Key Takeaways
1. PAYE (short for Pay As You Earn) is the method through which the UK tax authority, HMRC (HM Revenue and Customs) collects income tax via monthly payroll contributions.
2. The UK tax authority provides a personal allowance to eligible workers, which is the amount employees can earn in a year before paying income tax. This allowance has been frozen in recent years as part of UK fiscal policy.
3. The PAYE process also includes National Insurance contributions, which fund state benefits and the NHS.
4. Under the UK’s IR35 (off-payroll working) rules, the government has tightened restrictions around engaging contractors to combat disguised employment.
A recent article in the UK Guardian Newspaper highlighted the significant tax gap in the UK, which is the ‘difference between the expected income for the exchequer and actual receipts’. The shortfall for the 2020–2021 financial year was estimated at 5.1%, equating to £32bn. More recent HMRC estimates continue to show sustained enforcement activity aimed at closing the tax gap. HMRC has been somewhat unsuccessfully trying to reduce this tax gap for the last 6 years.
But now we seem to be coming out the other side of the pandemic, industry insiders are exerting pressure on the government to address the situation. The government’s very own findings suggest that there was “a very high chance that more households and businesses underpaid income tax and national insurance” during the pandemic.
What does this mean for international employers planning to or currently doing business in the UK? It’s likely that the UK HMRC may be entering a period of correction as it attempts to recoup losses in income tax and national insurance collection. So, employers should expect greater scrutiny around their tax filing affairs going forwards and need to be crystal clear on how PAYE is calculated.
What is PAYE?
PAYE (Pay As You Earn) is the system through which HM Revenue and Customs (HMRC) collects income tax and National Insurance in real time via payroll.
The term PAYE is also used in Ireland, New Zealand and Nigeria, whereas in Australia it is referred to as PAYG (Pay As You Go). In the US it is generally referred to as Income Tax Withholding. Employers are responsible for collecting and filing income tax contributions with their respective government authority.
How is PAYE calculated?
PAYE is calculated and the amount paid is based on how much an employee earns during the pay period, which is typically 1 month in the UK.
The UK tax authority provides a personal allowance to eligible workers. This is the amount that employees can earn in a year before having to pay tax. The personal allowance is £12,570 and has been frozen by the UK government until at least April 2028, meaning more income becomes taxable over time through fiscal drag.
Once employees earn above the threshold, they are charged income tax at either 20%, 40% or 45% according to whether they are a basic rate, higher rate or additional rate taxpayer. The employee’s tax rate band/classification is based on their income.
How is PAYE calculated in the UK?
The current UK PAYE income tax bands (applicable to the 2024/25 and 2025/26 tax years) are shown below.
Band | Taxable income | Tax rate |
Personal Allowance | Up to £12,570 | 0% |
Basic rate | £12,571 to £50,270 | 20% |
Higher rate | £50,271 – £125,140 | 40% |
Additional rate | Over £125,140 | 45% |
The additional-rate threshold was reduced from £150,000 to £125,140 in April 2023 and remains frozen.
HMRC also provides a useful tool with its PAYE payment calculator.
Tax is deducted at source by the employer based on the figures in this table each time an employee is paid, typically monthly in the UK. PAYE is therefore generally divided into equal payments over the course of the year and employees may receive a refund if they have paid too much tax, which is typically reconciled directly by HMRC through tax code adjustments or refunds. If the employee has paid too little tax for whatever reason, they will receive a bill requiring them to pay more.
National Insurance (NI)
In addition to income tax, PAYE also includes Class 1 National Insurance contributions.
Employee NI (Class 1):
0% on earnings up to £12,570
8% on earnings from £12,571 to £50,270
2% on earnings above £50,270
Employer NI (secondary Class 1):
13.8% on earnings above £9,100 per year
Employee NI rates were reduced in 2024 following the repeal of the Health and Social Care Levy.
Off-payroll – How Is PAYE Calculated?
Using the IR35 Directive, the UK government has tightened restrictions around engaging contractors in off-payroll working to combat tax avoidance via ‘disguised employment’. This tax avoidance occurs when employees are incorrectly classified as contractors, which means that contractors and their clients pay less tax and NI Contributions. Medium to large employers in the UK are directly responsible for correctly classifying workers under IR35 and fines of 30% of unpaid tax are issued if they get this process wrong. However, if HMRC finds that an employer knowingly contravened IR35, a fine of 70% of unpaid tax is incurred.
Enforcement of IR35 remains an active focus area for HMRC, particularly for medium and large employers engaging contractors.
IR35 employment classification is a complicated process and for this reason, the UK government has developed an online employment status checker that employers can use to ensure that independent contractors are paid correctly.
What is the penalty for failing to comply with PAYE?
Employers must pay their PAYE bills to HMRC according to specific schedules and procedures which can be found here. Employers who fail to make the appropriate PAYE deductions and file them with HMRC in full and on time will receive a late payment penalty. The first time that any employer does not pay their PAYE on time is not considered a default, but any future late payments will result in a penalty percentage being applied to the overdue amount for that month.
Number of defaults in a tax year | Penalty percentage |
1 to 3 | 1% |
4 to 6 | 2% |
7 to 9 | 3% |
10 or more | 4% |
Interest is also charged on late PAYE payments, and penalties escalate with repeated non-compliance.
HMRC video: When and how to calculate PAYE
In the video below, the UK tax authority (HMRC) explains how PAYE is to be calculated in the UK.
If the employer fails to pay monthly or quarterly PAYE deductions in full to HMRC after 3 months, they will be charged an additional late filing penalty of 5% of the outstanding amount. If full payment has not been made after 12 months than an additional 5% penalty is applied to the remaining outstanding amount.
Horizons calculates and processes PAYE for UK employees
PAYE compliance in the UK involves evolving income tax bands, National Insurance rules, and off-payroll legislation. Many international employers choose to work with payroll or Employer of Record partners to reduce compliance risk and administrative burden.
Frequently Asked Questions
The UK tax authority provides a personal allowance to eligible workers. This is the amount that employees can earn in a year before having to pay tax. For the 2022/23 tax year the personal allowance sits at £12,570. Once employees earn above the threshold, they are charged income tax at either 20%, 40% or 45% according to whether they are a basic rate, higher rate or additional rate taxpayer.
However, it is possible to pay independent contractors amounts on regular intervals that are equivalent to a salary or wages in monetary terms.
The UK tax authority providers a personal allowance to eligible workers. This is the amount that employees can earn in a year before having to pay tax. For the 2022/23 tax year the personal allowance sits at £12,570. Once employees earn above the threshold, they are charged income tax at either 20%, 40% or 45% according to whether they are a basic rate, higher rate or additional rate tax payer.
However, it is possible to pay independent contractors amounts on regular intervals that are equivalent to a salary or wages in monetary terms.
