Termination payments and income tax

Q When can termination payments be made tax free?

A Under Inland Revenue rules, payments on termination of employment can often be made tax free up to a maximum of £30,000. But they must be taxed if they are contractual payments.

This would happen most often when the payment is in lieu of notice and the company was exercising a contractual right to make such a payment. If the company had no contractual right to pay in lieu of notice, any payment in lieu would have to be for ‘damages’ for breach of contract and would not be taxable. It is worth bearing this in mind when preparing employment contracts. Remember, the ability to pay in lieu of notice will reduce the scope for tax-free termination payments.

Payments of outstanding holiday pay or contractual bonuses are also taxable because they are contractual payments.

The payment would be taxable if it was in return for the employee doing something new for the company after the end of their employment – for example, helping with a handover, if required, or agreeing not to indulge in unfair competition in a new business. If this kind of provision is to be included in a termination agreement, it is a good idea to apportion part of the total termination payment to the new obligation. That element will be taxed, but hopefully, the Inland Revenue would not challenge the tax-free status of the balance of the payment.

Beware of signing termination payment agreements too long before the termination date, unless the employee will be on ‘gardening leave’ and carrying out no duties for the company in the meantime. Otherwise, the Inland Revenue may view the payment as ‘buying’ the employee’s co-operation until they leave, and will tax it. Any payments relating to the ‘gardening leave’ period itself must be taxed as normal.

Q Do we have to make the termination payment tax-free?

A No. The employee has no right to a tax-free payment. The company could get the benefit of the tax break instead – by paying the employee ‘damages’ for the notice period. This would be the net of the tax figure which the employee would have taken had they worked out their notice period. The company could then keep the ‘tax’ element which it would have sent to the Inland Revenue had the employee worked out the notice period.

However, it often makes it easier for a company to reach an agreement with a departing employee, which everyone is satisfied with if the employee gets the payment tax-free.

Q How can the company protect itself if it does make a tax-free payment?

A If a company is really concerned, it should not make one and should account to the Inland Revenue for the full amount. That way, there can be no risk of any comeback.

If a tax-free payment is to be made, organisations can insist that the employee signs to indemnify the company against any tax demand as a pre-condition of making the payment. But, an indemnity is only as good as a company’s ability to enforce it against the employee if the need arises, and a county court action in such circumstances is unlikely to be an attractive option.

It is a good idea to describe the tax element of the payment as an ‘ex gratia’ payment. This clarifies that the organisation did not have to make the payment tax-free, and that it should get credit for this ‘overpayment’ if the employee subsequently brings any claim.

It is also advisable to require the employee to sign some sort of termination agreement in return for getting the payment tax-free. A compromise agreement may be over the top if the payment is small, but a simple letter will settle any contractual claims (as against statutory ones).

Q What happens if the payment is more than £30,000?

A The organisation is only obliged to deduct basic-rate tax and not higher-rate tax. Issue the P45 prior to payment. The same applies to contractual payments under £30,000, which cannot be made tax-free.

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