On 2 July 2017 HMRC launched the new system of dynamic coding. Sarah Bradford explains what this means for taxpayers, with two worked examples.
PAYE tax codes are becoming more refined. Under the system of dynamic coding, potential underpayments are replaced with in-year adjustments (IYAs). The tax codes are adjusted in-year to reflect changes in an employee’s circumstances as soon as HMRC becomes aware of the change. This is the ‘trigger point’ (see below). In the past, the potential underpayment was reflected in the tax code for the following tax year – under dynamic coding, the code is changed in the same tax year.
What is estimated pay?
The concept of ‘estimated pay’ is fundamental to this new system. Estimated pay is used to perform the coding calculation in order to arrive at the new tax code. Essentially, estimated pay is annualised year to date pay.
A weekly paid employee has year to date pay of £8,000.
This is equivalent to average weekly pay of £400 per week (YTD pay at week 20 of £8000) and annual pay of £20,800 (52 x £400).
Estimated pay for the purposes of the coding calculation is therefore £20,800.
The same procedure is used for monthly paid employees, but based on average monthly income. The calculation is performed on a daily basis if the employee starts part way through the year.
The PAYE code will only be amended if there is a trigger to tell HMRC that the employee’s circumstances have changed. This may be the individual amending his or her personal tax account, or the employer telling HMRC that something has changed, for example via payroll reports or the P46(car). Kate Upcraft explored the possible trigger points in her article HMRC unlocks the mystery of PAYE codes.
As we go forward, the FPS will increasingly be used as a means to notify changes to HMRC, and HMRC will also make more use of third party information.
Changing the code
Once a trigger event has occurred, dynamic coding will kick in and a new tax code will be calculated. This is best illustrated by an example:
HMRC becomes aware on 31 October 2017 that Harry has been provided with a company car since the start of the 2017/18 tax year. The car has a cash equivalent value of £5,000.
Harry is paid monthly and the FPS at that date (month 7) shows year to date pay of £14,583.33 and YTD tax of £1,573.80. Harry has had a tax code of 1150L.
Harry’s estimated pay for the year is £25,000 (12 x (£14,583.33 / 7)).
The dynamic pay calculator calculates Harry has underpaid tax at that date by £583.33 ((£5,000 @ 20%) x 7/12). This is the year to date tax on the car benefit.
As Harry is a basic rate taxpayer, this is equivalent to tax at 20% on income of £2,917 (£583.33 x 100/20).
The underpayment has to be collected over the remainder of the tax year, i.e. 157 days (1 November 2017 to 5 April 2018). The in year adjustment (IYA) produces an income figure of £6,781 (£2,917 x 365/157).
The amended tax code, which now includes the car benefit and the IYA is 27K, which is applied on a month 1 basis.
Personal allowance £11,500
Less: car (£5,000)
Less: IYA (£6,781)
Applying the new code of 27K on a month 1 basis you get the following tax deduction:
Added pay for code K27 = £23.25
Monthly pay £2083.33 + 23.25 = taxable pay: £2106.58
Tax due at 20% x £2106.58 = £421.31
The tax due for the year is £3,700 = (20% ((£25,000 pay + £5,000 car) - £11,500 allowance)).
This is achieved by the following deductions under PAYE:
Months 1 to 7 (per FPS) £1,573.80
Months 8 to 12 (5 x £421.31) £2,106.55
Due to rounding there is a slight underpayment of less than £20.
Bonuses, particularly if paid early in the year, can cause problems as estimated pay may be considerably higher than actual pay. The estimated pay calculation assumes that pay accrues evenly throughout the year, and where a bonus has been paid, average weekly or monthly pay will be higher than normal. The estimated pay calculation is only performed when there is a trigger event – it is not revised each month following submission of the FPS.
Further, there needs to be a trigger event for the PAYE code to be revised. This may depend on the individuals updating their personal tax account which, although this is something that HMRC encourages, many individuals will not due.
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Sarah Bradford BA (Hons) FCA CTA (Fellow) is the director of Writetax Ltd (www.writetax.co.uk) and its sister company, Writetax Consultancy Services Ltd. She writes widely on tax and National Insurance contributions and is the author of National Insurance Contributions 2020/21 published by...