In its final report into the taxation of employee benefits and expenses, issued at the end of July 2014, the Office of Tax Simplification (OTS) endorsed the idea of using termination payments as a test area for looking at reforming the treatment of National Insurance Contributions (NICs)
In June 2014, rumours circulated again that there were plans to merge National Insurance and income tax in a future parliament. However, these reports were quickly dampened.
The report included a recommendation that all payments be subject to taxation with a new relief being introduced. The new relief should only be available in cases of statutory redundancy with the level of the exemption made as a multiple of the payment that the individual is entitled to, or alternatively a flat amount. There is confusion with the current system as many believe the first £30,000 off any payoff payment is tax-free regardless of the circumstances.
A formal consultation has also been recommended to review the other existing exemptions, reliefs and reductions which apply to the charge for termination payments. This will determine in each case whether they should be retained as payments for Foreign Service or on death, illness or disability. (NICs)
Whilst some quick wins such as better guidance on the HMRC position on auto payment in lieu of notice (PILONs) and payments around retirement are recommended, this whole area is one to watch. Many of the OTS recommendations have found themselves in the law in the past.
But for now it is worth reminding ourselves exactly what the current rules are bearing in mind that HMRC regards payments made on the termination of employment or following an equal pay or discrimination claim as a hot topic for review. If a payment is wrongly assumed to be tax-free then HMRC will often recover any tax and NICs underpaid from the employer, along with interest and penalties.
When looking at a payment it is advisable to consider the position in the following order. This follows the order of priority in the tax legislation: (NICs)
1. Is the payment (including benefits) ‘earnings’ from the employment? If so, the earnings will be fully liable to tax and NICs in the usual way.
2. Is any part of the payment being made in respect of a restrictive covenant? If so, that part is fully liable to income tax and NICs.
3. Does the payment relate to a pension or is it linked in any way to retirement? If so, there are special rules relating to such payments.
4. Is it another type of payment made in consideration of, or in connection with, the termination of the employment? This could allow for the application of a tax exemption and no NICs would be due regardless of the size of the payment.
So what types of payments might you have and are they currently taxable?
Redundancy
Genuine statutory and non-statutory redundancy payments, whether or not they are written in an employment contract, will still attract the £30,000 exemption and will not be liable to NICs.
Terminal bonuses
Terminal bonuses are payments made by employers in return for the employee agreeing to stay until a specified date and/or performing certain duties. They are generally contractual and treated as subject to tax and NICs.
Restrictive covenants
Restating of restrictive covenant/s contained in the employment contract with no monetary value attached should not be taxable. See HMRC’s Statement of Practice 3/1996 for further guidance. Other restrictive covenants almost certainly should be subject to tax and NICs.
Contractual PILON
If the contract of employment provides the option of terminating the employment by a payment of a sum in lieu of notice (or provides the discretion to do so), then where a payment is made it will constitute a contractual PILON, subject to tax and NICs.
Customary or automatic PILON
Clearly HMRC will still question these payments. However, where an employer can demonstrate a procedure for making a genuine ‘critical assessment’, the position that the payment should be considered to qualify for the £30,000 exemption will be easier to defend. HMRC guidance confirms that:
• Simply making a payment ‘automatically’ or habitually does not of itself make it earnings – an employer may pay damages in that way.
• Damages can be reduced to take into account, for example, earnings in any new employment during what would have been the employee’s notice period. However, it will not always be possible for an employer to mitigate the payment.
Damages (or other PILON)
Where an employer summarily dismisses the employee without giving notice and makes a PILON and there is no right or discretion to do so under the contract, the employer is in breach of contract. In such cases the PILON represents damages since there is a likelihood that the employee could sue for breach of contract and the £30,000 exemption would apply and no NICs would be due.
Ex-gratia payments
Ex-gratia sums paid where there is no specific requirement to do so, if truly voluntary and ‘in connection or consideration of the termination’ and which do not fall under any of the other charging provisions, will attract the £30,000 tax exemption and will be wholly exempt from NICs.
HMRC will scrutinise such payments to check they do not relate to the performance of past duties such as recognition of long service (or retirement) and that they are not, for example, a terminal bonus. Care is needed in any written communication with the employee and phrases such as ‘in recognition of past services’ can cause issues.
Discrimination/Injury to feelings
Compensation in discrimination cases often includes a payment in respect of injury to feelings. HMRC tend to accept that payments made by employment tribunals for injury to feelings can be tax-free without limit where the injury was caused by events that took place in the course of the employment and not by the termination itself. Otherwise, the exemption may be limited to £30,000. Where the payments arise as part of a compromise agreement, HMRC will look more closely to see if they have followed the normal pattern of injury to ‘feelings payments’ as established by employment case law.
