Tax codes explained

Lots of employees don’t understand how their tax code is made up and they are likely to come to you when they have a question or a problem. What do you need to know to help them? Head of Payroll Joanne Gibson advises.

When do codes change?
There are several fixed occasions annually when tax codes must be reviewed en masse, as well as changes of personal circumstances that can drive change. HMRC undertakes its annual coding run in January/early February when all live taxpayer records are reviewed. If the only required change is because of an uplift in the personal allowance/marriage allowance no new code is generated as employers are authorised to make this change. As well as the annual coding run, when self-assessment returns and P11Ds/P46 (car) forms are processed, codes for affected taxpayers can be amended. The other personal circumstances that can lead to a code change are:

• late budget announcements of tax rate changes after the coding run.
• contact from the taxpayer notifying of a change of allowances, estimated pay, benefit in kind or address leading to a change of tax regime.
• notification of receipt of state pension or taxable state benefit by the Department for Work and Pensions.

UK tax regimes
Since 2016 the UK has no longer had a universal tax regime. Tax-sharing arrangements exist between Westminster and the Scottish government, and since 2019 with the Welsh Senedd. HMRC collects tax on behalf of Wales and Scotland from nationwide employers using a tax regime identifier to apportion tax receipts. Individuals who are determined by HMRC to be Scottish tax resident have a tax code with an S in the first position, e.g., S1257L and Welsh taxpayers have codes beginning with a C. The rules around tax residency are complex so regime identifiers can only be allocated by HMRC, not employers.

Even if a new starter has a home address in Scotland or Wales their new employer must allocate the standard codes based on statements A, B or C; there is no Scottish or Welsh equivalent. HMRC will issue a Scottish or Welsh code if appropriate.

Suffixes and prefixes
There are three tax code suffixes: L, M and N. They are used to group together taxpayers with similar personal circumstances allowing global changes to codes at the start of the tax year if the personal allowance or marriage allowance increases or decreases. Such global changes are carried out by employers/pension payrolls by running a routine authorised annually by HMRC using the P7X/P9X global uplift instruction that allows taxpayers with the relevant suffix to have their codes amended.

No global uplift will be required at the start of the 2022/23 tax year as there is no change to the personal or marriage allowances.

The prefix K is used to indicate a negative tax code, this means the employee has exceeded their personal allowance and requires additional earnings to be added to their taxable pay.

Number crunching
All taxpayers begin with the full personal allowance for the tax year (£12,570 2021-2026). Step 1 is to add in any additional allowance they may be entitled to, for example marriage allowance (where a spouse or civil partner transfers 10% of their personal allowance to the other party), blind person’s allowance, laundry allowance for laundering a staff uniform or additional tax relief on pension contributions. Step 2 is to consider reductions from the total of step 1, for example, tax owed from prior years such as on benefits in kind, reductions in the personal allowance because of the income limit (where total income over £100,000 leads to a £1 reduction in personal allowance for every £2 over the limit). If the answer after step 2 is a positive number the last digit is removed and suffix L, M or N is attached. If the answer is negative, a prefix K is attached.

EXAMPLE
A taxpayer has tax on private medical insurance to pay of £130 and owes tax on rental income of £450. His personal allowance for 2021/22 is £12,570 minus £130 and £450 = £11,990. Remove the last digit and append an L and the tax code is 1199L.

As payroll software doesn’t know what the missing digit is, it is always assumed to be a 9 and then HMRC reconciles exactly at year end although this doesn’t lead to any adjustment being required.

How do K codes work?
EXAMPLE
An English taxpayer has the standard personal allowance and tax on benefits in kind of £13,270 so his benefits exceed his allowance by £700. If K codes did not exist, the best we could do would be to give him tax code 0T. This would tax him at 20% and 40% and let’s assume his pay is £80,000. He would then pay tax of £24,460 through the payroll. In fact, though as he has exceeded his personal allowance his taxable pay is really £80,700 so he has underpaid tax by £280 as his tax should be £24,740.

If he was allocated a K code this would happen:

Step 1 personal allowance of £12,570 – tax on benefits in kind of £13,270 = £700, less the last digit = 70 and then reduce by 1 to 69 and add the K as a prefix. The reduction by 1 for a K code is necessary to ensure the taxpayer is not overtaxed as that would be illegal. Now with a tax code of K69 the payroll software will add £699 to their pay so £80,699 will be taxed and £24,739.60 deducted (this is 40p underpaid as it’s 40% of the £1 code adjustment but is as close as possible to accurate without the taxpayer being overtaxed and can be written off by HMRC).

Estimated pay
Since 2017 HMRC has introduced a new approach to tax codes called dynamic coding. This refers to the fact that when certain triggers occur (such as the processing of a P11D ) the system checks that the current estimated pay for the year, based on RTI returns to date plus any other information such as the P11D , will lead to the correct tax being collected based on the current code. If the code needs adjusting it is amended and if the tax in the next pay period will be £15 or higher than the tax collected in the last pay period based on the previous code the code is issued non-cumulatively, i.e. looking at each pay period in isolation. A non-cumulative code has a 1 or X after the suffix. For example, the non-cumulative emergency code for 2021/22 is 1257L/1 or 1257L/X.
When a new code is allocated it is issued to the taxpayer slightly ahead of the employer so that the taxpayer can object if they think it is wrong. Ideally, taxpayers should have activated their personal tax account and selected “go paperless” which will mean that they receive an email alert when their tax code changes so they can log in and check it.

Homeworking allowance
Ensure that all homeworking employees are aware that via their personal tax account or the micro-service that they can ask for a tax code adjustment for 2021/22 (and 2020/21 if not requested already). This will deliver a tax saving of £62.40 for a 20% taxpayer, £124.80 for a 40% taxpayer and £140.40 for a 45% taxpayer.

No global uplift will be required at the start of the 2022/23 tax year as there is no change to the personal or marriage allowances. The prefix K is used to indicate a negative tax code; this means the employee has exceeded their personal allowance and requires additional earnings to be added to their taxable pay.