New proposals to simplify the treatment of termination payments
HMRC and HM Treasury published a consultation paper, “Simplification of the tax and National Insurance treatment of termination payments” on 24 July 2015. The consultation is available and closes on 16 October 2015. If accepted, the proposals would mean the removal of the current £30,000 exemption from tax under s403 ITEPA 2003, its replacement with three new exemptions according to circumstances, and a new obligation to pay income tax, employee and employer National Insurance contributions on any excess sum.
Current treatment of termination payments
Termination payments are made for a variety of reasons connected with an employee leaving their employment such as damages, statutory redundancy payments, payment in lieu of notice (PILON), holiday pay, and compensation for loss of office.
At present, termination payments arising from the employee’s employment, or to which the employee is contractually entitled, are subject to income tax and National Insurance contributions.
If elements of the termination package are not from employment, then there is a £30,000 exemption from tax under s403 ITEPA 2003, and any amount in excess of this will be subject to income tax. The £30,000 exemption is not dependent on the employee’s length of service or reason for termination.
There are also exemptions from tax if the payment is because of the death, injury or disability of the employee, under a tax exempt pensions scheme, to a registered pensions scheme, for liabilities and indemnity insurance, to a member of HM Armed Forces, by a foreign government, where the employee has a certain type of foreign service, or in respect of legal costs arising from the termination.
Why change the system?
In the consultation paper, the government says that it wants to “review the tax treatment of termination payments with the aim of creating a regime that is easy for employers to administer and for employees to understand“. It believes the reforms proposed will provide certainty for employees that they have paid the correct amount of tax and National Insurance contributions (NICs). It also says that:
“HMRC has evidence that some employees and employers attempt to change the nature of their termination payments … For example there have been cases where employees and employers argue that a PILON (subject to tax and NICs) is actually a payment fo breach of contract, so there is no NICs liability and the payment is only taxable on amounts over £30,000. With such a complex tax treatment of termination payments it is often difficult forHMRc to disprove such claims. These employees are generally those who are well advised (and generally better paid).
“The government’s aims are to reform the taxation of termination payments in a new, simple to understand system which provides certainty, is easy to administer, be fair (so that those who are better paid and advised do not receive more favourable tax and NI treatment than those who do not) and be affordable for the Exchequer.“
The proposed reforms
- To remove the distinction between the tax and NICs treatment of contractual and non-contractual termination payments. All PILONS, whether contractual or non-contractual would be treated in the same way.
- To align the income tax and NICs treatment of termination payments. It is “illogical”, says the consultation paper, that the two regimes operate so differently. If tax is due, then both employer and employee would be expected to pay NICs on that amount as well.
- To replace the current rules (including the “first £30,000” exemption under s203 ITEPA) with either:
- A blanket exemption for all termination payments of whatever kind, without requiring a certain length of service or dependent on the reason for termination – but this would be unaffordable at the current £30,000; or
- To create a new exemption for which employees would qualify after two years’ service, which increases proportionally with the length of employment, “proportionately reward[ing] long serving, lower paid employees”. The consultation paper does not give any further examples of where the level might start, or how it might increase, but follows this with a worked example where the level starts at £6,000 after two years’ service and then increases by £1,000 per year.
- To make the new exemption available only to those who have been made redundant (including voluntary redundancies), but not to other dismissals, or where the employee is working on a fixed term contract.
- Payments would become retrospectively taxable and liable to NICs if the employee is re-engaged by the same or an associated company within 12 month period.
Changes to other exemptions
Other exemptions also apply at present to termination payments. The government proposes retaining the current exemptions for injury or disability, certain payments to members of HM Armed Forces, foreign service exemption (recognising years of service during which the employee performed duties abroad) and payments into recognised pensions schemes.
At present, if the employer pays the employee’s legal costs in connection with termination, these may be exempt from tax under section 413A of ITEPA 2003 if they meet certain conditions. Legal costs paid in connection with a termination are exempt from NICs in all circumstances. The paper notes that “There is some concern that the exemption in respect of legal costs is used to pay for legal advice with the sole purpose of reducing tax and NICs liability for employees and employers” and it proposes that this exemption should be removed. However, employees entering into settlement agreements would still need legal advice.
The paper also suggests that other, unspecified, exemptions should go. Although not named, it is likely that this may include the current exemption for outplacement counselling made available by some employers to departing employees.
Payments for wrongful dismissal, unfair dismissal and discrimination
The current exemption applies to payments made in connection with the termination of employment. If the new exemption above applies only to redundancies, two new exemptions would be introduced for payments made in connection with wrongful or unfair dismissal, and discrimination awards for loss of future earnings (payments for injury to feelings would remain outside the tax and NICs regime). They would not apply where the employee has resigned. The paper does not mention what would happen to other awards for claims other than unfair or wrongful dismissal or discrimination – for example, detriment claims or whistleblowing.
Whilst the paper recognises that such awards can be ordered by a tribunal or “arrangements between employee and employer”, it appears to suggest that for discrimination, only awards made by a tribunal would be tax and NIC-free (unlike wrongful and unfair dismissal). If correct, this would seem to overly complicate matters.
It’s also unclear how the new system would draw a distinction between a payment in lieu of notice (PILON) where there was no contractual right to do so (which might fall within the redundancy category, with a limited exemption based on length of service), and damages for wrongful dismissal (with a total exemption, perhaps subject to a cap) – in many cases, these will be the same thing.
A simple, easy to understand, certain and fair system – or not?
The consultation has attracted criticism, not least because despite its aims to create a simple, easy to understand, certain, easy to administer and fair system, it seems that it is mainly seen as a chance to “be affordable for the Exchequer” – another way of raising revenue. Some employees would be better off, especially those with a PILON clause in their contract – others would not.
The paper expresses the government’s wish to recognise and reward those who have lost their jobs “through no fault of their own” – but making the principal exemption for termination payments available to those with more than two years’ service who lose their jobs due to redundancy will mean there are a number of employees with less than two years’ service (already prevented from bringing claims for unfair dismissal or claiming a statutory redundancy payment) who will have less money to support themselves whilst seeking a new job, or employees who will lose out having lost their jobs for another reason that may not be their fault, such as capacity or some other substantial reason (which can include business reorganisations that are not redundancies, or a reasonable refusal not to sign a new contract of employment).
For many employers, there will be a greater cost with employer NICs due on payments outside the exemptions (pushing the cost of terminating employment without an exemption applying, or over the exemption cap, up by 13.8%), and the likelihood that it will cost the employer more to achieve settlements in the first place.
Your views on the proposals
We encourage all employers with views on the proposals to make submissions direct to HMRCso that there is a wide breadth of responses from employers of various sizes and from different industry sectors.