Prior to 6 April 2011, when an employee received a termination payment in excess of £30,000, the sum could be taxed at the basic rate (eg 20% using the BR tax code) without deduction of National Insurance contributions (NICs), provided the payment qualified under Sections 401-406 of the Income Tax (Earnings and Pensions) Act 2003. This often meant that the employee would have to account to HM Revenue & Customs (HMRC) for any additional tax due on the sums paid in excess of the £30,000 exemption (Exemption) at a later date but there was an immediate advantage to the employee in terms of cashflow. It was also a simple calculation and easy to administer.
From 6 April 2011, employers have had to use the OT code when deducting tax and NICs from termination payments that exceed the Exemption. This basically means that tax is deducted at source from post-termination payments over and above the Exemption at the basic (20%), higher (40%) and additional (45%) rates of tax as appropriate, with no personal allowance.
The OT code must be applied on a non-cumulative basis, so an individual receiving the termination payment as a lump sum will have 1/12th of the basic band available and, if applicable, 1/12th of the higher and additional rate bands available, irrespective of their level of salary. This leads to the ludicrous situation where someone who receives, say, a £100,000 pay off, is effectively treated for tax purposes as if they earn £1.2 million per annum.
There can be little doubt that the changes have improved cashflow for HMRC and have ensured that no tax payments for sums over the Exemption fall through the cracks. Under the old regime, the responsibility for declaring additional tax due on payments in excess of £30,000 was done through self-assessment forms. Now, employers have an obligation to make the correct deductions using the OT code.
However, HMRC is now frequently receiving too much money due to the OT tax code and individuals are left having to reclaim the over-payments. It is also now far more complicated to calculate the net sum an employee will receive if their termination payment exceeds £30,000. This level of uncertainty, at a time when the employee is facing financial instability, is far from ideal.
The Office of Tax Simplification's report suggests that many employers remain unclear about the operation of the OT code in relation to termination payments, a view certainly borne out from our experience. While there was some confusion under the old regime, the current regime has significantly complicated the matter to employers' and employees' disadvantage.
It is clear that the changes to the taxation of termination payments rules in 2011 have complicated matters unnecessarily. The position under the old regime was relatively simple in that, when a termination payment was in excess of the £30,000 tax exemption, it would be taxed at the basic rate (although there may be an obligation to account for further tax through the self-assessment process). The new regime has confused this and is, in our view, inconsistent with the aims of having a tax exempt termination sum.
While a legitimate aim of any change is to ensure that HMRC receives all tax due, this should not extend to an almost constant over-payment of tax which individuals then have to claim back. This area needs change, particularly as HMRC very rarely issues advance clearance quickly and the clearance issued is often vague. The Office of Tax Simplification has indicated that the whole policy behind the Exemption has become unclear and the government should carry out a full policy review of the taxation of termination payments. Hopefully, this will lead to clarity rather than an abolition of the tax-free slice (which has been threatened in the past).