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The taxation of termination payments
25 September 13 | By: Jas Jhooty
HMRC specifically target termination payments for review as most employers do not consider the tax & NIC implications surrounding redundancy payments. There is a popular misconception that the first £30,000 of any termination payment is automatically tax & NIC free.
There are many reasons why an employee leaves a business, including redundancy, health issues, early retirement etc. each with its own tax & NIC implications. Issues also commonly arise on the taxation of Payments in Lieu of Notice (PILONs), Restrictive Covenants, and ‘terminal bonuses’, which may be agreed as part of a Settlement Agreement (new name for Compromise Agreements) reached where an employee leaves or is being dismissed.
The following is a quick guide to the tax treatment of some of the various elements that may make up a redundancy payment.
What elements are earnings?
The following elements of a termination package should always be classified as earnings for income tax and NIC purposes: -
- wages or salary
- holiday pay
- contractual bonuses or commissions
- payments for any restrictive covenants agreed by the employee
- payments in lieu of notice
- garden leave payments
The £30,000 exemption
The first £30,000 of a termination payment that does not relate to earnings can be paid tax & NIC free. Any excess over £30,000 is subject to tax as normal, but not to any NIC. If two or more payments are made by the same employer they must be aggregated for the purposes of the £30,000 limit.
The tax treatment of discriminatory compensation claims depends on the precise nature of the payment. Some will fall within the £30,000 exemption, and some are entirely free of tax.
Ex-gratia payments and awards from the Employment Tribunal in respect of wrongful or unfair dismissal can fall within the £30,000 exemption. So can payments made on redundancy whether statutory, non-contractual or even contractual if they truly relate to compensation for loss of office.
Other miscellaneous exemptions
Certain payments made on termination of employment fall completely outside the tax regime, and are not taken into account in amounts to which the £30,000 exemption is applied. These exemptions include:
- foreign service exemption – full and partial exemptions apply to payments made in respect of foreign service, where an employee was both non-resident and non-ordinarily resident in the UK;
- death, injury and disability exemption – no tax is payable on payments of death benefits, where the death brought about the termination of the employment. HMRC interpret the exemption for termination on injury or disability very narrowly;
- pension contributions – if, as part of the termination package, the employer agrees to make a contribution to a tax exempt pension scheme or an approved pension scheme, the payment will not be subject to tax as long as the payment is not a right granted under the employment contract;
- payments of compensation or damages for personal injury;
- payments of an employee’s legal costs – this exemption applies where a dispute is resolved without going to court, provided that certain conditions are met.
Payments for retirement
Payments made into a non-HMRC approved retirement benefits scheme for the purpose of providing retirement benefits are taxable. The term ‘scheme’ has a very wide meaning here. It can simply be a decision or a payment made in accordance with an internal policy.
A payment made in connection with retirement, rather than on termination of employment because of redundancy or poor performance will be fully taxable. Great care must therefore be taken with payments to employees who are to retire on or soon after the termination.
Any benefits-in-kind that are stipulated in the contract of employment will have to be taxed in the same way as benefits received during employment. Non-contractual benefits may fall within the £30,000 exemption. These non-contractual benefits-in-kind will be valued at an amount equal to the cash equivalent of the benefit but should not be reported on forms P11D. This is because the provisioning of post-termination benefits-in-kind does not lead to a Class 1A NIC charge. Alternative HMRC reporting arrangements should be entered into for such post-termination benefits-in-kind.
The costs of providing any outplacement counselling (or associated re-training) are usually tax exempt.
Reporting the tax
The employer is obliged to account for any tax due under the PAYE system when it makes payments to terminate the employment of its employees. The employer will be liable for penalties and interest, as well as paying the tax itself, if it does not deduct tax when this becomes due.
If the termination payment is made before a form P45 is issued, then any tax due is deducted as normal under PAYE.
For payments made after a P45 was issued, the situation changed from 6 April 2011. Until this date, an employer was only required to deduct tax under PAYE at basic rate. If the employee was subject to a higher rate of tax then it would be up to the employee to declare and pay the further tax in his annual tax return.
From 6 April 2011, if the payment is made after the P45 is issued then the employer must instead deduct tax at all applicable rates as if the employee had no personal allowances available i.e. Code 0T. This may result in more tax being deducted than would have been the case under the old system, particularly for employees who receive a lump sum to terminate their employment but whose income is normally only taxed at basic rate. The employee is entitled to reclaim a repayment of the overpaid tax from HMRC.
How emTax can help
emTax consultants can review or draft your redundancy policies to maximise tax efficiencies and obtain clearance from HMRC on the tax position before any payments are made. Our approach guarantees considerable savings for both the employer and any affected employees.
For more information about this or any other employment tax service, please do not hesitate to contact us.