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 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 NICs, employers have to pay employer 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, the employer is, generally, liable for the tax and NICs not deducted, plus interest and penalties. (The employee in such circumstances is entitled to a tax credit for the tax that should have been deducted.)
Both the employer and former employee will want the termination payment to be legitimately structured to minimise 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 detailed information, see Practice note, Taxation of termination payments ( www.practicallaw.com/0-200-2422) .
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 received in connection with the termination and redundancy. The first £30,000 is tax-free under sections 401 to 404A of ITEPA 2003. These include:
- ex gratia payments;
- damages for wrongful dismissal ( www.practicallaw.com/8-200-3644) and payments on account of damages;
- compensation for unfair dismissal or other breach of statutory rights;
- payments of statutory and non-statutory redundancy; and
- non-contractual benefits in kind provided on termination.
- Payments where termination results from death and payments where there is a termination and payment is made on account of injury or disability. These are tax-free without limit. However, care needs to be taken with these payments because "relevant benefits", which are widely defined to include lump sums provided on the death of an employee, and lump sums provided on or after the death of an employee or former employee in connection with past service are taxable (although benefits in respect of death by accident during service are excluded). Further, the payment must be on account of injury or disability. There is conflicting case law on the meaning of injury.
- Payments to compensate for discrimination. These may or may not be taxable depending on whether the payment is compensation for discrimination that occurred pre-termination or in connection with the termination, and whether, in termination cases, the payment is to compensate for injury to feelings or for financial loss. This is a complicated area where the case law is in a state of flux. For discussion, see Practice note, Taxation of termination payments: Compensation for discrimination ( www.practicallaw.com/0-200-2422) .
- 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 tax-advantaged, the 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 (and without using any of the £30,000 amount). However, if contributions (employer and employee) exceed the annual allowance ( www.practicallaw.com/6-201-6478) or the lifetime allowance ( www.practicallaw.com/8-201-6477) , a tax charge arises to claw back excess tax relief. For further details, see Practice note, Restricting pensions tax relief by reducing the annual and lifetime allowances ( www.practicallaw.com/5-503-6633) .)
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:
- Outplacement counselling.
Legal costs paid by the employer to the employee's lawyer in connection with the settlement agreement ( www.practicallaw.com/6-200-3471) can also be paid tax free. (The employer will not be able to recover VAT on the legal fees.)
- 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 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% with no personal allowances (see Practice note, Pay as you earn (PAYE) ( www.practicallaw.com/7-520-4442) ). 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). 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.