Following consultation with various employers and interested professional bodies, HMRC has published guidance on how it will deal with cases involving an underpayment of PAYE.

The issue

Demibourne Ltd v Revenue and Customs [2005] was, at its core, a case concerning whether an individual should be treated as an employee or as self-employed. However, its most far-reaching effects were not in that area but in relation to a more practical matter: how to deal with cases where one party mistakenly fails to deduct tax from a payment but the recipient accounts for tax on it (based on the same mistaken belief).

The facts in Demibourne are simple. Demibourne, a company operating a hotel, had treated Mr Bone as a self-employed consultant. As a result, Demibourne did not deduct income tax under PAYE from payments to Mr Bone. Mr Bone, for his part, paid income tax on the payments received. Following a routine audit of Demibourne's affairs, HMRC concluded that Mr Bone should have been treated as an employee and that his remuneration was therefore subject to deduction of tax at source. It was held that Mr Bone was an employee and that tax should have been deducted from his earnings. This left Demibourne with a very substantial sum to pay, Mr Bone having been wrongly treated as self-employed for nine years or so.

The case highlighted that the PAYE system could generate surprising results. HMRC was entitled to recover all the tax that Demibourne should have deducted during the nine-year period. There was no provision that required HMRC to give credit to Demibourne for the tax that Mr Bone had paid on the same income. Because of the very long period over which the mistaken treatment had been applied, there was a possibility that HMRC would recover the tax twice because some of Mr Bone's tax returns for the period had become final and could not be reopened. The tribunal, while agreeing with HMRC that this was indeed the strict legal position, was clearly concerned at the possibility that the tax would be paid twice and suggested that HMRC and Demibourne should arrive at a negotiated settlement taking account of the tax paid by Mr Bone.

HMRC's reaction to Demibourne

At first, HMRC seemed to view Demibourne as a weapon to be added to its armoury. The very real possibility that employers would be asked to pay a tax that had already been paid by the employee seemed a powerful disincentive for employers to take any risk in this area. To be fair to HMRC, it was also possible, though less likely, that the decision would apply in situations that benefited the employee by allowing the employee to recover tax that the employer should have paid, but did not, and where there was no real prospect of the tax being recovered from the employer. There was therefore an incentive for both sides to achieve a fair compromise.

HMRC announced that it would consult with interested parties to achieve a resolution. Meanwhile, HMRC was prepared to give employers credit for the tax paid by their employees provided the employees signed a mandate that consented to it. This left large employers at risk due to the practical impossibility of obtaining mandates from a high number of employees, some of whom might well have moved on and be disinclined to assist their former employer.

New regulations and guidance

Earlier this year, HMRC introduced the Income Tax (Pay As You Earn) (Amendment) Regulations 2008 to deal with the anomalies highlighted by Demibourne, which should benefit all employers.

The aim is to allow HMRC to make directions that 'transfer' the liability to the employee in a wider range of circumstances. Broadly, HMRC will be able to make a direction where an employee has received a payment from which tax should have been deducted, the employee has paid tax on the payment and either the employer has not accounted for PAYE (or insufficiently accounted for PAYE) or the employer has been assessed to tax and has failed to pay such assessment within 30 days. In general, HMRC will use its new powers save where it suspects that the employer deliberately failed to pay the relevant tax without any collusion on the part of the employee.

The effect of a direction is to reduce the employer's liability, not to increase the employee's. In a number of cases (perhaps most of them) this means that the employer has a residual tax liability, which will bear interest. The employer may also be liable for penalties. There are also some potentially thorny issues for employers in assessing how much tax has been paid by their employees because HMRC is refusing (quite rightly) to release details of employees' self-assessment returns to employers. This makes it difficult, however, for employers to calculate what tax it should be given credit for.

Unfortunately, this does not mean that Demibourne can be safely ignored. The transitional provisions of the new Regulations are such that a number of cases similar to Demibourne will have to be dealt with under the old concessionary system. This will be the case where the employees have reclaimed tax not accounted for by the employer (a distinct possibility following Demibourne) and such claim was made before 6 April 2008. In addition, any assessment made before the new Regulations came into effect will also have to be dealt with under the old system.
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