The Government has launched a consultation on reforming the income tax and national insurance exemptions for termination payments. The consultation has the stated aim of giving employees certainty about the amount of money they will receive when they lose their jobs whilst, at the same time, simplifying the current position making it easier for employers and HM Revenue & Customs to administer.

Current position

When an employer makes a termination payment to an individual, broadly speaking, the elements of the payment that are from the employment (for example, payments in respect of accrued but untaken holiday) or that the individual is contractually entitled to (for example, a payment in lieu of notice (PILONs) under the terms of the employment contract), are subject to income tax and national insurance contributions (NICs).

In contrast, the elements that are not from the employment are only liable to income tax in respect of any amount exceeding £30,000. No employer's or employee's NICs are payable on these elements whatever the amount.

In addition, there are various other exemptions which apply to termination payments. These include payments made on termination of employment due to death, injury or disability, payments made under a tax exempt pension scheme, payments made to a registered pension scheme, payments made where the employee has a certain type of foreign service and payments by the employer of certain legal costs incurred by the employee.

Proposed changes

In summary:

  • The distinction between the income tax and NICs treatment of contractual and non-contractual payments should be removed.
  • A new exemption from income tax and NICs should be introduced. This will increase proportionately with the number of years' service with the exemption applying only once the employee had completed 2 years of service (Termination Exemption).
  • The Government is also considering that, rather than the Termination Exemption applying to all termination payments, it should only apply to termination payments made where the employee is made redundant.
  • In respect of the existing exemptions, the Government intends to retain the exemption in respect of payments made on termination of employment due to injury or disability (although it does not specifically refer to retaining the exemption in respect of payments made on termination of employment due to death) but to remove the foreign service exemption. It is seeking stakeholders' views on whether any of the other exemptions should be retained.
  • If the Government proceeds with the proposal to link the exemption from income tax and NICs to payments made where the employee is made redundant, it intends to introduce two new exemptions in respect of payments made in connection with wrongful or unfair dismissal and in respect of compensatory payments made in cases of discrimination. It is consulting on whether these exemptions should be subject to a financial cap and whether payments that have been settled by a tribunal should be treated differently to those made under a settlement agreement between an employer and the employee.

Comment

There will certainly be both winners and losers under the proposed changes. Employees with less than 2 years' service will not benefit from the Termination Exemption and, potentially, payments made to those who lose their jobs for reasons other than redundancy will be taxed in full. The consultation gives no clue as to the rate at which the Termination Exemption will apply or the amounts by which it will increase depending on service – much will depend on the actual rates set in determining the extent to which the proposed changes are merely a cost saving measure by the Exchequer.

The proposal to exempt payments made in connection with wrongful or unfair dismissal is helpful but much will depend on the amount of any financial cap and whether this will include payments made under a settlement agreement as well as those settled by a tribunal.

In our experience, the current position is relatively straight forward and readily understood by clients. The only areas of uncertainty tend to be those where HMRC policy or practice is unclear or has been subject to change; policy in respect of PILONs being a good example of this. We are therefore cautious about changing this area of law for a number of exemptions which, at best, do not appear to lead to greater tax simplification.

The consultation is open for comments until 16 October 2015. A copy of the consultation paper can be found here.