On termination of employment, an employee will often receive a compensation package made up of a number of different elements. When considering the tax treatment of this package, it is important to work out exactly what is being paid to the employee - considering each element of the package separately - and why that payment is being made.
It is often the case that the way in which the payments are classified for tax purposes is different from the way they are classified by the employer and employee, or how they are described in any termination documentation.
This guide sets out the tax treatment of some of the more common payments made on termination of employment.
The government is intending to make changes to the taxation of termination payments, including changes to the £30,000 exemption.. A consultation document issued in August 2016 states that that legislation will be introduced in the Finance Bill 2017 to tax as earnings all payments in lieu of notice (PILONs) and to abolish the foreign service exemption. The government also proposes that from April 2018 termination payments that are subject to income tax on amounts in excess of £30,000 will become subject to employer national insurance contributions.
When looking at a termination package, it is useful to bear in mind that payments will be subject to tax as earnings unless they come under one of the categories of exempt payments. In particular, any payments which are provided for in the employment contract will be fully taxable and will be subject to national insurance contributions (NICs).
Examples of taxable payments include those in respect of:
- wages or salary;
- contractual bonuses or commissions;
- restrictive covenants entered into by the employee;
- accrued holiday;
- certain payments in lieu of notice (see below);
- periods of gardening leave.
Therefore, some sums which are described in any termination documents as payments for 'compensation for loss of office' may be subject to tax in full, as if they are earnings.
The £30,000 exemption
The first £30,000 of a payment which is paid in connection with the termination of employment is tax free, as long as it is not otherwise taxable as earnings. Any excess over £30,000 is subject to income tax as normal, but is not currently subject to any NICs. If the government's proposals become law, from April 2018 any excess over £30,000 will be subject to employer's (but not employee's) NICs.
Two or more payments made in respect of the same employment, or different employments with the same employer, are aggregated for the purpose of the £30,000 limit.
Ex gratia payments, made where the employer is under no legal obligation to do so, and awards from the Employment Tribunal in respect of wrongful or unfair dismissal, can fall within the £30,000 exemption as can payments made on redundancy whether statutory, non-contractual or even contractual.
The tax treatment of payments made as compensation for discrimination claims depends on the precise nature of the payment. Some will fall within the £30,000 exemption, and some are entirely free of tax.
Certain payments made on termination of employment fall completely outside the tax regime, and are not taken into account in amounts to which the £30,000 exemption is applied. These exemptions include:
- foreign service exemption – full and partial exemptions apply to payments made in respect of foreign service, where an employee was both non-resident and non-ordinarily resident in the UK – the government intends to abolish this;
- death, injury and disability exemption – no tax is payable on payments of death benefits, where the death brought about the termination of the employment. HMRC interpret the exemption for termination on injury or disability very narrowly;
- pension contributions – if, as part of the termination package, the employer agrees to make a contribution to a tax exempt pension scheme or an approved pension scheme, the payment will not be subject to tax as long as the payment is not a right granted under the employment contract;
- payments of compensation or damages for personal injury;
- payments of an employee's legal costs – this exemption applies where a dispute is resolved without going to court, provided that certain conditions are met.
Payments in lieu of notice
Employment contracts often provide that, instead of giving full notice of termination, an employer can terminate an employee immediately and make a payment in lieu of notice (PILON) instead of requiring the employee to work a notice period. If an employer makes a PILON in accordance with such a contract term, the payment will be fully taxable.
Even if there is no specific contractual term HMRC argue that a PILON is fully taxable if it is an automatic response to the termination.
Under current rules if a PILON is not provided for in the employment contract, it can, depending on the precise circumstances, be within the £30,000 exemption. Howeverfrom April 2018 the government intends to remove the distinction between contractual and non-contractual PILONs so that all payments will be treated as earnings subject to income tax, employer NICs and employee NICs.
PILONS must be distinguished from gardening leave provisions. When an employee is put on gardening leave, the employee will be given proper notice of the termination of employment but will be told not to attend work during this notice period. In this case the payment is not made in lieu of notice, regardless of whether or not it is made as a lump sum. It is simply the salary due for the notice period, and is therefore fully taxable as such.
Payments made by an employer into a non-HMRC approved retirement benefits scheme for the purpose of providing benefits are taxable. The term 'scheme' has a very wide meaning here. It can simply be a decision or a payment made in accordance with a policy.
A payment made in connection with retirement, rather than on termination of employment because of redundancy or poor performance will be fully taxable. Great care must therefore be taken with payments to employees who are to retire on or soon after the termination.
Benefits in kind
Contractual benefits will be taxed in the same way as benefits received during employment. Non-contractual benefits may fall within the £30,000 exemption. Non-cash benefits, or benefits in kind, will be valued at an amount equal to the cash equivalent of the benefit.
The provision of outplacement counselling or associated re-training is exempt from tax provided conditions are met.
Reporting the tax
The employer is obliged to account for any tax due under the PAYE system when it makes payments to terminate the employment of its employees. The employer will be liable for penalties and interest, as well as paying the tax itself, if it does not deduct tax when this becomes due.
If the termination payment is made before a form P45 is issued, then any tax due is deducted as normal under PAYE.
If the payment is made after the P45 is issued then the employer must instead deduct tax at all applicable rates as if the employee had no personal allowances available. This may result in more tax being deducted than would have been the case if the payment had been made before the P45 was issued, particularly for employees who receive a lump sum to terminate their employment but whose income is normally only taxed at basic rate. The employee can claim a repayment from HMRC of any excess tax deducted.