Share options and share awards
Tax and NICs liabilities will depend on many factors including whether the scheme is taxadvantaged, the length of ownership and the reason for the termination of employment. A cash cancellation or compensation payment will be fully taxable, but other payments may not. Employees may also be entitled to exercise share options and obtain share awards either before or after termination.
Employer contributions to registered pension schemes
These can often happen on the termination of employment and may be made tax-free subject to the annual allowance and lifetime allowance limits.
Are there any other reliefs or exemptions?
More tax exemptions exist if certain considerations apply where:
• employees are terminated due to ill-health
• an employee has died
• the employment has included an element of foreign service
• counselling and other out placement services are included
• contributions are made to an approved retirement benefit scheme
• a payment is made by the employer to cover the cost of the employee’s legal costs in taking action against the employer in connection with the termination.
Certain tax exempt lump sums which are payable from an approved pension scheme are also excluded from income tax under the termination payments legislation.
However non-cash benefits that form part of the termination settlement eg the continuing provision of a company car or medical insurance, also need to be taken into account and an amount attributed to them for the purpose of working out if the tax exemptions apply. See the HMRC website for further guidance.
Do you need to report termination payments to HMRC?
Where the value of the settlement is more than £30,000, a formal report needs to be filed with HMRC by 6 July following the tax year in which the termination took place. There is no set format but a letter should be sent to HMRC with the termination details where they have not already been reported via the payroll under Real Time Information.
Can you obtain HMRC clearance?
HMRC do operate a process whereby advance clearance or confirmation of the tax treatment can be obtained. Employers should consider seeking clearance where possible. How do you process payments through the payroll?
Any payment made after leaving and the P45 process, will be subject to taxation (where due) using the tax code 0T on a month 1 basis. This code indicates that the employee has no personal allowances and all income is subject to the basic, higher or additional rates of tax depending on the amount being paid. Payment made before the employment ends will be processed using the employee’s marginal rate of tax.
The charge only applies to any payments above the £30,000 threshold or which are otherwise chargeable to income tax.
What records should employers keep?
Employers should be aware that tax-free termination packages will often be looked at closest by HMRC. Ideally, therefore each termination should be considered on a case by case basis with evidence retained identifying the individual elements of the package, along with the decision making process or negotiations. These will help support the tax treatment, which might be questioned by HMRC.
By Susan Ball.
In its final report into the taxation of employee benefits and expenses, issued at the end of July 2014, the Office of Tax Simplification (OTS) endorsed the idea of using termination payments as a test area for looking at reforming the treatment of National Insurance Contributions (NICs)
In June 2014, rumours circulated again that there were plans to merge National Insurance and income tax in a future parliament. However, these reports were quickly dampened.
The report included a recommendation that all payments be subject to taxation with a new relief being introduced. The new relief should only be available in cases of statutory redundancy with the level of the exemption made as a multiple of the payment that the individual is entitled to, or alternatively a flat amount. There is confusion with the current system as many believe the first £30,000 off any payoff payment is tax-free regardless of the circumstances.
A formal consultation has also been recommended to review the other existing exemptions, reliefs and reductions which apply to the charge for termination payments. This will determine in each case whether they should be retained as payments for Foreign Service or on death, illness or disability. (NICs)
Whilst some quick wins such as better guidance on the HMRC position on auto payment in lieu of notice (PILONs) and payments around retirement are recommended, this whole area is one to watch. Many of the OTS recommendations have found themselves in the law in the past.
But for now it is worth reminding ourselves exactly what the current rules are bearing in mind that HMRC regards payments made on the termination of employment or following an equal pay or discrimination claim as a hot topic for review. If a payment is wrongly assumed to be tax-free then HMRC will often recover any tax and NICs underpaid from the employer, along with interest and penalties.
When looking at a payment it is advisable to consider the position in the following order. This follows the order of priority in the tax legislation: (NICs)
1. Is the payment (including benefits) ‘earnings’ from the employment? If so, the earnings will be fully liable to tax and NICs in the usual way.
2. Is any part of the payment being made in respect of a restrictive covenant? If so, that part is fully liable to income tax and NICs.
3. Does the payment relate to a pension or is it linked in any way to retirement? If so, there are special rules relating to such payments.
4. Is it another type of payment made in consideration of, or in connection with, the termination of the employment? This could allow for the application of a tax exemption and no NICs would be due regardless of the size of the payment.
So what types of payments might you have and are they currently taxable?
Redundancy
Genuine statutory and non-statutory redundancy payments, whether or not they are written in an employment contract, will still attract the £30,000 exemption and will not be liable to NICs.
Terminal bonuses
Terminal bonuses are payments made by employers in return for the employee agreeing to stay until a specified date and/or performing certain duties. They are generally contractual and treated as subject to tax and NICs.
