There are always some grey areas in every profession. Taxation in the field of accounting happens to be one area where interpretations and applications of the provisions of the Finance Act / Tax Laws. Understanding the application of effective tax rate to employee income is an important forensic accounting skill that you will never regret having.
In my many years of practice as a finance professional, I have seen many organizations wrongly apply the progressive tax rate system. A staff who work for say 20 days out of 30 days in a month would pay less than the normal tax while a staff who joined a company after the payroll cutoff date say 26th of a month would be taxed more than normal.
This practice is pure laziness and sometimes wickedness on the part of preparers of PAYE (pay as you earn). You may want to have a look at my earlier article on how to calculate PAYE using Microsoft excel formula if you haven’t done so already.
Note that the principles discussed and demonstrated in this post can be applied to the scenarios discussed in this article in any country that operates a progressive tax system. Also note that effective tax rate is not the same as marginal tax rate.
In all of these years, I have always admonished that effective tax rate should be applied to correctly and fairly tax an individual’s entitlement from a company no matter how small the amount maybe.
I will demonstrate the application of effective tax rate to employee income using three different scenarios as follows (they are on the same monthly contractual income of
N500,000 but resumed on different days – their effective tax rate is 14.51%):
Scenario 1 – normal staff worked for full month. Application of effective tax rate to many paid to staff who worked for one month.
Here, a staff whose letter of employment states that s/he is on an annual gross salary on
N6,000,000.00 (Six Million Naira only) resumes work on the first day of the month. This is a normal scenario. This person under the Nigerian 2021 Finance Act will be paying a monthly tax of N72,554.67 (download attached effective tax rate on employee income demonstration). Applying the effective tax rate of 14.51% on N500,000 gives a monthly PAYE of N72,554.67.
Scenario 2 – staff worked for only 18 days out of the 30 days in April. Application of effective tax rate to many paid to staff who worked for less than one month.
Here, the staff started work on the 13/04/2022. This means that s/he only worked for 18 days. What I see people do in practice is to simply assume that the person’s monthly salary is
N300,000 for the month and then use this figure to calculate annualized tax. This will mean that this staff will only pay tax of N36,457.87 as against N43,532.80 when effective tax rate of 14.51% is used.
This implies that the taxpayer is cheating the government here by underpaying to the tune of
N7,074.93 – this figure may not appear significant but it adds up when aggregated. (download attached effective tax rate on employee income demonstration). This is one of the reasons why a lot of companies get worked up when ever the tax auditors are coming.
Scenario 3 – staff worked for 39 days (reason is because staff joined after salary cutoff date). Application of effective tax rate to many paid to staff who worked for more than one month.
Here, the staff started work on the 23/03/2022 after salary for the month has been processed (am not saying that not paying the staff for the month is best practice but, this is common practice in Nigeria). Simply assuming that the staff in this instance is on
N650,000 per month, annualize this and then use it to calculate monthly tax will expose the staff to excess tax of N6,400.
The use of effective tax rate of 14.51% will again be consistent with the principle of PAYE. You can simply prorate the monthly tax using the number of days worked divided by the number of days in the month and still get same result.
I hope you have benefited from this article on the application of effective tax rate on individual employee income. You can contact me using the contact form on this accounting blog if you have any question. Or better still leave your thought in the comment section. Thank you