The future of PAYE: How the 66-year-old tax system is changing

Real-time information could spell the end of troublesome year-end tax reckonings

The grind of the year-end tax reckoning looks set to be consigned to the dustbin of history under a proposed overhaul of pay-as-you-earn (PAYE) - a revamp the taxman reckons will ease the burden of administering payroll and save UK employers hundreds of millions of pounds a year to boot.

According to HM Revenue & Customs, some 40 million people are currently taxed via PAYE, and it calculates the operating costs for private sector employers and pension providers of PAYE now stand at £0.7bn per year.

The UK's system for income tax filing, which began operating during the Second World War, requires employers to calculate and deduct tax and National Insurance contributions from employees' wages on behalf of HMRC - typically sending the resulting deductions to HMRC once per year.

HMRC is consulting on changes to PAYE that could make it easier for employers to calculate tax deductions
(Photo credit: ansik via Flickr.com under the following Creative Commons licence)

HMRC is now planning to update the process, which still involves year-end tax reckonings and paper forms such as the P45, with the introduction of a modern software system called Real Time Information (RTI).

Keeping pace with the changing workforce
Although HMRC says the vast majority of individuals are still taxed correctly via PAYE, it admits the current system has failed to keep pace with the UK's changing workforce where concurrent employments, frequent job moves, multiple income sources and diverse taxable benefits are increasingly common - a workforce that RTI is aimed at better accomodating.

Under RTI, the finance department will send payment data to HMRC every time an employee is paid rather than once a year. While the introduction of RTI will see payment data be sent to HMRC more frequently than under PAYE, the trade-off will be worth it, according to HMRC: it calculates employers' PAYE admin costs will be reduced by an estimated £360m per year.

"[RTI] will collect information from employers about the deductions they make under PAYE at the time at which they pay their employees," an HMRC consultation document (PDF) published earlier this month says. "Obtaining this information at the time payment is made, instead of annually, will allow improvements to be made to PAYE, reducing the administrative costs of PAYE for employers and HMRC.

"It will enable reductions in fraud, error and overpayments in the current benefits and tax credits system. It will also increase the number of individuals who are taxed correctly through PAYE."

Full details of how RTI will work in practice are...

...yet to be finalised as the consultation process is ongoing - there is a February 2011 deadline for industry responses to HMRC's consultation document. In the meantime, CFOs and finance directors should keep a watching brief on PAYE developments, industry experts advise, and ensure they fully engage with the consultation process.

"Be vigilant and keep up to date on news," Elaine Gibson, senior policy officer and manager of postgraduate qualifications at the Institute of Payroll Professionals (IPP), said. "It's such a major change that [finance chiefs] need to have read and digested things like the [consultation document] so they at least know what the key points are... so they understand why government are saying and proposing what they are, and they're able to respond accordingly."

Talk to your payroll provider
According to HMRC's consultation, the change to RTI will require payroll programs to be updated by rewriting the parts of the software that submit payment instructions in order to implement a common standard for the exchange of information. CFOs should therefore ensure their payroll software provider is aware of the looming change and has an update schedule in place.

"[CFOs] really need to keep an eye on it - take an enlightened interest," says John Whiting, tax policy director at the Chartered Institute of Taxation (CIOT). "Their reaction may be 'all we need to do is just leave it and our payroll software suppliers will sort it'. Yes but, either themselves or through the various industry bodies, they need to make sure their views are heard and concerns are expressed."

PAYE remains a paper process at heart - HMRC's plan to introduce real-time information is set to change that
(Photo credit: mrmanc via Flickr.com under the following Creative Commons licence)

Norman Green, chair of the British Computer Society's payroll group, also recommends that finance chiefs should ensure their department checks the organisation's payroll software provider is keeping abreast of developments and will be able to rise to the upgrade challenge - as "any reputable payroll software will".

Organisations using their own in-house software for running payroll should take an even closer interest in PAYE developments, he added, as they will be responsible for making the updates themselves.

Finance departments will also have to review their payroll processes to fit the new system, according to HMRC, but should only need to spend a small amount of extra time dealing with the additional reporting.

"For RTI to work, employers will need to...

