The Government has issued a consultation paper on proposals to simplify the tax treatment of termination payments. The proposals stem from reports into the current system undertaken by the Office of Tax Simplification (OTS). The OTS concluded that the current system, including the £30,000 tax exemption for certain termination payments and different treatment for income tax and NICs in certain situations, is “fraught with confusion and uncertainty”.

The Government is therefore proposing substantial reforms to the system, with five stated aims:

  • simplicity for employers and employees;
  • certainty for employees;
  • ease of administration for employers and HMRC;
  • fairness (the OTS believes that the current system favours the better paid who are able to take advice on the tax structure of settlement payments);
  • affordability for the Exchequer.

With those aims in mind, particularly affordability, the Government has rejected the suggestion for a blanket exemption which would apply to all payments. Instead, it proposes to scrap the current £30,000 tax exemption and replace it with a new system.

The proposal – a new exemption based on length of service

The suggested new exemption would apply to all employees who have completed two years’ service. The amount of the exemption has not been specified, but it would increase with each year of service, up to a maximum amount. The other significant qualification proposed, however, is that it would only apply where the termination of employment is “wholly or mainly attributable to a redundancy (as defined for the purposes of entitlement to a statutory redundancy payment, but also including voluntary redundancy). Individuals who cannot qualify for statutory redundancy pay because of their employment status (for example employee shareholders and civil servants) would however be included.

This proposal is at an early stage, so we are missing crucial information, such as the amount of the tax exemption. The proposal raises obvious concerns. First, limiting the exemption to redundancy will put pressure on employers to make employees redundant in order to qualify for the tax relief. While the consultation suggests including anti-avoidance measures, it is unclear to what extent this may lead to HMRC looking behind a settlement agreement to ascertain the real reason for the termination. Second, an exemption which applies only after two years’ service carries with it indirect discrimination issues. While the two year threshold is already used for entitlement to unfair dismissal and redundancy rights, introducing it in relation to tax treatment may be vulnerable to challenge.

And reforms to other existing exemptions

In relation to existing exemptions, the consultation proposes retaining (and simplifying) the exemption for payments on account of injury or disability, but removing some other exemptions such as foreign service relief. While this suggests a simplified approach, this is tempered by the proposal for two new exemptions:

  • an exemption for wrongful or unfair dismissal compensation; and
  • an exemption for all compensation relating to discrimination.

In both cases, the consultation asks whether respondents believe that the amount should be capped and/or whether a distinction should be drawn between payments awarded by the tribunal and sums agreed between parties. These proposals currently lack detail and have the potential to cause considerable uncertainty, particularly if they are applied beyond awards made by a tribunal. If, on the other hand, the exemption only applies to tribunal awards, this could impede settlement or lead to settlement payments being grossed up to compensate for the loss of the tax exemption.

What does this mean for employers?

Given the Government’s commitment to reform in this area, it seems very likely that changes will be made to the current termination payment tax regime. The current proposals suggest we can expect to see an increase in the tax due on high value termination payments. The consultation runs for 12 weeks, closing on 16 October 2015. As it is the first stage of the reform process, it will be a while before any changes are implemented. As already indicated, based on the current proposals, the reforming legislation will need careful drafting to avoid replacing current uncertainties in tax treatment with a new set of problems for employers and employees to navigate.