Employers often misunderstand the tax rules that apply to termination payments. Susan Ball outlines some common mistakes.
There is a common misconception that any termination package can be made without deduction of tax if it does not exceed £30,000.
While this relief may be available in many situations, in some cases the whole payout may be taxable and liable to national insurance contributions (NIC), while in others there is no cap on what can be paid tax/NIC-free.
Getting it wrong through lack of foresight or misunderstanding can be a very expensive mistake. Employers end up having to pay their employees’ tax liabilities as well as NICs for both parties, plus, if discovered later, interest and penalties.
Termination packages may consist of many elements, for example accrued holiday pay, bonus, payment in lieu of notice (“PILON”), restrictive covenant payments, continued benefits and compensation. You must determine the reason for paying each element separately as each could be treated differently for tax and NIC purposes.
The recent first-tier tribunal case of Mrs A v HMRC shows just how important it is to look closely at what the payments are for. Mrs A entered into a settlement agreement with her employer under which she agreed to be bound by confidentiality and non-disclosure obligations. Broadly speaking, these were to ensure the circumstances surrounding the settlement agreement and events leading to it were not made public.
Under the settlement agreement, Mrs A received compensation on the condition that she would be bound by confidentiality and non-disclosure obligations. The employer treated the compensation as being connected with the termination of her employment and, under Section 401 of the Income Tax (Earnings and Pensions) Act (ITEPA) 2003, treated the first £30,000 as tax free and taxed the balance under PAYE. The tribunal concluded that the confidentiality and non-disclosure obligations were restrictive undertakings for tax purposes and fully liable to tax and NIC.
Break down a termination payment
This case demonstrates the importance of breaking down the various elements of the package when deciding what is taxable and liable to NIC. Consideration should then be given to the tax treatment in a specific order of priority as outlined below:
- Is the payment (including benefits) earnings from the employment? If so, the earnings will be fully liable to tax and NICs in the usual way
- Is any part of the payment being made in respect of a restrictive covenant? If so, that part is fully liable to income tax and NICs
- Does the payment relate to a pension or is it linked in any way to retirement? If so, special rules apply
- Provided 1, 2, or 3 above do not apply, is it another type of payment made in consideration of, or in connection with, the termination of the employment? If so this payment could qualify for special treatment where the first £30,000 is exempt from tax and NIC. In very limited circumstances, such as ill-health, injury or disability, the amount could be completely exempt.
Getting it wrong through lack of foresight or misunderstanding can be a very expensive mistake. Employers end up having to pay their employees’ tax liabilities as well as NICs for both parties.”
Confusion has arisen because, prior to 6 April 2018, some PILONs were not taxable as earnings as they didn’t fall into 1,2, or 3 above and so benefited from the £30,000 exemption. This was because the tax treatment of PILONs depended broadly on whether the employer had the contractual right to terminate the employment by paying a PILON rather than serving notice, or if the PILON was paid under an established custom or practice. However, Post Employment Notice Pay (‘PENP’) was introduced in April 2018 and some employers seem to have missed this change.
Post Employment Notice Pay rules
Employers must consider these PENP rules if they make any payments, or provide any benefits on termination of employment, which are Relevant Termination Awards (‘RTAs’) when the employee has not worked their notice period in full.
PENP is broadly the basic salary the employee would have received during any unworked period of notice, and any part of an RTA which represents PENP does not qualify for the £30,000 exemption and must be subject to tax and NIC, like normal earnings.
Employers still do not seem familiar with the calculations in relation to RTAs and PENP. Even when a PILON has already been taxed, there may still be further tax and NIC payable under the PENP rules if an additional RTA has been paid. We often see employers assuming that taxing all of the PILON produces the same result. It can in some cases but not in others, for example, where an employee has a salary sacrifice the PENP amount can be higher than the PILON taxed.
In addition, since April 2020 a ‘real-time’ employer’s Class 1A NICs charge has applied when tax applies over the first £30,000, but not employee NICs.
Non-cash benefits that form part of a termination package, such as the continuing provision of a company car or medical insurance, also need to be considered.”
Non-cash benefits that form part of a termination package, such as the continuing provision of a company car or medical insurance, also need to be considered, and an amount attributed to them for the purpose of working out if the tax exemptions apply.
Termination payments and tax FAQs
Do you need to report termination payments to HMRC?
Where the value of the settlement (including a non-cash element) is more than £30,000, a formal report needs to be filed with HMRC by 6 July following the tax year in which the termination took place. There is no set format, but a letter should be sent to HMRC with the termination details where they have not already been reported via the payroll under real time information.
Can you obtain HMRC clearance?
HMRC operates a process whereby advance clearance or confirmation of the tax treatment can be obtained in certain circumstances. Employers should consider seeking clearance if in doubt. It can often be advantageous to obtain clearance from HMRC, for example, where complete exemption from tax is being applied under Section 406 ITEPA 2003 in relation to a termination of employment because of injury or disability.
What records should employers keep?
Employers should be aware that HMRC will often look at tax/NIC free termination packages closely. Each termination should be considered on a case-by-case basis, with evidence retained identifying the individual elements of the package, along with the decision-making process or negotiations. These will help support the taxation treatment, which might be questioned by HMRC.
By carefully considering the nature of the termination payment, employers can avoid making costly mistakes when it comes to tax and NICs.