The tax treatment of termination payments has once again been the subject of judicial scrutiny and whilst the decision is unlikely to have implications beyond the facts of the particular case, it highlights the risks and uncertainties for employers and employees alike on this aspect of severance arrangements. Once you read this article, all should become clear.
The tax rules relating to payments made to an employee on termination of their employment are complex. In each individual case it will be important to assess the basis upon which the payment is being made in order to determine the correct tax treatment. Both income tax (and the need to operate Pay as You Earn (PAYE)) and national insurance contributions (NICs) need to be considered. Contemporaneous records should be kept recording the basis of any payment. Failure to tax payments appropriately may not only give rise to interest, penalties and costs, but may also lead HMRC to pay closer attention to the treatment of past and future termination arrangements.
Does the payment constitute “earnings”?
In practice, the main question is often whether the payment made constitutes “earnings” from the employment, or whether it is instead provided in connection with the termination of the employment.
“Earnings” will be subject to income tax and NIC’s in the usual way. “Earnings” are any payment the employee is entitled to pursuant to the terms of the employment contract – such as salary or bonus payments, contractual severance payments and contractual payments in lieu of notice (PILONs) – as well as benefits in kind (e.g. the provision of a company car). It would also cover a payment made when an employer chooses to exercise a discretionary contractual right to make a PILON.
If the payment falls into the second category, the first £30,000 of the payment will be exempt from tax. Any amount in excess of £30,000 will be subject to income tax, but no NIC’s will arise in respect of the payment, not even in relation to the excess. It will therefore be beneficial to structure a compromise agreement, so far as possible, so that the payment falls within this second category. Relevant payments would include damages for breach of contract/wrongful dismissal (non-contractual PILONS), compensation for unfair dismissal and/or discrimination, redundancy payments and ex gratia payments.
Treatment of non-contractual PILON’s
In practice, many difficulties in this area relate to the treatment of non-contractual PILON’s.
HMRC take the view that if a PILON is paid as an automatic response to a termination it will constitute “earnings” as being an integral part of the employer-employee relationship, even it non-contractual.
Where the contract is silent and there is no custom or practice of making such payments, or the employer does not exercise a discretionary right to make a PILON, the PILON should, in theory, be treated as a payment for damages for breach of contract and fall within the second category above. However, in practice, it can be difficult to convince HMRC that the payment is a genuine payment of damages, in particular where the amount of the payment equals the amount of the lost remuneration in the notice period. Consequently an employer may often feel it is prudent to treat the payment as taxable earnings rather than potentially failing to account for income tax and NICs.
What can be done?
HMRC is more likely to accept the payment as being damages for breach of contract (or otherwise falling into the second category above) if:
- the payment is adjusted to take into account one or more of (i) the employee’s ability to mitigate their loss, (ii) the upfront receipt of the damages payment, and (iii) the beneficial income tax and NIC consequences of a payment for damages, as well as all salary and benefits that would have been available in the notice period;
- any decision not to exercise a discretionary right to pay a PILON is evidenced in writing;
- a procedure is in place for making a “genuine critical assessment of each payment”. Each case should be looked at individually, with the decision as to the nature and amount of any payment being made on a case by case basis;
- complete documentation (including contemporaneous notes) has been prepared and retained recording the events surrounding each individual termination, the rationale behind the payments and the calculation of the payment made.
Payments exempt from tax
Certain payments are exempt from tax. These include payments made on account of an employee’s death, injury or disability, certain payments made into approved pension funds and payments referable to a period of employment abroad. Thought should be given as to whether any of these exemptions could potentially be relevant.
HMRC attitude and powers
HMRC are increasingly focusing on how termination payments have been treated when undertaking employer compliance reviews. For example, they have been known to request full details of all non-contractual PILONs and investigate the facts surrounding each payment and the justification for the payment not having been made as an auto-PILON. And where HMRC suspect that a termination payment previously made has been incorrectly taxed, they are more likely to review such payments going forward.
In this context, HMRC have powers to request such information as is reasonably required for the purposes of checking the tax position. They can request the information informally or, if necessary, they can issue a formal “information notice” which then legally requires the recipient to provide the information requested. All correspondence is discloseable to HMRC (although there is no obligation to disclose relevant communications with legal advisors which are subject to legal professional privilege). Without prejudice correspondence is discloseable. It is often these ‘off the record’ exchanges that evidence the rationale behind the way severance payments are structured.
If any termination payments are made before the employee’s P45 is issued, tax must be deducted from all taxable sums at the employees normal rate. If the payment is made after the P45 has been issued, the employee will be 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.
Emma Bailey is a partner and head of the tax practice at Fox Williams and can be contacted on firstname.lastname@example.org or 020 7614 2560.