Decoding the tax tables

Ian Whyteside focuses on accurately calculating income tax payments by understanding allowances, codes and taxable pay - and what will earn you top marks in the Payroll exam

In Unit 73: Determining Net Pay (DNP), much is made of the skill of calculating income tax and National Insurance contributions precisely without necessarily understanding the legislative background to them. For the exam, you should seek to provide sufficient information to gain maximum marks, even if some of the figures produced are incorrect.
The only way to achieve this is to follow the strict step-by-step process that you have been taught during your studies. Ensure that all those steps are included in the exam paper so that the marker can see not only how you got to the correct answer but also where you went wrong. Many of the marks available may still be awarded as long as the process is correct.

What needs to be done
This article concentrates on the thorny issue of identifying the pay figure on which tax is calculated, and how to determine which tax rate is used. We can then look at how the calculations are carried out before considering how to do this for maximum marks in the exam.
It is important for payroll departments to know exactly what they are being asked to pay, so that the correct tax treatment is applied. This is because the total sum paid to an employee is not necessarily the amount on which tax
is calculated.

As soon as we know what all the payments are for, the tax calculation can be done using the information supplied by HM Revenue & Customs (HMRC) in the form of tax tables. There are different versions of the tables depending on the users' needs, including a manual calculation version and a more recent version to be used with a calculator.
Before moving to those, we first need to determine if there is an allowance against income which can be used to reduce the amount of tax due. This will be determined by the employee's tax code.

All taxpayers have a personal allowance. For 2006-07, these are:

? all taxpayers: £5,035;
? taxpayers aged 65-74: £7,280; and
? taxpayers aged 75 and over: £7,420.

For the purpose of taxation, the age 65 and over allowance applies for the whole tax year in which the taxpayer's 65th birthday occurs. The same rule applies to the over 75s. In practical terms, the allowance represents the amount of income the person can have before they start paying income tax.
The allowance is converted to a tax code by taking off the final digit and replacing it with a letter, called a 'suffix':

? 'L' is a standard suffix that applies to most taxpayers, and hence employees;
? 'P' is used to indicate someone aged 65-74 who is entitled to the ordinary age-related allowance;
? 'V' is someone aged 65-74 with the age-related allowance plus the full married couple's allowance;
? 'Y' is a taxpayer aged 75 and over; and
? 'T' is not a temporary code, but is used where there is a non-standard review of a taxpayer's affairs.

Also, 'K' codes are a special category where the allowance is negated by deductions (usually benefits in kind) that are greater than the allowance due. Special rules apply to 'K' codes which we will cover in a future article.

For example
Let us assume that our fictional employee is under 65, has a tax code of 503L and is being paid £48,000 a year. In April, the employee is paid the month's salary, plus a bonus of £500. Each month, he or she pays pension contributions of £250 and makes a charitable donation of £100.

To determine how much of the annual allowance of £5,035 will be allowed in April, we turn to HMRC's Pay Adjustment Tables (also known as Tables A). When we look at the table, we find that there is no value for 503 because the page ends at 500. There is however, a box immediately below which explains how to calculate the tax-free allowance for code 503L.

To get the allowance for 503 in Month 1, take the figure of £416.67 and add on the allowance for the difference between the two codes of 503 and 500 - in this case 3. The allowance for 3 is £3.25, so the allowance for April for 503L is £419.92.

The Taxable Pay Tables (also referred to as Tables SR and B to D) for April 2006 tell us the amount of income tax to deduct from the employee's pay. Page 3 of this booklet has a guidance table directing users to the correct rates for different levels of taxable pay. Our employee has £3,730 of pay to be taxed (the 8p is ignored at this point) and the table on page 3 shows that because the amount is more than £2,700, the correct tables to use are Tables C and D on pages 10 and 11.

Exam advice
Candidates in the DNP exam should remember that every stage of this calculation earns marks, so not showing each part of the process and getting the total wrong could cost you. The key to getting maximum marks for the above calculation is firstly using the guide on page 3 of the Taxable Pay Tables and working out the tax on the correct rates, and secondly showing all the workings. This will mean that even if there are few arithmetic errors in the calculation, the correct use of figures and tables should be enough to provide the marker with evidence of competency.

One further piece of information to note is that the questions are staged in April and May to make them straightforward and to avoid the need to consider brought-in pay and tax from previous employment. Many of the statutory rates used change on 18 May each year, so, to avoid using two sets of tables in the exam, you will be issued with just one set.

You can be assured that even though the rates changed in May 2006, you will be judged on your use of the information supplied, not the true rates (if you can remember them).

Ian Whyteside is the Chief Assessor for Unit 73: Determining Net Pay and Unit 75: Completing Year-End Procedures of the AAT Payroll Qualification

Accounting Technician - December/January 2007 - pages 28-29