The Government has launched a consultation process on proposed reforms to the way in which termination payments are taxed.  The proposals would significantly change the tax treatment of any payments made to employees on termination of their employment.

The current position

The current position is that, in general, any elements of a termination package that arise from the contract of employment (eg a contractual payment in lieu of notice) are subject to income tax and National Insurance Contributions (NICs). In contrast, any payments which do not arise from the employment (eg damages) are only liable to income tax on any amounts over £30,000.  Further, employer and employee NICs are not payable on these payments.  There are also various exemptions applying to termination payments which apply, even on elements over £30,000. These include payments made because of the death, disability or injury of an employee, payment under a tax exempt or registered pensions scheme, HM Forces payments and payments in respect of certain legal costs.

The purpose of the reforms

A termination package is typically made up of several different types of payment (eg damages, statutory redundancy payment, payment in lieu of notice). The Office of Tax Simplification has concluded that the tax system applying to these payments is “fraught with confusion and  uncertainty”,  and that it is unfair as it benefits those who are better paid and better advised.  As a result it has recommended that reform is necessary.  The Government agrees and is therefore proposing to create a regime which is intended to be easier for employers to administer and for employees to understand.

The proposals

The Government’s proposals include:

  • A new exemption for individuals who have lost their job through redundancy. An employee would need 2 years’ service to qualify for the exemption but the exemption would then increase proportionately with the number of years’ service an employee has completed, up to a prescribed maximum. The Government is seeking views on whether an individual’s redundancy would need to meet the definition in the Employment Rights Act 1996:
    • the employer ceasing, or intending to cease, to carry on the business for the purposes of which the employee was employed;
    • the employer ceasing or intending to cease to carry on that business in the place the employee was employed;
    • the requirement for the employee to carry out work of a particular kind of work has ceased or diminished or is expected to cease or diminish; or
    • the requirement to carry out work of that particular kind in the place where that employee was employed has ceased or diminished or is expected to cease or diminish.

It proposes, however, that voluntary redundancies would be included.

  • Removing the distinction between contractual and non-contractual termination payments. This would mean that all payments made in connection with termination of employment would be treated as earnings and therefore subject to income tax and employer/employee NICs.
  • No exemption would be available to employees who choose to resign and receive a payment from their employer for doing so. Further, the Government suggests that the exemption would not be available to employees receiving a termination payment at the end of a fixed-term contract, or where the custom/agreements is that the employment will end after a fixed period of time.
  • Any tax-free payment made would become taxable and liable to NICs if the employee is re-engaged to do a similar job for the same company or associated company within a 12 month period.
  • A new exemption for payments paid in connection with compensation for unfair or wrongful dismissal, or payments connected with discrimination awarded by a tribunal
  • The current exemption for payments in respect of injury or disability would be retained, as would HM Forces payments. The Government is seeking views on retention of any of the other existing exemptions.

The Government’s proposals mark a significant shift away from the current regime and potentially reduce the situations in which tax-free payments can be made to an employee on termination of their employment. In circumstances where tax-free payments may still be available eg in redundancy situations, the Government has not yet indicated what new tax-free threshold will apply but it seems likely that this will be much less than the existing £30,000. The fact that employees will need 2 years’ service to even qualify, and that the tax-free threshold will increase depending on years’ service, means that any future tax-free sums are likely to be significantly lower than an employee may currently expect. For employers, this may mean that it becomes more difficult to negotiate attractive termination packages with its employees, resulting  in protracted terminations and increased expense.

The consultation closes on 16 October and the progress of the Government’s proposals will be reported in future alerts.