In the current economic climate, many employers are finding that they have no choice but to make redundancies. They are often under pressure to progress dismissals quickly, which can lead to them being more costly. In this feature, Shepherd and Wedderburn Corporate Tax Partner, Stephen Miller, gives pointers to employers on how to get the tax treatment right and avoid unnecessarily increasing the costs of their redundancy exercise.

Employers who fail to operate PAYE correctly on termination payments can be liable to pay income tax and national insurance contributions (NICs) which they should have deducted. HM Revenue and Customs (HMRC) can also impose interest and penalties. Therefore it is clearly important for employers to get the tax treatment right. There are many different types of termination payment, but this note focuses on redundancy payments and highlights some common issues for employers to watch out for.

Redundancy payments are normally taxed as "compensation" rather than earnings. The first £30,000 of compensation can normally be paid tax-free and no NICs (either employer's or employee's) are normally payable on compensation. Although most redundancy payments will fall below the £30,000 threshold, they will still use up part of the tax-free band, so if the total compensation paid to an employee on redundancy exceeds £30,000 the excess will be liable to tax.

Employers often choose to provide an enhanced redundancy package on top of the minimum statutory payments. However, they must take particular care to check whether any part of the enhanced redundancy package is in fact earnings, rather than genuine compensation for redundancy.

For example, a retention payment - conditional on the employee remaining employed until a particular date - or payments in connection with an employee's retirement may be taxable as earnings. In case of doubt, employers can seek advance clearance from HMRC. Any applications to HMRC must be in writing, accompanied by copies of the redundancy scheme document and copies of any letter to employees explaining the terms of the scheme.

Where an employee is subsequently re-engaged by the same employer or an associated employer, the tax treatment of any redundancy payment should not be affected, provided of course that the redundancy was genuine. However problems can arise where there is a more indirect re-engagement, for example where employees are made redundant because their job is being outsourced to another company, and they subsequently become employees of that other company. HMRC may look closely at this situation to ensure that the arrangements are genuine and on arm's length terms, and there is no intention to avoid tax.

Where a court or tribunal makes an order for re-instatement or re-engagement, an award relating to arrears of pay is normally treated as earnings, and therefore taxable in full and liable to NIC.

Where an employee has worked abroad, it is important to consider whether the foreign service exemption applies. This can exempt all or part of a redundancy payment without using up any of the £30,000 tax free band. Employers who intend to rely on the foreign service exemption often seek advance clearance from HMRC to obtain comfort that the position will not be challenged at a later date.

Many other payments may be paid at the same time as redundancy. Payments which arise under the employment contract are generally taxable as earnings. A common example is a payment in lieu of notice (PILON) paid under a term in the contract.

There are also practical issues for employers to consider which can affect the employee's tax position, such as whether to make lump sum or staged payments, or defer payment into the next tax year.

If payment is made after the P45 has been issued, the employer only deducts tax at the basic rate, with the remainder paid by the employee through self-assessment, which can give a significant cash flow benefit to higher rate taxpayers.

Subject to certain conditions being met, employers are also able to reimburse an employee's legal fees in connection with the compromise agreement, and pay for outplacement counselling and retraining without the employee having to pay tax on the benefit received.