How to tax Termination Payments
Employment can come to an end for different reasons, such as redundancy, dismissal, retirement or resignation and can result in a payment(s) being made to the leaving employee. Therefore, it is important that the employer understands its obligations when considering the tax and National Insurance Contributions (NIC) position on any such payment.
If a mistake is made and HMRC establish that a termination payment has not been treated correctly for tax and NIC, they will look to the employer rather than the employee for any liability that may be due, including interest and penalty considerations.
What needs to be considered
When looking at termination payments, it does not matter what terminology is used to describe the payment. Ultimately, the tax and NIC liability will depend on;
- what the payment(s) relates to;
- what the employee was entitled to under the terms of their contract of employment;
- what the reason was for the termination; and
- what the terms of the termination are.
It is therefore very important to establish all information, including the background details into why the payment is being made and how the payment has been calculated.
Can a £30,000 termination payment be made without deductions?
There is a general misconception that payments made on the termination of a person’s employment are only taxable on amounts that exceed £30k – the belief being that payments made up to £30k can be made free of tax and NIC. This is not true. Whilst there is an exemption threshold of £30k, you can only consider this charging position once it has been established that the payment is not liable to tax and NIC when taking into consideration other charging provisions.
What element of a termination payment is taxable?
Each element of the termination package must be reviewed and consideration given to the relevant tax provision in specific order.
Firstly, there are the payment earnings from the employment. In general terms, if a payment is made under a contractual right to receive it, then almost inevitably the payment will be treated as earnings. Examples of such contractual payments are salary, overtime, arrears of pay, holiday pay and bonuses. If not, does the payment relate to a restrictive covenant – that is, is it in return for a payment given where the employee agrees to restrict their conduct or activities?
Secondly, is the payment in connection with the employee’s retirement or death and meets the definition of an Employer Funded Retirement Benefit Scheme (EFRBS)? Particular attention needs to be paid where the employee is near to retirement age, as HMRC could challenge the termination payment and consider it does qualify as an EFRBS, meaning it will be liable to tax.
Finally, if none of the above tax liabilities arises, then is the payment being made as a result of the termination of the employment? For payments which do fall within this provision, the first £30k is exempt from tax with any excess being liable to tax. Payments which might fall within these provisions include compensation for loss of employment, damages and redundancy.
There is a statutory definition of redundancy, so it does need to be proved that the payment being made is a genuine redundancy payment. Statutory redundancy payments do fall within the £30k exemption threshold.
From 6 April 2018 new rules were introduced regarding payments in lieu of notice (PILON) made on termination. Since then, all PILON, whether contractual or not, are liable to both tax and NIC, meaning non-contractual PILONs no longer benefit from the £30k tax-free threshold. There is a specific calculation that needs to be followed regarding the Post Employment Notice Payment (PENP) and this now has to be considered in all cases.
There are certain payments made on termination that fall within other tax exceptions, as long as the relevant qualifying conditions are met. These exceptions can include:
- Termination caused wholly on account of injury or disability;
- Employer makes a contribution to a tax-exempt pension scheme or an approved personal pension scheme;
- Employer pays the employee’s legal costs in connection with the termination; and
- Payments for outplacement counselling.
What is the NIC position on termination payments?
NIC are generally payable in respect of all termination payments to which an employee is entitled under the contract of employment. It is important to establish what the payment does relate to, in order to ensure that the correct approach to the NIC liability is taken. This may not necessarily be the same as the tax position.
Benefits in kind included in termination packages
Termination packages can also include benefits in kind, with the benefit being gifted to the employee or continuing to be provided for a specified period once the employment has ended, such as the use of a company car or provision of medical benefit. The benefit in kind is taxable and the value of the benefit may form part of the total taxable payment on which you can apply the £30k threshold.
For National Insurance purposes, where a benefit in kind continues to be provided post termination, Class 1A NIC remains payable until the benefit is returned or ceases. The employer will still need to account for the benefit through the P11D(b) end of year process and pay the resulting Class 1A NIC.
Reporting requirements to HMRC
Employers are required to send a written report to HMRC, detailing any termination packages which exceed the £30k threshold, and also include cash payments and non-cash benefits.
Changes from 6 April 2020
From 6 April 2020, a new Class 1A NIC charge was introduced on termination awards that exceed the £30k threshold that have not already been subject to Class 1 NIC deductions. For termination awards that fall within these new rules, the Class 1A NIC due needs to be reported and paid to HMRC via the real time information process and not via the P11D(b) process.
Points to remember
The tax and NIC position in respect of termination payments is not necessarily straightforward and presents a number of potential pitfalls. Ensuring that the correct approach is adopted can be particularly difficult, especially where a termination payment comprises a number of different elements.
It is important that employers understand the rules and have a suitable and robust system in place to enable them to navigate, process and determine the correct tax and NIC treatment.
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The content of this article is for guidance only and shall not constitute advice. Please seek independent advice or contact GuildHUB for information about its services.