Consultation on tax treatment of termination payments
Many experts struggle with calculating the correct tax to be deducted (or not to be deducted) on employee termination payments. The Government has now launched a consultation to consider changing the law to (hopefully) simplify matters. For many the consultation could not come soon enough because for a long time it has been recognised that simplification in this area is urgently needed as trying to ascertain the correct tax treatment is problematic. But are the proposals good news? Perhaps not. The proposals could well have a substantial impact on the amount of tax (and national insurance) payable and the increased cost could result in employers having to pay more to terminate employment.
Many employers believe that all termination payments up to £30,000 can be paid tax free. That is not strictly correct. Instead, the ‘tax free exemption’ of up to £30,000 only applies if ‘the payment is not otherwise chargeable to income tax’. This means that for many employers they may well be making termination payments which should be subject to income tax and NIC in full. How do employers know if the exemption applies? Well, essentially the employer has to determine what the payment is for. Of course many termination payments comprise a variety of elements such as notice pay, holiday pay, bonus pay, compensation for lost employment, compensation for ‘injury to feelings’, ‘garden leave’ pay, outplacement counselling fees, redundancy payments.
Whether the termination payment is taxable will depend whether it is ‘earnings’. But what are earnings? Well it includes any element of the payment which is a reward for service (such as a bonus or holiday pay). Most contractual payments fall into this category.
A particularly tricky area is ‘payment in lieu of notice’ (PILON). A general rule of thumb is ‘no PILON, no tax’ [up to the £30,000 exemption]. In other words, if the contract of employment has a clause that stipulates that the employer has the right to terminate the contract of employment by making a payment in lieu of notice, the notice element of the termination payment will need to have tax and national insurance deducted. If however the contract does not have such a clause, then tax and NI might not need to be deducted (it will depend on other rules, including whether there is a custom and practice within your organisation in doing so).
So what is being proposed? Well the proposals include:-
1. Removing the distinction between contractual and non contractual payments.
2. Whether the income tax and National Insurance treatment of termination payments should be aligned.
3. Which of the existing exemptions (including for the payment of legal fees) should be retained and whether any new exemptions should be introduced.
4. Introducing a two year qualifying period so no employee can receive a tax free termination payment unless they have been working for the employer for two years.
5. Changing the fixed £30,000 tax free sum to an amount which increases the longer an employee has worked. The consultation document does not set out amounts or thresholds. However, it does include a worked example which suggests a £6,000 tax free sum after two years employment, increasing by £1,000 for each additional year of employment. The concern is that if this “hypothetical example” is the type of level that the Government intends to implement it is clear that the impact will mean a significantly reduced tax free sum for employees on leaving.
What would the changes mean for employers?
If the current proposals are implemented then it is likely there would be a significant cost implication for employers when terminating employment since more of the termination payment will be taxed and so employees would likely seek higher payments.
The consultation remains open until 16 October 2015.
So, interesting times ahead. We will of course keep you updated but for now, if you would like to discuss any issues arising or need assistance in this area just get in touch. We would love to hear from you.