When an employment relationship comes to an end, the tax-efficient structuring of termination payments is key. If you get it wrong, it can be costly for both parties. Unfortunately the current legislation which governs the taxation of termination payments is complex and there is a common misconception that there is a tax-free allowance of £30,000 for all termination payments. However, the reality is not so straightforward.

The current position

The first £30,000 of a payment received in connection with the termination of a person’s employment is not subject to income tax.

Examples of payments which may form part of the £30,000 tax-free allowance are:

  • genuine compensation for the loss of employment;
  • tribunal awards and monies received as part of a settlement agreement; and
  • statutory and enhanced redundancy payments.

In addition there are some other types of payment which do not incur a tax liability, such as certain contributions to a pension scheme, legal fees (provided they are paid directly to the employee’s solicitor) and certain payments on account of disability.

Payments that arise under the contract of employment, however, are subject to tax and National Insurance contributions (NICs) in the usual way.

One of the most difficult issues is the consideration of whether to tax a payment in lieu of notice. You can be certain that if there is a clause in the employment contract entitling the employer to make a payment in lieu of notice, commonly known as a PILON clause, then it must be subject to tax and NICs in the usual way. If there is no such clause in the contract, then an employer may be able to make the payment in lieu of notice tax-free (up to the £30,000 limit in total) provided that other conditions are satisfied.

The criticism

Case law demonstrates that employers frequently get this wrong. In July 2014 the Office for Tax Simplification (the “OTS”) published their conclusions following a review. The OTS concluded that, although employers want to pay the correct amount of tax, the complexities of the system are often overwhelming. Most importantly, the OTS found that employers want a system that is clear and easy to administer, and employees want certainty about the net amounts they will receive.

The proposals

The Government has already stated that continuing a blanket exemption – even if the current level of £30,000 is reduced – is unlikely to meet their aims for reform.

The proposals include removing the distinction between contractual and non-contractual termination payments and replacing the current £30,000 tax-free allowance with an exemption for redundancy (voluntary or compulsory) at a rate increasing with length of service. There would also be new tax exemptions for payments on account of wrongful dismissal, unfair dismissal and discrimination.

Any compensation awarded by an Employment Tribunal in connection with discrimination may remain tax-free.

This new system would result in both winners and losers. Those with under two years’ service will be disadvantaged, although longer serving, lower paid employees, a group which the Government has identified as being most in need of assistance upon the termination of their employment, may not be significantly impacted. 

Our view

We support any proposals that will give greater clarity on the taxation of termination payments and protect employers and employees from inadvertently breaching the rules.

Nonetheless, the tax-free exemption has long been a useful tool in negotiating the departure of employees. If it is abolished (or significantly watered down), it is likely to be more difficult to incentivise employees to agree an amicable exit and could potentially lead to increased litigation relating to the termination of employment if no deal can be done. The new system should not, in our view, undermine this crucial tool available to employers when managing their workforces.

How the new exemption will apply to Employment Tribunal awards may also have an impact on the number of people who bring a discrimination claim after the end of their employment, as bringing a claim may be seen by employees as a worthwhile gamble if the new rules would enable them to receive a payment with more favourable tax treatment. Furthermore, in anticipation of new legislation coming in to force, might a raft of employers offer generous termination payments to some employees before they have to stump up more money to produce the same net figure?