Legal opinion: Redundancy pay – tax pitfalls

Many employers wrongly assume that up to £30,000 can be paid free of tax to a departing employee. But HM Revenue & Customs (HMRC) is increasingly challenging termination payments, and the courts are looking closely at the facts behind them. 

Payments and penalties

The attraction of the £30,000 payment is that PAYE and national insurance contributions (NICs) are not payable on compensation up to £30,000. Only income tax, and not NICs, is due on any compensation above £30,000.

Failure to manage redundancy payments correctly can result in an income tax and NICs bill of £16,140, before any interest or penalties are imposed. Under a new penalty regime, applying to tax returns due to be filed on or after 1 April 2009, penalties can be up to 100% of the tax liability – depending on the employer’s culpability – plus interest on unpaid tax, with mandatory reductions for disclosure. 

Where the employment relationship ends, payments can take several forms, and each element should be considered and ‘payrolled’ appropriately. The rule of thumb of many tax inspectors and advisers is, if in doubt, an employer should payroll payments, and let the employee argue about the nature of the payment through their self-assessment tax return.

Unsurprisingly, many staff would prefer the payment of £30,000 to be made tax free. It is common practice to include an indemnity in a compromise agreement, allowing the employer to seek recompense from the employee for any tax and NICs due. But tax risk is best dealt with up front – not least because it is illegal for an employee to meet an employer’s NICs liability, other than in very specific circumstances. Attempting to enforce any indemnity will generally be costly and potentially futile.

Other considerations

There are many other important considerations surrounding the nature of the employee’s departure, which will have a bearing on the tax treatment. For example, any payment made to those resigning voluntarily is generally seen as a ‘golden handshake’ or terminal bonus and, as such, subject to the normal tax and NIC rules. The same is true of payments to enter into restrictive covenants and other contractual payments – for example, accrued holiday pay, pay in lieu of notice (PILON) and commission.

PILON can be a delicate area, particularly if discretionary or reserved. Any decision not to award PILON must be clearly justified and recorded, along with any subsequent decision to compensate for other claims. Failure to do so – particularly where the level of compensation is similar to what PILON would have been – is likely to result in HMRC arguing that PILON has simply been dressed up as compensation for tax purposes.

Similarly, where there is no PILON clause, any equivalent payment risks being viewed by HMRC as “auto-PILON”, and subject to tax and NICs. Decisions on whether staff should work their notice or be placed on garden leave should be based solely on merit.  

For redundancies, voluntary or compulsory, all statutory redundancy payments are tax and NIC free. Enhanced redundancy payments will also be tax free up to £30,000, provided there is genuine redundancy. Likewise, payments of up to £30,000 made under the terms of a compromise agreement are free of tax, provided they compensate for the loss of the employment and are paid in settlement of potential claims against the employer.

Finally, many benefits in kind are valued in the same way as benefits provided during employment, using the money’s worth or cash equivalent rules, as appropriate.

Key points

  • Identify each element of a termination/redundancy package and payroll each one appropriately.

  • Critically assess all the facts and circumstances of the ending of the employment relationship.

  • Fully tax and NIC all contractual and restrictive covenant payments.

  • Include, but don’t solely rely on, a tax indemnity in a compromise agreement.

  • Take care with PILON clauses/payments.

For the latest news and guidance on all aspects of redundancy, view our dedicated redundancy page.

FAQs on calculating redundancy pay

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