Payments on termination – General
When a payment is made to an employee on the termination of their employment it is important to assess the basis on which the payment is made in order to determine the correct tax treatment. Failure to tax payments appropriately can not only lead to HM Revenue & Customs (“HMRC”) seeking interest, penalties and costs, but may also mean that HMRC pay closer attention to the way in which past and future agreements have been treated.
The Income Tax (Earnings and Pensions) Act 2003 (“ITEPA”) sets out the way in which payments should be taxed. Under Part 2 of ITEPA, general earnings and income specifically derived from employment is taxable. This means that an employee’s salary as well as any bonus, commission, contractual payments in lieu of notice and many benefits in kind (such as the provision of a company car) will be subject to tax and national insurance contributions.
The £30,000 exemption
However, the position is not so straightforward for certain other payments made on termination of employment, such as redundancy payments, damages for wrongful dismissal or compensation for unfair dismissal and/or discrimination. Sections 401 to 416 of ITEPA apply in these circumstances. The first £30,000 of any payment that falls within section 401 ITEPA is exempt from tax, and any amount in excess of £30,000 will be subject to income tax in the normal way. It is also worth noting that such payments are not liable to employee or employer national insurance contributions, even if they exceed £30,000, because they are not earnings. The employee gains the benefit of the £30,000 exemption only if the payment is not otherwise taxable. This means that the payment must not be characterised as earnings. If the payment is deemed to form part of an employee’s earnings, for example holiday pay, it will not fall within the £30,000 exemption even if paid on termination of employment.
If an employee’s employment is to be terminated, but the employee will continue to provide services to the employer (for example under a consultancy agreement), it is still possible for the £30,000 exemption to apply. HMRC will have to be satisfied that the new relationship is fundamentally different and that the payment is genuinely in relation to the termination of employment.
If any of the above payments are made before the employee’s P45 is issued, tax must be deducted from all taxable sums the employee’s normal rate. If the payment is made after the P45 has been issued, the employee will taxed at basic rate. This means that employees who are higher-rate tax payers will have to account to HMRC for the tax shortfall at the end of the tax year when they complete their next tax return.
Payments exempt from tax
Certain payments are exempt from tax, these include payments made on account of an employee’s death, injury or disability. These payments should be treated separately from the payments which attract the £30,000 exemption.
It may be possible for the employee to avoid paying tax on a severance payment when the employer pays the sum directly into an approved pension fund. However, this is subject to the rules of the particular pension scheme and HMRC maximum limits. Professional pensions advice should be sought before such payments are made.
Payments in lieu of notice
If the employee has a contractual right to a payment in lieu of notice (PILON) on termination, this payment will be subject to tax and liable to national insurance contributions. The situation is the same where an employer gives a PILON as a matter of course, even if there is no contractual entitlement.
Where the contract is silent and there is not a custom or practice of making such payments, the PILON will not be contractual and should be treated as a payment of damages which falls within section 401 ITEPA (so that it will be tax free up to £30,000 with no liability for national insurance contributions). Despite this, many employers are taking the view that it is prudent to treat the payment as taxable as earnings rather than potentially incorrectly pay the sum as damages.
Some contracts give the employer a discretionary right to make a PILON. In such circumstances, a payment under the exercise of this discretion would be liable to tax and national insurance contributions. If the employer did not exercise their discretion, but made a payment of damages instead, the payment would fall within section 401 ITEPA, as above. However, in practice, the difficulty is in convincing HMRC that this is a genuine payment of damages rather than a PILON and so it is often recommended that employer’s treat such payments as taxable earnings. To demonstrate that a payment is in fact a damages payment, account should be taken of the employee’s ability to mitigate their loss and the fact that they are receiving the damages upfront. By making a reduction to the payment in order to reflect mitigation/early receipt, HMRC is more likely to accept that the payment is genuinely damages rather than earnings.
Where an employer wishes to impose new or amended restrictive covenants, or restate covenants in a contract where it is alleged that the employer has broken the contract (and would not, therefore, otherwise be able to rely on those covenants) consideration is often specifically attached to those covenants to increase the likelihood of them being binding. Any such payment of consideration will be treated as earnings under section 225 ITEPA and will be liable to tax and national insurance contributions.
If the employer pays the employee’s legal costs, these will be exempt from tax and national insurance contributions under HMRC’s Extra-Statutory Concession (ESC) A81 if the following conditions are met:
- The costs are incurred solely in connection with the termination;
- The fees are paid directly to the solicitor;
- The payment is made under a term of the compromise or severance agreement.
If the employer is unwilling to cover all of the employee’s incurred legal costs, and the employee is receiving a settlement sum in excess of the £30,000 exemption, the employer may agree under the compromise agreement to cover all of the legal costs, provided that the balance is re-apportioned from the agreed settlement payment. This will allow the employee to take the benefit of the tax concession without the employer paying any more money.
As the employer will be liable to pay the income tax charge and national insurance contributions together with any interest and penalties if the exemption is wrongly applied, so that tax and national insurance contributions fail to be deducted, the employer may seek an indemnity from the employee in respect of any such tax and employee national insurance contributions. A clause in the compromise agreement stating that the employee will be responsible for any such payments should be included in your precedent.
The employer may also include a carefully worded clause in the compromise agreement to allow the employer to ‘claw back’ the termination payment from the employee in certain circumstances, for example, if the employee brings proceedings against the employer at a later date in breach of the compromise agreement. However, following on from case law such as CMC Group Plc v Zhang  EWCA Civ 408, there is a risk that a court may deem such a clause to be a penalty rather than a genuine pre-estimate of the loss the employer is likely to suffer as a result of the employee’s breach. If the clause is deemed to be a penalty, it will be unenforceable.
For further information on tax matters please contact Emma Bailey, Head of Tax at Fox Williams LLP. Emma can be contacted on 0207 628 2000 or firstname.lastname@example.org