Taxation of termination payments: a quick guide

A quick guide to the way termination payments are taxed. For the changes that are due to take effect from 6 April 2018, see Practice note, Taxation of termination payments: Reform of termination payments from April 2018.

This is one of a series of quick guides, see Quick guides.

Contents

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.

  • Redundancy.

  • Retirement.

  • 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, including on the proposals for reform, 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:

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 ( www.practicallaw.com/9-508-1157) 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.

  • Re-training.

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.)

 

Practical issues

  • 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 ( www.practicallaw.com/0-507-0436) 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.

 
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