How should termination payments be taxed?

The correct tax treatment of a termination of employment package can cause headaches for employers and employees alike.

There is a common misapprehension among both employers and employees that the first £30,000 of a termination payment can be paid free of income tax and National Insurance Contributions (NICs), regardless of the contract or the circumstances. In fact, it is necessary to consider each element of a termination payment and to consider the purpose or reason for the payment.

Some elements, such as contractual payments or payments for restrictive covenants, will be subject to income tax and NICs, but other payments will benefit from a £30,000 income tax exemption and a blanket exemption from NICs.

One area which is particularly complicated is the tax treatment of payments in lieu of notice (PILONs). If an employee works out their notice period or is on garden leave, then the pay they receive while on notice or garden leave is subject to income tax and NICs in the usual way.

If the employee is not required to work out their notice, the tax treatment of the PILON depends on whether there is a provision in the contract which allows the employer to terminate by making a PILON. If there is such a provision, the PILON will normally be taxable and subject to NICs.

If there is not, then the PILON may not be taxable or subject to NICs, but HMRC might argue there was a contractual term to make an automatic PILON which came into existence when the payment was made. This is far from satisfactory, and often employers, to avoid uncertainty, deduct income tax and NICs on any payments made for the notice period, regardless of the existence of a PILON clause in the contract.

The government is looking at ways to simplify the tax treatment of termination payments and has issued a consultation. This follows on from recommendations of the Office for Tax Simplification (OTS) last August.

The OTS found that there is a widespread but mistaken belief that the first £30,000 of any pay-off is not subject to income tax or NICs. Many employers are unclear about how the current £30,000 exemption for termination payments operates and do not understand the difference between contractual and non-contractual payments. Employers and HMRC also find it difficult and time- consuming to establish the true nature of each separate element of a termination payment in order to assess its tax treatment. There is also a widespread lack of understanding about when PILONS are taxable.

The government wants to create a regime which is easy for employers to administer, for employees to understand and which creates certainty about the tax and NICs treatment of termination payments. At the same time, it wants the new system to be fair, so that those who are better paid and better advised do not receive a more favourable tax treatment than those who are lower paid. It must also be affordable to the exchequer.

In order to simplify matters, the government proposes to align the income tax and NICs treatment of termination payments. This will mean that if a payment is subject to income tax, it will also be subject to employer and employee NICs.

The government also proposes to remove the current distinction between contractual and non-contractual termination payments. All payments made in connection with the termination of employment will be earnings and subject to income tax and employer and employee NICs, although it will introduce a new exemption (see below). This means that all payments in lieu of notice will be taxed in the same way, irrespective of whether there is a PILON provision in the employment contract.

A new exemption from income tax and NICs will replace the current £30,000 income tax exemption. One option being considered is that the exemption will be available after two years' service and increase with length of service, up to a maximum (as yet unspecified) amount. Service would include employment with the same or an associated employer and any change of employer under the Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE).

This would mean that anyone who receives a termination payment after completing two years' service would not have to pay tax on some, or possibly all, of their award ( depending on the size of the payment). The exemption would not be available to employees who choose to resign and receive a payment from their employer, nor possibly to payments made on the expiry of a fixed-term contract.

The government is also considering whether to target the new exemption at those most in need by only making it available for termination payments made in connection with redundancy (including voluntary redundancy), as defined in the Employment Rights Act 1996. This covers situations where redundancies are made because the employer is ceasing business altogether or at a particular location or has a reduced requirement for employees, either generally or at a particular workplace. If this proposal were implemented, the government says it would also introduce two further exemptions for:

• payments made in connection with compensation for unfair or wrongful dismissal; and compensatory payments made in cases of discrimination.

It is not clear whether these two further exemptions would only apply where the payment is made to a former employee who has issued a claim. If that were the case, it could lead to employees issuing claims just to benefit from the tax exemption and defeating government attempts to reduce the number of tribunal claims. The government seeks views on whether the amount of these exemptions should be capped and whether a distinction should be drawn between payments awarded by the tribunal and sums agreed between the parties.

The government is also reviewing current exemptions. It proposes to retain the exemption for injury or disability and remove the foreign service exemption. It seeks views on whether any other exemptions should be retained.

The consultation closes on October 16, 2015. The government expects to announce its final proposals as part of the 2015 autumn statement.

The proposals represent a significant change to the current regime, although the devil will be in the detail. Employers will be concerned that a more limited exemption will lead to an increase in their employee termination costs. Employees concerned at the loss of a valuable tax exemption will seek to negotiate higher termination payments. Employers may have to offer more to achieve a settlement or face fighting claims.

If the government decides to limit the exemption to redundancy, HMRC will be alive to attempts to avoid tax by describing the reason for dismissal as redundancy. This is not always a straightforward assessment and employers can expect HMRC to scrutinise borderline cases carefully. Then again the exemption available may not be that great. Simplification in this context means more tax and NICs will be payable on termination payments.

This article, written by Peter Doyle, was originally published on Thomson Reuters Accelus at http://www.complinet.com/hr/news/article.html?ref=180565&high=taxation+of+termination+payments