Amended to reflect the renaming of compromise agreements as settlement agreements from 29 July 2013.
Taxation of termination payments: a quick guide
A quick guide to the way termination payments are taxed.
This is one of a series of quick guides, see Quick guides.
What are termination payments?
Termination payments are severance payments to employees on termination of their employment
They can arise in a number of ways - for example, in connection with:
- Dismissal or constructive dismissal.
- Departure because of disability.
Why do employers need to know about the taxation of termination payments?
Termination payments must be taxed correctly because HM Revenue & Customs (HMRC) can recover unpaid tax, national insurance contributions (NICs), penalties and interest from the employer
Consider both income tax and NICs. In addition to employee's NICs, employers have to pay employer's NICs on payments that constitute earnings from employment (see Current rates and limits for employment lawyers: Tax and NICs (www.practicallaw.com/4-200-2038) for the current rates). This can significantly add to the costs of settlement.
If an employer does not deduct tax or NICs from a termination payment, it is, generally, liable for the tax and NICs not deducted, plus interest and penalties.
Both the employer and former employee will want the termination payment to be legitimately structured to reduce the tax liability and will also want certainty that no future tax liability will arise.
The taxation of termination payments is a complex topic and this quick guide is only a brief overview. For more information, see Practice note, Taxation of termination payments (www.practicallaw.com/0-200-2422). In his 2012 Autumn Statement, the Chancellor confirmed that the Office of Tax Simplification is to carry out a review of ways to simplify the taxation of termination payment (see Legal update, 2012 Autumn Statement: business tax implications: Employment benefits and termination payments simplification (www.practicallaw.com/2-522-7686)).
How much of the payment is taxable?
How much of a termination payment is taxable will depend on the nature and amount of the payment. Accordingly, it is important to ascertain why the payment is being made and all the background facts.
Payments fall into a number of categories including:
- Sums that the employee was contractually entitled to or which relate to past or future service. These are generally taxable in full under section 62 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). They include:
- Consideration for entering into restrictive covenants. This is taxable in full under section 225 of ITEPA 2003.
- Non-contractual payments made as a result of the termination and redundancy. The first £30,000 is tax-free under sections 401 to 404A of ITEPA 2003. These include:
- damages for wrongful dismissal (www.practicallaw.com/8-200-3644) and payments on account of damages;
- compensation for unfair dismissal;
- compensation for discrimination made in connection with the termination to compensate for financial loss;
- payments of statutory and non-statutory redundancy; and
- non-contractual benefits in kind provided on termination.
- Payments where termination results from a disability or from a discrimination claim not connected to the termination. These are tax-free without limit.
- Share options and share awards. Employees may be entitled to exercise share options and receive share awards either before or at some point after termination. The tax and NICs liabilities will depend on many factors including whether the scheme is HMRC approved, length of ownership and the reason for cessation of employment. A cash cancellation or compensation payment will be fully taxable.
- Employer contributions to registered pension schemes. These may be made tax free subject to the annual allowance (www.practicallaw.com/6-201-6478) and lifetime allowance (www.practicallaw.com/8-201-6477) limits. From 6 April 2011, to the extent that contributions (aggregate of employer and employee) exceed the annual allowance (£50,000 but with some limited scope for carry-forward), a tax charge will arise. The rate of charge is designed to claw back tax relief at the employee's marginal tax rate (For further details, see Practice note, Restricting pensions tax relief by reducing the annual and lifetime allowances (www.practicallaw.com/5-503-6633).) The Chancellor announced in the 2012 Autumn Statement that the annual allowance will reduce to £40,000 with effect from April 2014.
National Insurance Contributions
NICs are generally payable for all termination payments that the employee is entitled to under the employment contract. HMRC may argue that NICs are payable where there is an established practice of making termination payments, even where there is no express contractual right. Payments within sections 401 to 406 of ITEPA 2003 will not generally be liable to NICs.
Tax-free benefits that can be provided to employees
Provided that payment is made directly to the provider of the service, the following services can be made available to the employee without attracting tax:
- Legal fees in connection with the settlement agreement (www.practicallaw.com/6-200-3471). (The employer will not be able to recover VAT on the legal fees.)
- Outplacement counselling.
- Lump-sum or stage payments. Most employees would prefer a lump-sum payment, but employers may want to make (and in certain circumstances, employees may want to receive) the payments in stages (for example, to help enforce covenants the departing employee has given). Being paid in stages may affect the amount of tax paid by the employee (for example, the additional rate reduced to 45% from 50% from 6 April 2013) or may give rise to cash-flow benefits. (Care must be taken with staged payments to ensure that entitlement to the payment does not arise before the payment is received.)
- Calculations. For payments made after termination and after the P45 has been issued, the employer must apply the 0T tax code. This means that tax is deducted on a non-cumulative "month 1/week 1" basis at 20%, 40% and 45% (50% for payments made before 6 April 2013) with no personal allowances (see Ask the teams: PAYE treatment of post-P45 termination payments (www.practicallaw.com/1-505-0188) and PAYE treatment of post-P45 share plan gains and bonuses (www.practicallaw.com/0-505-2951)). If payment is made before the P45 is issued, PAYE must be operated in the normal way.
- Advance clearance. Employers can seek clearance from HMRC if the payment relates to redundancy. For other types of payment, HMRC may give a binding determination if the matter is commercially significant. Application for clearance should disclose all relevant information, including documents such as the settlement agreement and contract of employment.
- Reporting to HMRC. No report to HMRC is required if there is a cash-only settlement and no tax is deducted. If tax is deducted, the only obligation is to include the taxable payment in gross pay for PAYE purposes (which will then be reported to HMRC under real time information and for tax years 2012-13 and earlier years in the end of year PAYE returns). If there is a non-cash element or non-cash package, report it to HMRC if the total value of cash and non-cash elements exceeds £30,000. The report must be made by 6 July following the end of tax year (www.practicallaw.com/2-107-7375) in which employment terminated - that is, at same time as the P11D. (However, it can be made earlier.)
- Timing of tax liability. Tax payable under section 62 of ITEPA 2003 is collected through the PAYE system. For most payments, tax must be withheld under the PAYE system at the time the payment is made (which is the earlier of the time the payment is made and the time when the employee becomes entitled to the payment). Tax is payable for cash termination payments in the tax year(s) of receipt and is similarly collected through the PAYE system. Cash termination payments are treated as received when the payment is made or when the recipient becomes entitled to require payment of it. Benefits are taxable in the year in which the benefit is used or enjoyed.