Tips and Troncs - a Continuing Problem

Introduction 

HM Revenue & Customs (HMRC) released a new version of its E24 booklet in late 2006 which aimed to provide practical guidance to employers and others within the hospitality sector about the treatment of tips for income tax, Pay As You Earn (PAYE), National Insurance Contributions (NICs), National Minimum Wage (NMW) and VAT purposes. The following article aims to explain this booklet as well as its practical implications.

What is a gratuity?

Advisers and employers unfamiliar with the terminology used in connection with tips need to tread warily. The first issue to be clear about is whether the amount paid by the customer is for the food and drink served. If it is, then it will be deemed as part of the business’ income for corporation tax and VAT purposes. Similarly, there may be other compulsory charges on the bill, such as cover or service charges. If the customer is required to pay them, then these too are deemed as business income. In neither of these cases will there be any element of gratuity.

Where cash tips are left on the table to be retained by the serving staff, or given personally to them by the customer, they do not constitute income of the business. As the employer is not involved, they can have no obligations to deduct PAYE. Similarly there is no obligation for the employer to account for NICs. The tips are, however, income in the hands of the staff member and they are responsible for ensuring a full return of the amounts received, which may result in an adjustment to their PAYE code.

The business should ensure that there is a clear agreement with its workers as to the way cash tips will be handled. In some businesses there is an agreement between staff that cash tips will be pooled and shared out. So long as the employer is not involved in this in any way, there should be no implications for them.

Sometimes a bill may contain service charges which are said to be discretionary. It is important to check that there is real discretion. Evidence to look for includes the menu and anything else displayed on the premises. The customer must have a genuine option not to pay this charge and it may be very useful to see if there are instances of this amount not being paid. While no restaurateur likes the idea that a customer did not rate the service given, ironically this sort of incident may prove beneficial in showing this part of the bill is genuinely gratuitous, and therefore outside the scope of VAT.

HMRC considers that a tip or gratuity is ‘an uncalled for payment’ which is offered spontaneously by a customer and it may be paid in cash, cheque or by credit card. In practice, most tips are nowadays made by the completion of a credit card slip where an amount of a discretionary service charge has been suggested. This should not mean that the tip given is not an ‘uncalled for payment’, and in practice HMRC accepts that such payments are gratuitous so long as sufficient evidence can be shown that they are not compulsory.

Having established whether the additional payments made by the customer are gratuitous or not, the tax treatment then depends on what is done with the monies received by the business. It is important to note at this point that even where a customer intends a credit card, debit card or cheque gratuity to go to the waiter or waitress who served them, because the bill and payment slip are made out to the restaurant itself, the payment becomes the property of the business. This follows the decision of the European Court of Justice in the Nerva case (2002).

The business may make contractual payments to its staff. These are clearly employment income and PAYE and NICs will apply. Otherwise it may make non-contractual payments, and these will almost invariably come from the gratuitous tips or service charges.

What is a tronc?

A tronc was originally a wooden box used in French restaurants to collect the cash tips. HMRC now defines it as a ‘special pay arrangement used to distribute tips, gratuities and service charges’.

In fact, a tronc is any way that tips and gratuities are pooled and shared out among restaurant staff. If the tips come from cash received at tables and there is an arrangement among staff to share them out, then the PAYE obligation rests with the person who organises or is responsible for this process and no NICs are due.
 
The contentious area is where the tips arise from payments originally made to the establishment. This is where HMRC has concentrated its investigative efforts in recent years, during what was known as ‘Operation Gourmet’.

The individual who runs the tronc is normally called the tronc-master and is appointed by the staff, or allowed by them, to administer the tronc monies. This involves keeping track of the tips received and how they are distributed to the tronc members (normally the front of house workers, but in some instances kitchen and other staff are included).

Because there is no standard form of tronc, and as most troncs deal with discretionary service charges paid first to the restaurant, the mechanism whereby tronc members receive their share of the gratuities has moved a long way from the simple wooden box on the bar. This is why it is crucial to understand the precise methods used by restaurants and others when dealing with tips to ensure the correct tax treatment.

Whether there is a tronc in practice is a matter of fact. In larger establishments, the tronc may have written rules, a managing committee which meets and produces minutes, a dedicated bank account and so on. Elsewhere, there may be little in writing but merely an oral understanding among staff as to how tips will be handled.

PAYE

Where a tronc was formed after 6 April 2004, the employer must let HMRC know the name of the tronc-master, as HMRC may want to set up a PAYE scheme for them that is separate from the employer’s own scheme.

