There remains a widely-held misconception that the first £30,000 paid to an employee on the termination of their employment will always be exempt from income tax. It is important not to fall into this trap.
The actual tax treatment will depend upon a number of factors including the background circumstances to the termination of the employment and the basis on which the termination payment is being made to the employee. It will often be the case that the termination payment is made up of several elements, each of which may well have their own distinct tax treatment.
The Government confirmed at its Autumn Statement in November 2016 that it would both simplify and tighten-up the tax rules for termination payments with effect from the start of the 2018/19 tax year.
This note provides an overview of the current tax treatment of termination payments and the changes scheduled to be brought in from 6 April 2018.
How are termination payments taxed?
The nature of the payment, the intentions of the employer and the reasons behind each payment require to be reviewed to help establish the correct tax treatment of termination payments. As part of this exercise the following questions should be asked:
- Is the payment earnings or is it in payment for past, present or future service?
- Is it a payment for entering into a new or amended restrictive covenant?
- Is the payment or other benefit received directly or indirectly in connection with the termination of a person’s employment?
The £30,000 exemption for payments for “loss of office”
The first £30,000 of a termination package that qualifies to be treated as “compensation for loss of office” is exempt from income tax. Anything above the £30,000 limit will be subject to income tax at the employee’s marginal rate of tax (e.g. 20%/40%/45%).
An unfair dismissal award is taxed in the same way as a compensation payment for loss of office, with the £30,000 exemption applying.
The £30,000 exemption will only be available if there is no other provision in the legislation under which the payment would be taxed. Where, for example, a payment could be treated as both compensation for loss of office and general earnings then it will be subject to income tax and Class 1 NICs as earnings.
Where the payment is “compensation for loss of office”, it is also exempt from Class 1 NIC’s. Indeed this exemption extends to the whole value of any termination package that qualifies as damages (there is no £30,000 cap on the exemption for NIC purposes). This unrestricted Class 1 NICs exemption currently extends to both Employer’s and Employee’s Class 1 NICs.
Contractual and non-contractual payments
The vast majority of contractual payments (e.g. golden handshakes) are liable to income tax and Class 1 NICs. This is the case even if the payment is intended to compensate for the loss of future earnings.
Genuine redundancy payments (whether statutory, non-contractual or contractual) will, however, qualify for the £30,000 exemption.
Payments in lieu of notice (PILONs)
The tax treatment of a PILON currently depends upon how it is categorised:
- Contractual - Where there is an express contractual provision, the payment will generally be treated as earnings. The PILON clause could, for example, be found in an employment contract, side letter, staff handbook, etc...
- Discretionary - Where the contract of employment gives an employer a discretionary right to make a PILON then such payments will be treated as earnings.
- Automatic - An ‘auto-PILON’ (i.e. where the PILON is an automatic response by the employer to any period of unworked notice) will be treated as earnings for tax purposes. A non-contractual PILON should not be treated as earnings if the employer has some form of genuine internal assessment protocol in place that is applied.
- Damages - A PILON that is paid as genuine compensation for loss of notice should qualify for the £30,000 income tax exemption and be entirely exempt from Class 1 NICs.
Compensation for discrimination
The tax treatment of compensation received by an employee as a result of discrimination will depend upon the nature of the payments awarded by the tribunal or the terms of any settlement agreement. In general, a distinction is made between the tax treatment of compensation payments for:
Discrimination which occurred during the course of an employment
There is an unrestricted tax exemption available where the payment does not relate to the termination of employment;
The termination of employment itself
The £30,000 exemption should apply where there is a payment for injury to feelings arising from the termination of employment. Any value in excess of the £30,000 threshold will be subject to income tax at the employee’s marginal income tax rate.
It is, however, necessary to review the individual circumstances of each case when establishing the tax treatment of any discrimination payment being made as part of a termination package. Occasionally it will not be clear whether the injury arises from discrimination occurring during the employment or whether it arises in connection with the termination of the individual’s employment. Tax legislation, relevant case law and HMRC practice all need to be taken into account.
Certain types of payments forming part of a termination package could be exempt from both income tax and Class 1 NICs if the relevant qualifying conditions are satisfied. These payments include:
- Contributions to registered pension schemes
- Payments out of registered pension schemes
- Legal costs
- Outplacement costs
- Payments made in respect of death, injury or disability
- Payments made in respect of foreign service by the individual
Termination payments that fall into one of these categories will be tax exempt and will not be taken into account when calculating whether the £30,000 exemption threshold has been reached on the termination package.
A number of Government reforms to the tax treatment of termination payments were incorporated into the 2017 Finance Bill. The actual enactment of the legislation has been postponed until the next Parliament. The measures that are due to come into force from 6 April 2018 include:
£30,000 threshold for employer’s Class 1 NIC’s exemption
Class 1A Employer’s NICs (currently at a rate of 13.8%) will be payable on compensation for loss of office payments, with the exception of the first £30,000. The unrestricted exemption from Class 1 NICs available to employees on the receipt of damages on the termination of their employment will continue to apply;
All PILONs, regardless of their nature, are to be treated as earnings subject to income tax and Class 1 NICs with effect from 6 April 2018;
Payments for injury to feelings
The unrestricted tax and NI exemption for certain injury payments will only be available where the injury amounts to a psychiatric injury or other recognised medical condition; and
Foreign service relief
The relief for termination payments relating to foreign service is to be withdrawn with new provisions being introduced to ensure that termination payments will only be taxable where the employee is resident in the UK under the statutory residence tests or if the employee has performed duties in the UK.
It is always important to review at the earliest opportunity the tax implications of any proposed payments forming part of a termination package. The reforms to the taxation of termination payments coming into force from 6 April 2018 should focus employers’ minds on separately identifying and establishing the tax treatment of each and every part of a termination package.
Anderson Strathern has a large team of experienced employment and tax specialists who are able to offer practical, commercial and effective advice to help you minimise the potential tax exposure while protecting your rights.