Introduction
When you hire someone in your business, one of the first questions you must answer is: Are they an employee or a contractor? This decision affects not only how they’re paid but also how you manage their tax obligations—including PAYG (Pay As You Go) withholding.
PAYG withholding is part of Australia’s income tax system. If you get it wrong, your business could face penalties, back taxes, or compliance issues with the ATO (Australian Taxation Office). In this guide, we’ll explain the difference between employees and contractors for PAYG purposes, when you’re required to withhold tax, and how to accurately calculate PAYG withholding in each case.
What Is PAYG Withholding?
PAYG withholding is a tax withholding system where employers (and in some cases, businesses paying contractors) are required to withhold a portion of a payment and send it to the ATO on behalf of the payee.
This ensures that the individual or entity receiving the income meets their tax obligations gradually throughout the year rather than in one lump sum at tax time.
Step 1: Classify the Worker Correctly
Why Classification Matters
The first and most important step in calculating PAYG is knowing whether the person you’re paying is legally an employee or a contractor. Misclassification is a common and costly mistake.
Key Differences:
| Criteria | Employee | Contractor |
|---|---|---|
| Control over work | Employer directs how and when work is done | Contractor decides how work is completed |
| Tools and equipment | Provided by employer | Provided by contractor |
| Payment basis | Hourly wage or salary | Invoice or fixed fee |
| Superannuation | Must be paid by employer | Usually paid by contractor themselves |
| Leave entitlements | Eligible (annual leave, sick leave) | Not eligible |
| PAYG withholding | Mandatory | Depends on ABN or agreement |
The ATO has a decision tool to help you assess the correct classification.
Step 2: PAYG Withholding for Employees
If the person is an employee, you are legally required to withhold PAYG tax from their wages or salary.
How to Calculate:
- Determine Gross Pay
- Includes salary, overtime, allowances, bonuses, commissions, etc.
- Check TFN Declaration
- If the employee has claimed the tax-free threshold, they’ll pay less tax.
- If no TFN is provided, withhold at maximum rate (47%).
- Use ATO Tax Tables or Withholding Calculator
- The ATO provides updated tax tables for weekly, fortnightly, and monthly pay cycles.
- Alternatively, use the online PAYG Withholding Calculator.
- Account for Study and Training Loan
- If the employee has a HELP, VSL or other loan, extra withholding is required.
Example:
Weekly gross earnings: $1,400
Tax-free threshold claimed: Yes
Study loan: No
→ Use the ATO calculator or tax tables → PAYG withholding = approx. $277
Payroll Summary:
| Category | Amount |
|---|---|
| Gross pay | $1,400 |
| PAYG withheld | $277 |
| Net pay to employee | $1,123 |
Step 3: PAYG Withholding for Contractors
In most cases, you do not withhold PAYG for contractors—unless one of the following conditions applies:
1. Contractor Has NOT Quoted an ABN
If the contractor does not provide a valid Australian Business Number (ABN), you must withhold 47% of the total payment.
Example:
- Invoice total: $2,000
- No ABN provided
→ Withhold $940
→ Pay contractor $1,060
→ Report and remit $940 to the ATO
2. Voluntary Agreement to Withhold
A contractor can voluntarily agree to have PAYG withheld from their payments.
- This requires completing and signing an ATO Voluntary Agreement form (NAT 2772).
- You must withhold tax using the No Leave Loading tax table, available from the ATO.
Example:
- Weekly contract amount: $1,000
- Voluntary agreement in place
→ PAYG withheld (approx.): $180 (depending on tax table)
3. Labour-Hire or Similar Arrangements
If your business operates as a labour-hire firm, or if the contractor is part of a labour-hire arrangement, you may be required to withhold PAYG even if they have an ABN.
This applies when:
- You supply workers to another business
- The contractor is performing work under your direction
In this case, withhold tax as if they were an employee.
Step 4: Report and Remit PAYG Withholding
Whether you’re withholding for employees or contractors, you must:
- Register for PAYG withholding with the ATO
- Use Single Touch Payroll (STP) to report pay events for employees
- Include amounts in your BAS (Business Activity Statement)
- Send withheld amounts to the ATO by your due date
- Issue income statements (via STP) or payment summaries (for contractors under voluntary agreement)
Step 5: Use Tools to Simplify PAYG
Managing PAYG manually is time-consuming and error-prone. Consider using accounting or payroll software such as:
- Xero – Offers built-in STP and PAYG calculations
- MYOB – Ideal for small to mid-sized employers
- QuickBooks – Integrates payroll and GST management
These platforms automate tax calculations, employee records, and ATO reporting.
Summary: PAYG Withholding Rules at a Glance
| Worker Type | Withholding Required? | Notes |
|---|---|---|
| Employee | Yes | Use ATO tax tables and STP reporting |
| Contractor with ABN | No (usually) | Withhold only if voluntary agreement in place |
| Contractor without ABN | Yes (47%) | Withhold at top rate if ABN not provided |
| Labour-hire Contractor | Yes | Treat as employee for PAYG purposes |
Conclusion
Calculating PAYG withholding accurately is a critical responsibility for any business. While withholding for employees is straightforward with ATO tools and tax tables, managing contractors requires extra attention to classification and ABN status.
By understanding the rules, using the right tools, and keeping clear records, you can avoid penalties and ensure full compliance with ATO requirements.
If you’re ever unsure about classification or calculations, consult a registered tax agent or accountant to get tailored advice for your situation.