During Operation Gourmet, clients were warned by HMRC of the need to have a separate PAYE scheme for the tronc and to ensure that this was entirely separate from the main employer scheme. Now HMRC has acknowledged that the tronc may choose to use the employer’s payroll without necessarily implying that the employer is somehow involved in allocating the tronc money or in some way influencing its allocation.

Individual tronc-masters usually want to use the restaurant’s own payroll systems as they themselves will not have any knowledge of PAYE or payroll procedures, nor the time or facilities to operate them.

HMRC still maintains that the troncmaster should keep PAYE records and run a separate scheme. However, in practice, although the tronc-master should keep records to ensure proper allocation of the tips, these will often be handed on to the employer’s payroll section which should retain them and use them to ensure a correct payroll run. It is these records that may then be subject to inspection through a routine PAYE audit.

Troncs and NIC

Tips and gratuities are exempt from NICs so long as the employer does not directly or indirectly influence their allocation. HMRC had contended in the past that there were many ways in which this rule might be breached, but it now acknowledges that the NIC exemption will continue to apply even where the employer has some role in the tronc. For example, the employer may appoint the tronc-master and recommend a points system for allocation. And while neither of these will necessarily lose the exemption, it should be clear that the staff and troncmaster freely accept such a system.

It has, for many years, been common practice for larger restaurants to have points systems for the allocation of the tronc to staff. These are administered by a head waiter, acting as tronc-master, who is appointed  by the proprietor to allocate tips from which some deductions have been made by management. The new E24 explicitly accepts that these arrangements do not affect the NIC exemption so long as the allocation condition is met.

In smaller restaurants difficulties can arise where the tronc-master may also have a management role. If they are a director of the company, then their position will mean that the employer is allocating the tronc. The situation is also complicated when the tronc-master is not an officer of the company, but is an associate or relative of the proprietor. This kind of situation should be avoided to ensure that the exemption is not lost.

The employer may allocate some part of the tips, but then allow the balance to be allocated by staff. In this case, the NIC exemption is not totally lost but will only apply to the amounts allocated independently of management. There are a number of different scenarios possible: the employer may use some of the money to pay employees, retain money to cover breakages, offset the costs from credit card companies or for running the payroll. From the NIC perspective, the balance may be given to the tronc-master and allocated, independently of the employer, without losing the exemption on that part of the total gratuities received.

Contracts

There has been an ongoing dispute with HMRC that arises from the wording of many employment contracts. It is quite usual in the industry for contracts and staff manuals to refer to the existence of the tronc. HMRC had contended that this gave a contractual entitlement on the part of the employee to receive amounts of tronc from the employer. Hence the tronc monies were earnings subject to NIC.

HMRC now accepts that even where the contract of employment includes a right to participate in the tronc (which leads employees to expect a share of the tips) this does not constitute a contractual entitlement. Where there is no right to receive payment, then the NIC exemption will apply - provided the employer does not allocate the tips. If the contract mentions a minimum entitlement to tronc monies, then the minimum entitlement amount would not be exempt from NIC. Any money paid from the tronc on top of the minimum entitlement would still be exempt so long as the allocation requirement is met.

National Minimum Wage (NMW)

The relationship between the NIC and NMW legislation has been the most difficult of all these issues for many hospitality businesses to deal with. HMRC has previously maintained that because the worker had a legal right to receive NMW from their employer, even if some part of this statutory obligation was funded from tips, the employer should account for NICs at least up to the NMW amount.

The difficulty with the HMRC view was that NMW legislation allows tips paid to the employee through the employer’s payroll to count towards the NMW obligation. So, where there is a tronc which allocates the tips and the tronc decides to use the employer’s payroll to make the allocations to members, not only will the amounts be exempt from NIC but they will also count for NMW. The new E24 gives an excellent summary of the interaction between the two sets of legislation in practice and demonstrateshow far HMRC has moved from its
original position.

Of course, where cash or other tips are paid directly to the waiting staff by the customer they do not count for NMW, nor do they if tronc money is paid out without going to the employer and through the payroll. Given the advantages obtained it would be surprising if the employer did not allow the payroll to be used to make payments of tronc money to staff if requested.

The new version of the E24 booklet provides a much needed common sense approach to the tips and troncs issue.

Richard Clarke was part of the PricewaterhouseCoopers LLP team who advised the British Hospitality Association on the E24 issue.

The above article was first published in Tolley's Practical Tax (2 February 2007), and is reproduced with the kind permission of Lexis Nexis UK.  

Article Added Saturday, 17 February 2007

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