Restrictive covenants
Restating of restrictive covenant/s contained in the employment contract with no monetary value attached should not be taxable. See HMRC’s Statement of Practice 3/1996 for further guidance. Other restrictive covenants almost certainly should be subject to tax and NICs.
Contractual PILON
If the contract of employment provides the option of terminating the employment by a payment of a sum in lieu of notice (or provides the discretion to do so), then where a payment is made it will constitute a contractual PILON, subject to tax and NICs.
Customary or automatic PILON
Clearly HMRC will still question these payments. However, where an employer can demonstrate a procedure for making a genuine ‘critical assessment’, the position that the payment should be considered to qualify for the £30,000 exemption will be easier to defend. HMRC guidance confirms that:
• Simply making a payment ‘automatically’ or habitually does not of itself make it earnings – an employer may pay damages in that way.
• Damages can be reduced to take into account, for example, earnings in any new employment during what would have been the employee’s notice period. However, it will not always be possible for an employer to mitigate the payment.
Damages (or other PILON)
Where an employer summarily dismisses the employee without giving notice and makes a PILON and there is no right or discretion to do so under the contract, the employer is in breach of contract. In such cases the PILON represents damages since there is a likelihood that the employee could sue for breach of contract and the £30,000 exemption would apply and no NICs would be due.
Ex-gratia payments
Ex-gratia sums paid where there is no specific requirement to do so, if truly voluntary and ‘in connection or consideration of the termination’ and which do not fall under any of the other charging provisions, will attract the £30,000 tax exemption and will be wholly exempt from NICs.
HMRC will scrutinise such payments to check they do not relate to the performance of past duties such as recognition of long service (or retirement) and that they are not, for example, a terminal bonus. Care is needed in any written communication with the employee and phrases such as ‘in recognition of past services’ can cause issues.
Discrimination/Injury to feelings
Compensation in discrimination cases often includes a payment in respect of injury to feelings. HMRC tend to accept that payments made by employment tribunals for injury to feelings can be tax-free without limit where the injury was caused by events that took place in the course of the employment and not by the termination itself. Otherwise, the exemption may be limited to £30,000. Where the payments arise as part of a compromise agreement, HMRC will look more closely to see if they have followed the normal pattern of injury to ‘feelings payments’ as established by employment case law.
Share options and share awards
Tax and NICs liabilities will depend on many factors including whether the scheme is taxadvantaged, the length of ownership and the reason for the termination of employment. A cash cancellation or compensation payment will be fully taxable, but other payments may not. Employees may also be entitled to exercise share options and obtain share awards either before or after termination.
Employer contributions to registered pension schemes
These can often happen on the termination of employment and may be made tax-free subject to the annual allowance and lifetime allowance limits.
Are there any other reliefs or exemptions?
More tax exemptions exist if certain considerations apply where:
• employees are terminated due to ill-health
• an employee has died
• the employment has included an element of foreign service
• counselling and other out placement services are included
• contributions are made to an approved retirement benefit scheme
• a payment is made by the employer to cover the cost of the employee’s legal costs in taking action against the employer in connection with the termination.
Certain tax exempt lump sums which are payable from an approved pension scheme are also excluded from income tax under the termination payments legislation.
However non-cash benefits that form part of the termination settlement eg the continuing provision of a company car or medical insurance, also need to be taken into account and an amount attributed to them for the purpose of working out if the tax exemptions apply. See the HMRC website for further guidance.
Do you need to report termination payments to HMRC?
Where the value of the settlement is more than £30,000, a formal report needs to be filed with HMRC by 6 July following the tax year in which the termination took place. There is no set format but a letter should be sent to HMRC with the termination details where they have not already been reported via the payroll under Real Time Information.
Can you obtain HMRC clearance?
HMRC do operate a process whereby advance clearance or confirmation of the tax treatment can be obtained. Employers should consider seeking clearance where possible. How do you process payments through the payroll?
Any payment made after leaving and the P45 process, will be subject to taxation (where due) using the tax code 0T on a month 1 basis. This code indicates that the employee has no personal allowances and all income is subject to the basic, higher or additional rates of tax depending on the amount being paid. Payment made before the employment ends will be processed using the employee’s marginal rate of tax.
The charge only applies to any payments above the £30,000 threshold or which are otherwise chargeable to income tax.
What records should employers keep?
Employers should be aware that tax-free termination packages will often be looked at closest by HMRC. Ideally, therefore each termination should be considered on a case by case basis with evidence retained identifying the individual elements of the package, along with the decision making process or negotiations. These will help support the tax treatment, which might be questioned by HMRC.
By Susan Ball.
