Taxation Of Termination Payments


The Law Of... Taxing Termination Payments

When entering into a settlement agreement with an employee or terminating the employment relationship, employers should be aware of the current tax position in relation to termination payments. This helps to ensure that an employer is not presented with an unexpected tax liability after the employment relationship has terminated.

This article takes a look at the Government’s proposals to change the tax and NICs treatment of termination payments.

Remember that HMRC applies its own set of guidelines in relation to the taxation of termination payments. This article should therefore not be taken as tax advice and for any specific queries employers or employees should contact HMRC directly.

The Current Position

Many employers will already be aware that genuine ex gratia payments of up to £30,000 are taken to be free of tax and national insurance deductions. The same rule also applies to contractual and statutory redundancy payments.

The position in relation to payments in lieu of notice (known as PILON payments) can be less clear. Broadly, where a PILON clause is contained within the employee’s contract of employment, then any payment exercised in line with this will be subject to tax and national insurance deductions. The same tax treatment can also apply where an employer makes PILON payments on a routine basis, to the point where this is considered custom and practice.

Where there is no payment in lieu clause in the employee’s contract, then any payment made to the employee is classed as damages (i.e. non-contractual). This means that such payments are generally considered free of any income tax or national insurance deductions.

Termination Payments In Settlement Agreements

When advising on settlement agreements, it is quite a common occurrence that our team will come across proposed termination payments where the correct tax treatment has not been applied. For instance, a PILON payment may be put forward as a tax-free amount when this is not the case under HMRC rules. Employers need to be careful when taking this approach as they can be held liable for any tax that has not been applied under the terms of the settlement agreement.  

Proposed Amendments

The Government’s plans, which are due to come into effect from April 2018, set out that all PILON payments should be subject to tax and class 1 national insurance deductions. This is a substantial shift from the current position where some PILON payments can escape any tax or NI liability.

Currently, any termination payments above the £30,000 threshold attract income tax liability but are not subject to national insurance deductions. The Government’s amendments will change this so that any payments above this threshold will be subject to income tax and class 1 national insurance deductions.

Practical Tips For Employers

It is common for any settlement agreements to contain an indemnity clause. This means that the employee will cover the employer for any additional tax that may fall due after the point of termination.

Whilst this provides employers with some cover, it is important that any termination payments are applied in the correct manner for tax purposes. Employers who apply this incorrectly or in an attempt to provide an employee with an undue tax benefit are likely to come under scrutiny from HMRC.

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