Each employer in the UK must register as an employer with HM Revenue & Customs (HMRC). Registering to run a PAYE scheme is obligatory if employees have earnings at or above the Income Tax threshold or has earnings at or above the National Insurance contributions (NI) lower earnings level.

PAYE (Pay As You Earn) was first introduced in the UK in 1944 as the system that HMRC uses to collect Income Tax and NI from employees' pay.

Deductions are paid over to HMRC on or before the 19th of the month following the pay period. Small businesses that have a quarterly liability to income tax and NI less than £1,500 per quarter can arrange to pay every 3 months rather than every month.

The financial tax year in the UK is from 6 April to 5 April the following year with each tax year divided into 53 week numbers (allowing for odd days at the end of the tax year) and also into 12 monthly periods. Income Tax deducted is calculated by the business operating the PAYE scheme on a cumulative basis during the tax year by using either manual tax tables, payroll software or by outsourcing the function to a payroll services provider. The tax tables determine the tax free allowance each pay week or month during the year according to the employees tax code.

PAYE administration involves the calculation of Income Tax using a tax code system. Each member of staff is allocated a personal tax code which consists of a number equal to approximately one tenth of the personal tax allowance as adjusted by the employee personal tax adjustments. Special conditions and circumstances for each employee is usually represented in the tax code with a letter known as a suffix to the prefix tax code number.

To calculate Income Tax, the employer determines the cumulative tax free allowance in a or month and deducts this from the cumulative gross wage or salary that employee is due that tax week, including both current wages or salary and all previous income earned during the current tax year including any earnings from other work. Having established the taxable pay that amount is then applied to the percentage of Income Tax to be paid under the current tax rules for that financial year.

The employer is responsible for deducting the correct amount of Income Tax, issuing the employee a wage slip to advise of the tax deducted and also for paying the tax deducted to HMRC. The PAYE calculations and the production of payslips is an essential function of payroll software that many employers adopt to ensure accuracy and compliance with the tax rules.

The second aspect of PAYE administration is where businesses deduct NI from employees. NI is calculated, not on a cumulative basis as Income Tax, but according to the gross income earned in a specific pay period.

The amount of NI deducted is determined by looking up the employee gross pay on a NI deductions table. A different NI table is applied according to the personal circumstances of the employee. In addition to the employees NI each employer also has to pay employers NI.

The starting point of the PAYE system is form P45 which all employees receive when they leave an employment and is a certificate of the cumulative gross pay and Income Tax deducted up to the date of the P45. Details from the P45 also include the employee tax code that must be entered into the employee PAYE records to enable the new employer to calculate the Income Tax due to date.

If an employee does not hand the new employer a P45 form then they are taxed on a week to week basis until the tax code and cumulative Income Tax position are known. Confirmation of an employees tax position is obtained by the new employer by submitting a P46 form to the Inland Revenue when an employee does not have a P45.

Having engaged an employee and deducted Income Tax and NI the employee must receive a payslip from the employer showing the gross pay, deductions and net pay. In additional the employer also needs to maintain records of payments to the employee and deductions made. Payroll software can produce these records and HMRC also provide small employers with a P11 deductions working paper for this purpose, these days this is available from a CD which can be ordered from the HMRC website.

After the end of the tax year an employer must send HMRC an Employer Annual Return (form P35 and forms P14). These are now filed online and are usually done by your normal payroll services provider.

Each employee has to be given a P60 certificate of earnings and deductions during the financial year. The P60 is an important document and often required for many diverse purposes unconnected with the PAYE system such as future mortgage applications and other purposes as proof of income.