To help with cashflow in these difficult times, directors or employees may agree to waive their salary or bonus – either temporarily or on a permanent basis. However a tax trap can catch out employers if the timing of the waiver is not considered carefully.

Here we explain the background to the issue and what can be done to prevent falling into this trap. This is intended as a general guide and more detailed advice should be sought before taking any action.

Earnings are taxed when treated as received

Surprisingly, earnings can be taxable even if they are not actually paid. This is because earnings become taxable when they are treated as “received”, whether or not they are actually paid. Once earnings become taxable, the employer becomes liable to pay income tax and national insurance to HM Revenue and Customs under PAYE. This liability remains even if the earnings are subsequently waived.

When are earnings treated as received?

Directors’ earnings are treated as received at the earliest of:

  • when payment is made of, or on account of, the earnings;
  • when the director becomes entitled to payment of, or on account of, the earnings;
  • when sums on account of the earnings are credited in the company’s accounts or records,
  • whether or not the director is able to actually draw any funds;
  • when a period ends, if the earnings for that period have been determined by then;
  • when the amount of earnings for a period is determined, if that occurs after the period has ended.

For these purposes, “director” includes any person who manages a company’s affairs or in accordance with whose directions or instructions the company’s directors are accustomed to act. The rules apply if the person is a director at any time during the tax year.

For employees who are not directors, only the first two bullet points apply: earnings are treated as received at the earlier of when payment is made or when the employee becomes entitled to payment.

The timing of a waiver is critical

In order to avoid an unexpected PAYE liability for the employer, it is critical that any waiver of earnings takes effect and is properly documented before the earnings are treated as received under these rules.