This article was first published in the March 2009 edition of Accounting and Business magazine.  

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No employer wants to lose employees, and it is inevitable that matters will be awkward when staff are made redundant or forced to leave. However, the strains of the situation often mean that the tax implications take a back seat.

This can be a very expensive mistake when, through lack of foresight, employers end up having to pay their employees' tax liabilities, as well as national insurance contributions (NICs) for both parties.

The common belief that any termination payment can be made without deduction of tax, provided that it does not exceed £30,000, often turns out to be wrong. While this relief may be available in many situations, in some cases the whole of a pay-out may be taxable, while in others an unlimited sum can be paid tax-free.

To add to the confusion, the rules for NIC do not necessarily mirror those for income tax. It is, therefore, essential that employers take detailed advice, especially when large numbers are at stake.

Redundancies

If payments are made under the Employment Rights Act 1996, then they should qualify for tax-free status up to £30,000 for each employee. This relief, always subject to the £30,000 limit, includes not only statutory payments but additional non-statutory redundancy payments as well. However, this exemption does not extend to supplementary payments that are made for other reasons, such as contractual entitlement.

Contractual obligations

Employers and even advisers commonly make mistakes in situations where employees have a pre-existing right under their contract of employment. Such contractual rights do not have to be explicitly stated in the employment contract, but may merely be implied through previous custom or practice. Payments of this type will always be treated as employment income and therefore be subject to income tax and NIC. The most common examples are final salary payments, holiday pay or contractual bonuses.

Compromise agreements

Where a termination payment is to be made, tax and NIC savings can often be achieved if a flexible approach is taken by both employer and employee. However, the full savings may not accrue if one formal contractual entitlement is simply replaced by another. Where there has been a complete breakdown of trust between employer and employee, it might not always be possible to come to an informal compromise, but it is always sensible to take tax, as well as legal, advice about such payments.

Payments in lieu of notice

This is an extremely complicated legal area and, depending on the exact wording of the individual's employment contract, payments in lieu of notice (PILONs) might or might not be taxable. The key is whether the employee has a contractual right to receive a PILON or only the entitlement to serve a notice period.

Even if PILONs are not subject to tax, they must still be added to any other payments received in connection with the termination to calculate whether the £30,000 limit will be breached.

Even if PILONs are not subject to tax, they must still be added to any other payments received in connection with the termination to calculate whether the £30,000 limit will be breached.

Illness or injury

If someone is forced to give up employment as a direct result of illness or injury, compensation payments are exempt from tax, without limit. Not surprisingly, HM Revenue & Customs (HMRC) rigorously checks that such payments have been made for the right reason and that the infirmity is genuine and serious enough to prevent the employee from carrying out the duties of their employment. It also investigates whether the infirmity justifies the level of compensation.

Payments for injury to feelings

These are treated in a similar way to payments made for illness or injury. If a company makes a 'damages' payment as a result of causing injury to an employee's feelings, this is outside the tax net, regardless of size. These days, the most common examples are where an employer discriminates sexually, racially or on grounds of age, against a staff member.

HMRC will always look closely at these payments to ensure they really do relate to injury to feelings rather than being an excuse for converting a taxable payment into a tax-free one. There is also a great deal of precedent regarding the size of payments, so care has to be taken to allocate any payments appropriately.

Payments linked with retirement

A completely different set of rules applies to payments made to individuals who are retiring or who are expected to retire, particularly if they are aged 50 or over. Broadly, these payments will be taxable and charged to NIC (though not for older employees where only the employer's contribution is payable) rather than falling within the usual exemptions.

The position has hardened since pensions 'A' day, so that even relatively small payments must now be subjected to this treatment. There is guidance on the HMRC website that outlines its views on the issue and gives a number of examples.

Payments on death

If the termination of employment has occurred by reason of death, the likelihood is that the rules referred to above will apply and the whole of the payment will be taxable. However, in certain circumstances it may be possible to make arrangements that are tax-free. It is obviously sensible to take detailed guidance on this, as there may be ways to take advantage of exemptions, such as structuring payments.

Ex-gratia payments

As a general rule, if a payment is made for gratuitous reasons or it results from a breach of contract by the employer, then this will not be subject to tax. This is subject to a limit of £30,000 for each employee.

To fall within the gratuities exemption, it is important that there is no pre-existing entitlement or expectation for the employee, whether arising under contractual terms or established through custom and practice.

Overseas service

If an employee has spent a significant proportion of their working time outside the UK, part, or in some cases all, of any termination payment will fall outside the tax net. Clearly it might be necessary to consider whether tax is due in any other jurisdiction.

Benefits in kind

Sometimes employers allow employees to continue receiving benefits in kind after termination of their employment. This might apply where an employee has use of accommodation or a car.

In these circumstances, the benefit will continue to be taxable, although potentially, if the total of all payments does not exceed £30,000, then this element might be treated as part of the exempt sum.

Share options

As part of any settlement or compromise, it is necessary to consider any subsisting share options. Each scheme's rules will be different, but in many cases an employee will have a chance to exercise their options on termination. Alternatively, they will lapse. In the former case, the tax treatment needs to be considered and it may well be that the tax relief available under an approved scheme will be lost. If options lapse, then often an employee will expect, and possibly be entitled to receive, compensation.

National insurance contributions

The general principle is that if a payment falls outside the tax net, it will not be subject to NICs, although there are exceptions. There is, however, one big difference between the tax and NIC treatment.

While there is a limit on the amount that can be paid tax-free for income tax purposes, there is no such limit for NICs. This means that if, for example, a company decided to make a £100,000 ex-gratia payment to an individual and the first £30,000 is deemed to be tax-free, then the whole of the £100,000 is free of both employer's and employee's NICs.

Legal fees

Where an employer makes a contribution towards the legal fees of an employee in connection with the termination of their employment, this is exempt from tax.

Outplacement costs

If an employer makes a contribution towards retraining a worker who has been made redundant or whose employment has been terminated, provided it fits in with the terms of the legislation, the contribution will not be regarded as a taxable benefit.

Taxing payments

Where sums paid to employees on termination of employment are to be taxed, the net amount will depend on the timing of the payment. If it is made before a P45 has been issued, the payment must be taxed as if it were normal salary. But if compensation is paid after issuing a P45, tax has only to be deducted at the basic rate, regardless of the employee's marginal tax rate.

Philip Fisher heads the employment tax and rewards team at PKF (UK) LLP and is the author of the recently published Employee Share Schemes, published by CCH