...make some changes to their current payroll processes," HMRC's consultation document says. "By embedding the new reporting processes into the regular pay run, when deductions are calculated and recorded, the additional time that the employer needs to spend on reporting to HMRC should be marginal.

"This would be particularly so where payroll software is used and the software deals with reporting as an integral part of the payroll run. Once the RTI system has bedded in, and employers have successfully switched to the new system, they would no longer have to submit P14/P35 end of year returns to HMRC and the procedures for joiners and leavers would be simplified. P11Ds (Benefits in Kind) would remain."

The change could benefit organisations, according to Richard Baron, head of taxation at the Institute of Directors (IoD). "RTI has the potential to be pretty useful because you wouldn't necessarily have to bother with P45s and P46s anymore. The new employee would just show up on your payroll file that month and the Revenue's computer would automatically clock them," he said.

As for the procedural switch, the IPP's Gibson reckons the average finance department will easily take it in its stride. "RTI is pretty much how we do things now except that HMRC will be able to see data in-year more frequently than currently," she says. "A lot of your larger employers are going to be producing monthly returns internally within their organisations anyway... so the only difference is they're not submitting data to HMRC, it's just kept in-house for the records."

Proposed changes to PAYE could mean the end of P45 forms
(Photo credit: Shutterstock)

"When I was a hands-on payroll manager, I used to religiously balance my payroll every month [anyway] because if you found an error in that month, it was so much easier to find and correct than it was at the end of a tax year," Gibson added.

To Bacs or not to Bacs
The main channel that HMRC is proposing employers use to send it RTI data is the electronic payments system Bacs, sending payment data alongside their regular payment instructions to minimise the extra legwork created by the new system.

According to the BCS' Green, around five per cent of UK workers don't get paid via Bacs, however. "There are some end users who will just not use the banking system in that way at all - they might still pay cash. If you only employ two or three people why would you bother? Once you know what net pay is, you can write them a cheque or give them cash... those people will be outside Bacs."

The consultation document says that smaller employers - those with under 50 staff - who do not use Bacs will initially be able to submit RTI through the government's web portal, the Government Gateway. However, HMRC is consulting on...

...whether all payments should be made electronically via Bacs in future - an issue SMEs need to factor into their future payroll plans.

The introduction of RTI
HMRC has set a completion date for delivering RTI of April 2014. It's proposing IT infrastructure be in place by April 2012, and is currently in the process of developing a high level specification for software developers.

The CIOT's Whiting describes the RTI timeframe as "challenging", saying: "That is only 15 months away. We're talking about major system overhaul."

PAYE: Payment data will have to be sent to HMRC at the point of payment
(Photo credit: Shutterstock)

The IPP's Gibson's major concern over the looming shift to real-time information is that HMRC's systems are robust enough to cope - and that it builds in enough time for new processes to be thoroughly tested and to allow payroll software providers to make the necessary updates before any national policy rollout.

"With any computerised system when changes are made there are bound to be hiccups - it doesn't matter how large or small the organisation is. The problem is with the HMRC, because they're a national organisation and provide a service for the whole of the UK, when something goes wrong the impact's huge because it affects a lot of people," she said.

In recent years HMRC has overhauled PAYE's backend - since 2009 it has been streamlining record keeping by consolidating 12 customer databases into a single database, called the National Insurance and PAYE Service (NPS), that contains one record for each individual holding all their PAYE details.

"Some of the issues that have come out of the NPS system have really caused tremendous problems for employers so that would be the concern," said Gibson, "that the consultation period and development phase is long enough to enable robust testing in live environments to ensure that when this is rolled out nationally most of the major things that can go wrong have been identified."

In an earlier proposal for evolving PAYE, HMRC had included a second phase - known as centralising deductions (CDs) - in which it also proposed acting as the payroll function, by receiving gross pay, making deductions and sending net wages on to the employee. However CDs have not been included in HMRC's consultation document or its business plan, and so appear to have been shelved indefinitely.

Stepping away from CDs is a welcome move, according to the IoD's Baron, who dubbed the plan for HMRC to pay wages "an absolute disaster".

"You can't trust the government with our gross pay," he said. "Sooner or later it would go wrong and none of us would get paid."