Employers will be disappointed to learn that tax and NIC free termination payments up to £30,000 may soon become a thing of the past. The government proposes to replace the current tax and NIC treatment of termination payments with a "simpler" regime consisting of new exemptions on termination payments. A quick analysis of the proposals indicates that the new regime will undoubtedly be less beneficial for employers and employees.
All the details can be found in the government's consultation paper Simplification of the tax and national insurance treatment of termination payments. Closing date for comments is 16 October 2015.
The current regime
A payment made on termination of employment is often made up of several different elements which may include, for example, a statutory redundancy payment, a payment in lieu of notice (PILON) and compensation for breach of contract or for discrimination. Currently PILON payments are taxable as earnings but other elements such as compensation for breach of contract and statutory redundancy are treated differently and are only liable to income tax on the amounts exceeding £30,000. Significantly, even termination payments exceeding the cap are currently free of employer's and employee's national insurance contributions (NICs). A report by the Office of Tax Simplification has found that there is much confusion that arises from the complex rules giving this tax relief: for example, whether the termination payment is a PILON (fully taxable) or whether it is in fact compensation for breach (not taxable up to £30,000). The government believes that employers and HMRC find it difficult and time consuming to establish the true nature of each separate element of a termination payment. So to simplify the rules, and to make the system fair for all, the government is considering removing the distinction between contractual and non-contractual payments, aligning the tax and NIC treatment of termination payments and seeking views on whether to remove or replace some or all of the existing exemptions.
Summary of the proposals
The government proposes to abolish the £30,000 relief and replace it with a new exemption from tax and NICs for payments made to employees in connection with termination of their employment where their employment ends for no fault of their own. To qualify for the relief, the employee would need at least two years' service and the relief would increase proportionately with the number of years' service completed up to a maximum amount, which has not yet been revealed. Significantly both tax and NICs will be payable on the proportion of the termination payment which exceeds the set amount. There is a strong indication in the consultation paper that this relief may be restricted to redundancy situations only. If so, there will be two further exemptions which may also be subject to a cap:
- A new exemption for compensation for unfair/wrongful dismissal
- A new exemption for compensation for discrimination
In addition, the government will review the current exemptions from payment of tax and NICs:
- Current exemptions to be retained:
- Payments for injury or disability
- HM Forces payments
- Payments into a registered pension scheme up to any limits in the legislation
- Current exemptions to be reviewed:
- Exemption on payment of legal costs for advice on the Settlement Agreement
- Foreign service exemption
What these proposals mean for employers
Employers will have mixed feelings about these proposals for reform.
On the upside, the rules may in future be simpler. There will be no need to analyse whether a termination payment falls under the contract of employment as a PILON or whether it is non-contractual and therefore potentially free from tax. In discrimination cases, there will no longer be a need to distinguish between compensation for injury to feelings (not taxable) and the rest of the award (currently taxable but subject to the £30,000 relief). Employers will therefore welcome the proposal to keep some tax relief for termination payments (including PILONs) which relate to unfair dismissal and discrimination, as well as redundancy.
On the downside, it looks like any termination payments which fall outside the scope of the new exemptions could be subject to employer NICs (currently 13.8% of earnings above £156/week) and employee NICs for the first time. This reform would represent a significant additional cost for employers meaning that the cost of settlements will increase. Furthermore, as the cap on the relief is also likely to be less than the current £30,000 cap, employers may need to offer higher termination payments to compensate the employee for having to pay tax on a greater proportion of the termination payment. Currently, the ability to pay tax free up to £30,000 is often what bridges the gap between employer and employee in settlement negotiations.
Employees will also lose out. On the list of losers are those employees who are dismissed fairly for poor performance and those whose employment ends on the expiry of a fixed term contract. Employees with less than two years' service will no longer be entitled to any relief for redundancy payments at least (although they may still qualify for unfair dismissal/discrimination relief). The extent to which longer serving employees will benefit from the new exemptions will depend on the rates of exemption that will be set, but they are likely to be worse off than before because the cap will be lower. If the government decides to set no cap eg on discrimination awards, employees who receive large awards for discrimination could be better off but there is little indication in the consultation paper that this is the government's intention.
Finally, there are some unknowns. First the consultation paper does not clarify what employers and employees will need to show in order to establish that any settlement was for unfair dismissal or discrimination. For example, will it be sufficient for the settlement agreement to set out the facts to establish this? Will it need to be verified by an ACAS conciliator? Normally, of course, there is a dispute between employer and employee as to whether there has been an unfair dismissal or discrimination and any system which requires an admission of liability by the employer will be unworkable. Secondly, to fully understand the impact of the proposed reforms, we need to know what rates of exemption and cap the government is proposing. Employers will be dismayed if they are set as low as the examples set out in the consultation paper - £6000 for an employee with two years' service, rising £1000 per year of service. What about any cap on the unfair dismissal/discrimination payments? The government is consulting on this so in theory, it could differ from the cap on the redundancy exemption, and there may be a different cap for awards made by a tribunal as against awards agreed between employer and employee. It's also worth noting that although the government has indicated its intention to keep the exemption for injury or disability (which is available during and at the end of employment), it is consulting on whether it should be retained. With all these variables, there is a risk that the new regime doesn't even end up being simpler, just more expensive.