Tax Treatment of Payments on Termination of Employment

Most employers are aware that in certain circumstances a lump sum payment to an employee on the termination of their employment may be tax-free.  Where tax-free treatment is available it is usually capped at £30,000, but unfortunately this has led many employers to believe that all payments made to employees in these circumstances will be tax-free up to £30,000.  This is very far from the case and the circumstances in which a termination payment might be treated in this favourable manner for tax purposes are in fact very restricted. 

The favourable tax treatment referred to above will only be available where the payment is damages or compensation to an employee for loss of rights on termination of their employment.  Otherwise any payment is likely to be part of the earnings from their employment and taxable in full including national insurance contribution liability.  As a number of different situations can arise in practice, some of these are considered below and a summary of the tax consequences provided.

Resignation

The payments made to an employee whilst serving notice are subject to PAYE (tax and NIC)  in the normal way.  This would be the case even if the employee is on “garden leave” during this period   It is of course possible that an employer might decide to terminate the employment at an earlier date by making a payment in lieu of notice (“PILON”).  If the contract of employment in question specifically provides for a payment to be made to the employee as an alternative to working notice, then the payment is always subject to PAYE (tax and NIC).

Dismissal

If an employee is given notice for poor performance (appropriate disciplinary procedures having been followed) then any earnings during the period in which that notice is being worked, will be taxable in the same way as outlined above

Where a summary dismissal takes place because of gross misconduct there will presumably be no entitlement to a termination payment in any event.  Sometimes however a payment may be made because of a failure (or perceived failure) to comply with appropriate disciplinary procedures.  In these circumstances it should be possible to argue that the payment is damages and thus tax-free up to the limit of £30,000. 

Compromise Agreements

Even where poor performance or some degree of misconduct is a factor it is often quite rare for employees, particularly relatively senior ones, to be dismissed.  Departure by “mutual agreement” is more common and lawyers are usually employed to draw up compromise agreements under which an employee receives certain payments, usually in return for making certain undertakings, one of which will normally be an undertaking not to pursue any legal action against the employer.  Compromise agreements are often very difficult to evaluate from a tax point of view and expert advice will usually be required.  All employers should ask a tax advisor to review the wording of compromise agreements before they are finalised. 

Notwithstanding the above, it should be noted that where employers contribute to the legal costs of the employee HM Revenue will usually allow this to occur on a tax free basis.

Redundancy

Redundancy will often offer the best opportunity for a payment to be received tax-free on termination, but it must be a genuine redundancy.  Statutory redundancy payments are tax-free, but count towards the £30,000 limit.  If the redundancy payment includes anything in respect of restrictive covenants, holiday pay, terminal bonuses and so on, these will all be taxable. 

Retirement or Quasi-Retirement

Non-contractual lump sum termination payments made to employees who leave voluntarily at or around or approaching retirement age, are treated by H M Revenue as unapproved retirement benefits and as such are taxable and do not benefit from the £30,000 exemption. 

Payments made as Compensation for Discrimination

There are various statutory obligations on the employer to prevent discrimination in the work place on the grounds of sex, disability, politics, religion and now age.  This is a particularly complex area in terms of establishing whether a tax liability arises when a compensatory payment for discrimination is made.  Broadly however payments for discrimination/injury to feelings are likely to be totally tax free whereas other payments will be taxable to the extent that they exceed the £30,000 threshold. 

Tax Deductibility for Employer

In the majority of situations there will be no difficulty for the employer in obtaining a tax deduction against business profits for the cost of an employee termination payment.  The basic deductibility of the costs of hiring and firing staff is well established.  One area of potential difficulty, however, is where the payment relates to a change in ownership of a business

National Insurance

Where payments are liable to tax then, almost certainly, National Insurance will also be due.  However, where payments are tax free or only taxable to the extent the £30,000 limit is exceeded then, almost certainly, no National Insurance will be due.

Conclusion

It is probably fairly clear from the above that there are many more possibilities that a termination payment will be taxable than that it will be non-taxable and employers have to proceed on that basis.  Failure to operate PAYE will always fall back on the employer in these circumstances, often with an interest and penalty charge included in any late settlement of the PAYE liability.