly or indirectly, to the employee by the employer and does not comprise or represent monies previously paid to the employer, for example, by customers
  • Tips are not allocated, directly or indirectly, to the employee by the employer PAYE does not apply

The following flow chart explains when exactly tips are and are not subject to NIC:

Stuart Masters has spent almost 20 years in accounting with a significant amount of time focused on Outsourcing and the provision of bookkeeping and financial management information for businesses. He is the managing director of The Financial Management Centre

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By Peter Davies
21st Sep 2015 13:44

Some errors in this article I'm afraid

I'm afraid there are a number of serious mistakes in this article - as someone who specialises in these issues (and many years ago wrote a large part of HMRC's E24 booklet) I see a lot of incorrect information out there. Apologies to the author but this is a very misleading article.

 

If a service charge is genuinely discretionary and advertised to the consumer as such (or optional, voluntary or suggested), and it is separate to the cost of supply - i.e. shown as a  separate line item on the bill, - it is outside of the scope of VAT and should not be included as part of a business's turnover for VAT. The service charge is not subject to VAT. This is regardless of what the business subsequently chooses to do with the proceeds.

 

Secondly, it isn't down to staff to decide if a tronc system is set up or not. Proceeds of service charges and gratuities paid as part of a non-cash transaction are the legal property of the business (confirmed by both UK domestic courts and the European Court of Human Rights) and it the employer's prerogative whether to have a tronc or not and, if so, what proportion of the funds paid by customers will form the tronc.

 

Employers are not automatically required to register a tronc with HMRC or notify them of its existence. This obligation only exists if a business passes tronc funds to the troncmaster (either in cash or by transfer to a separate bank account under the troncmaster's control) and they are responsible for making payment to the employee. If a business makes payments to employees from its own funds under instruction from the troncmaster then the employer will be responsible for the deduction of PAYE via its own payroll and reported to HMRC via RTI as a part of their existing submission. Provided the conditions for exemption are satisfied this would be an NIC-free payment to the employee; the NI status is not compromised merely by the physical payment and operation of PAYE being dealt with via the employer.

 

There are indeed two conditions as set out. But they are "either/or" conditions; an employer needs only to satisfy one of them to meet the exemption from NI. So it is wrong to say that "the slightest involvement from the employer" will expose the payments to NI. The employer must not control the tronc or enter into contractual arrangements covering any payments from the tronc. Just because a tip is paid to an employer as part of a card payment does not automatically make it subject to NI.

 

It's no wonder that there is so much confusion ad uncertainty among the business community on these issues.

 

Peter Davies

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