Holiday pay tax and NICs

"Sumer is icumen in," says the old Cuckoo Song, so it is appropriate to have some reminders about the income tax and NICs liabilities on holiday pay. Ian Congreave considers the common and not-so-common situations.

The General Rule

The general rule is clear; holiday pay is subject to both income tax under PAYE and Class 1 NICs. The payment is simply added to gross pay.

The most straightforward situation is for employees who are paid monthly. They just receive their salary each month, take the holiday when agreed, and the number of days taken is monitored outside of the payroll. Alternatively, where the cost of holiday pay for salaried staff is recorded separately in the accounts, the amount of holiday pay due is shown as an addition to pay, and a corresponding deduction is made from the monthly salary. The gross pay thus stays the same.

Weekly Payment Of Holiday Pay In Advance To Employee

Cumulative basis

Another very common arrangement is the payment of holiday pay in advance to weekly-paid employees. The procedure here appears uncomplicated, but there are some potential problems. In its simplest form, on the payday immediately preceding the holiday, an employee receives a week's pay plus the payment for the number of holiday weeks being taken. If, say, payment is made for two holiday weeks, the tax week number is advanced by two weeks and the employee receives three weeks worth of 'free pay'.

For example, on the Thursday payday in tax week 20, an employee is paid £387 pay and £237 for each of two weeks holiday. The whole of the £861 is taxed as if it were week 22. This is a common situation and computerised payroll systems handle it routinely. What may not be so clear, however, is that the NICs are calculated using a procedure that the Revenue calls "Method B".

"Method B" has the same effect as advancing the tax week. The £861 earnings are averaged over the period to which they relate, 3 in our example, and the resulting £287 is used to determine the NICs for one week. Using the 'not contracted-out' rate (10%) and the exact method of calculating NICs, the employee's NICs for one week is £20. This is then multiplied by 3 to give £60 employee NICs for the £861 earnings.

Non-cumulative basis

A different calculation procedure is required if the employee is paid on a non-cumulative Week 1 basis, although the tax week is advanced in just the same way. The payment for each week must be subjected to tax separately, and then added together. Using the figures from the example above, the tax on £387 would be calculated separately, followed by calculations for each of the £237 payments. The NICs is this situation may well be determined using "Method A".

"Method A" also treats the payment for each week separately. The 'not contracted-out' exact calculation would give £30 for the £387 earnings, and £15 for each of the £237 holiday payments, £60 in all, the same total as "Method B". Both "Methods" give similar results unless the earnings in any of the weeks exceed the Upper Earnings Level for NICs, in which case deductions under "Method A" come to a little less than under "Method B".

Limits

There is a limit to how far the tax week may be advanced if the holiday extends over the tax year-end. For example, if a week's pay plus two weeks' holiday pay were paid in week 51, the pay would be taxed as week 51 and the two weeks' holiday taxed as being paid in week 52. In a year with a week 53, with a week's pay and two weeks' holiday paid in week 52, the pay would be treated as week 52 and all of the holiday pay as if it were week 53, i.e. as if it were week 1. Readers with computerised systems may be interested in checking which of the two "Methods" are used to calculated NICs in these situations.

The standard methods for calculating tax and NICs when holiday is paid in advance to weekly-paid employees are fine as long as no payments have to be made to the employee during the holiday period. Once the tax week has been advanced, computerised payrolls normally do not allow any further payments to be made until the tax week following the holiday, e.g. week 23 in the example above.

Complications

Complications arise, however, when it is necessary to make further payments to an employee in one or more of the weeks before the week to which the tax week has been advanced.

For example, what happens if the employee is paid "a week in hand" and the pay for the week immediately preceding the holiday is due to be paid in the first week of the holiday? Or if there is some overtime due to be paid to the employee during the holiday period? Or if, despite receiving the holiday pay, the employee stays at work and wages become due during the holiday period?

Most businesses avoid the problem of the week-in-hand payment by paying the outstanding wages on the payday of the week in which the employee returns to work. But that solution may not be available if other contractual payments fall due during the holiday pay period. The way in which the NICs are calculated for such additional payments depend on which of the two "Methods" was used for calculating NICs on the holiday pay.

- If "Method A" was used, the NICs were calculated for each week separately. Therefore, any further payment for one of those weeks is added to the amount of the holiday pay for that week and NICs are calculated on the new gross pay. The original NICs on the holiday pay are then deducted, leaving an amount of NICs in respect of the new payment.

- If "Method B" was used, the NICs were calculated on the average weekly earnings for all of the weeks paid. Whenever the further payment is made, whether during the holiday period, or after the holiday, NICs are calculated as if it were an entirely new payment.

Effects Of The Rules

The effects of these rules must be clearly understood. If the employer wishes to pay a "week-in-hand" payment, or any other payment that fell due during the holiday, in the week following the employee's return, the payment may only be treated as liable to NICs in that week if "Method B" had been used for the holiday pay. However, if an employee is taxed on a Week 1 basis, "Method A" may have been used to calculate the NICs, in which case the NICs on the further payment must be recalculated retrospectively.

Although "Method A" is more appropriate for Week 1 tax code cases, there is no rule that says it must be used in that situation. The Revenue's instructions (CWG2 page 26) say that either of the two "Methods" may be used to work out NICs. This suggests that there is nothing to stop one method being used instead of the other in any situation, even though it may be different to the tax method of calculation.

The implication from all of this is that "Method A" should be used with caution and, indeed, it is more likely to be used by employers who calculate their payroll manually. Readers should check to see which "Method" their computerised payroll system uses, but it will probably be "Method B" in all cases, even though it not appropriate for Week 1 tax code situations. If only "Method B" is used, there is no problem with handling the NICs on further payments in the week following the employee's holiday.

Worked examples of "Method A" and "Method B" are to be found on pages 27 and 28 of booklet CWG2 Employers Further Guide to PAYE and NICs.