It is a common misconception amongst many workforce’s that any and all termination payments made to compensate an employee for the loss of their employment can be made tax free or that the employer has some sort of discretion to decide whether to pay tax on these payments or not.
At Nelsons, we often advise employers on negotiating payments and frequently, we are then instructed to prepare a settlement agreement confirming the agreed package.
It is very important that the tax and national insurance position is clear as HM Revenue and Customs (HMRC) can recover unpaid tax, national insurance, penalties and interest from the employer. The employer may then have to pursue the employee for the unpaid tax via an indemnity in the settlement agreement (if one has been included).
Are Termination Payments Taxable?
- Is it general earnings or a benefit of employment?
- If not, is it a payment for a restrictive covenant?
- If not, is it taxable under sections 401 to 416 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA)?
There are separate rules to deal with termination payments relating to shares, securities and share options and payments to registered pension schemes.
General Earnings & Benefits of Employment
These are taxable.
This currently includes: salary, wages, contractual payments in lieu of notice and “golden hellos”. Generally, this category will cover any payments made prior to the termination date.
Restrictive Covenants
Money paid for entering in to a restrictive covenant is taxable.
Sections 401 To 416 ITEPA
This section only applies to payments which are not caught by another provision. This covers most ex gratia payments, redundancy payments, currently non-contractual payments in lieu of notice which are not automatic or custom and practice (i.e. damages for wrongful dismissal) and compensation for alleged unfair dismissal or alleged discrimination.
The first £30,000 of payments that fall within section 401 is exempt from tax and any excess will be subject to income tax in the normal way.
Changes From April 2018
From 6th April 2018, all notice pay and payments in lieu of notice (whether or not the employee is required to work it and regardless of whether there is a provision in their contract about payment in lieu of notice), any other contractual payments, (such as bonuses, commission, performance payments or any other monies that would have accumulated during that notice period) and any payments made to compensate the employee for the loss of a benefit, (for example a cash payment to cover the early return of a company car, or the loss of private health insurance), will be regarded as general earnings and therefore taxable.
After 6 April 2018, employers who make payments in lieu of notice without deducting tax, expose themselves to the risk of incurring additional costs, as HMRC will seek to recover not only the unpaid PAYE tax and National Insurance Contributions (NIC) but also penalties and statutory interest.
In looking at payments, HMRC will consider what part of any settlement package is attributable to their pay, other contractual payments and benefits for their notice period (if they have not been required to work all or part of their notice).
More Changes From 6 April 2019
From this date, payments exceeding £30,000, in addition to being liable to income tax will also be subject to employer national insurance contributions (but not employee national insurance contributions).
What Does This Means For Employers
Employers who are already negotiating with employees or ex-employees might wish to finalise arrangements quickly if they wish to benefit from the current rules and make a payment in lieu of notice tax free.
After 6 April 2018, all payments made or benefits related to notice periods will be taxable in full as earnings.
Employers already considering restructures and redundancies in the future, might wish to consider the timing of their plans as employer national insurance contributions will be payable on notice payments post April 2019.
When reviewing employment contracts, employers may wish to reconsider including contractual provisions regarding termination payments in lieu of notice (which they might previously have left out for the tax benefits) as including these in contracts mean that contracts can be lawfully terminated by a payment in lieu of notice (so that restrictive covenants and other contractual provisions still apply) and these can be drafted to limit the value of payments in lieu of notice to basic salary only.
How Nelsons Can Help
For more employee legal advice or to comment on this article please contact Laura Kearsley, one of our employment law specialists, on 0800 024 1976 or via our online form to find out how we can help.