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Question 2 in Part 3 of the P35 Employer Annual Return asks:
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"Did you make any 'free of tax' payments to an employee? In other words, did you bear any of the tax yourself rather than deduct it from the employee?"
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The question is not clearly worded and many employers would not understand its significance. The only explanation given, on page 19 of the E10(2005) booklet is equally vague, stating: "A free of tax payment is a payment where the employer (rather than the employee) bears any tax due."
Payments made "free of tax" refer to what are effectively cash-in-hand arrangements, where employees are paid a fixed net wage rather than a fixed gross wage, and the employer grosses up the payment and accounts correctly for the tax and NICs liabilities. Employers should not use this arrangement unless they have contacted their tax office and received instructions on how to handle the grossing-up process, depending on whether the payments are "free of tax" or "free of tax and NICs". For employers handling such payments manually, the tax office can provide special P11(FOT) working sheets, FOT tax tables (Tables G), and FOT1 guidance notes. HMRC's guidance on these arrangements is provided on page 21 of the CWG2(2005) Employer's Further Guide to PAYE and NICs.
When completing the P35 Employer Annual Return, an employer would answer YES to question 2 if this method of paying wages is used. The tax office should not be surprised to see the answer YES if agreement has already been reached for this method to be used. However, if the tax office does not know that the employer is making free of tax payments and the employer gives the answer YES, the tax office will ask the employer to provide, within 30 days, the names and addresses of the employees, the amounts involved, and what those amounts represented.
However, the question does not relate to PAYE Settlement Agreements (PSAs), even though the employer is bearing the employee's tax liability on the payments and thereby avoiding having to handle the tax and NICs liabilities through the payroll. If the only way in which an employer is bearing an employee's tax is a PSA, question 2 can be answered NO.
For more technical information on "free of tax" payments, see
...back to 19 January 2006
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For Payroll and Human Resource Professionals
