The Government is currently consulting on “simplifying” the tax treatment of termination payments.
Currently, termination payments can be made tax free up to the first £30,000 in certain situations, such as where a termination payment is paid as compensation for damages for breach of contract, or where it is paid as a redundancy payment. In addition, termination payments are usually free from National Insurance contributions given that they are not classed as “earnings”.
However, the Government is concerned that it is difficult for employers to classify termination payments correctly and that the rules governing the tax position are too complicated. They have therefore put together a consultation paper with proposals for a new tax regime which they believe, if implemented, will simplify the way that termination payments are taxed.
The key change that they are proposing is to abolish the £30,000 tax relief and remove the distinction between contractual and non-contractual payments made on termination. This means that, as a starting point, all payments all be treated as earnings and therefore all will be subject to tax and employer and employee National Insurance contributions. This is a significant change from the current position.
The Government does, however, recognise that employees should be protected in situations where they lose their jobs “through no fault of their own” and, as such, is proposing new exemptions as follows:
- Exemption for payments made in connection with redundancy. The Government proposal is to provide tax relief to payments made on redundancy where employees have at least 2 years’ service (in other words, where they qualify for a statutory redundancy payment). The level of tax and National Insurance exemption would then increase at a set rate after each additional year of service to a maximum level (which has not yet been specified). Voluntary redundancy would also qualify. However, these payments would then become retrospectively taxable and subject to National Insurance contributions if the employee was re-engaged to the same or a similar job for the now ex-employer (or any associated company) within a 12 month period. These proposals pose clear potential and substantial headaches for employers. The worked example in the consultation document demonstrates some of the potential pitfalls. The example is as follows: Pat gets made redundant after 10 years’ service and receives a termination payment consisting of a statutory redundancy payment, a payment on an ex-gratia basis for loss of employment, a payment in lieu of notice and holiday pay. The total paid to him in their example is £13,750. In the proposals, they have suggested an exemption of up to £6,000 tax and National Insurance contribution free at 2 years’ service and then an additional £1,000 per year of service after that. In Pat’s case, this would give a total exemption of £14,000. As such, if his dismissal constitutes a genuine redundancy situation, the entire payment to him would be tax free. Interestingly, this would include the accrued holiday pay (which would of course currently be taxable as earnings). This highlights just one of the potential pitfalls the new with the new proposals as: the taxable status of an employee’s holiday pay would therefore depend on their length of service at termination and whether they were redundant or not. It is hard to see how this is a simplification to the existing regime.
In addition, if Pat were to be re-employed within 12 months doing the same job, the entire payment would become taxable retrospectively. This means that the tax status of any payment made to employees will not be definitively established until after a year after their employment comes to an end. Again, this gives rise to unwelcome continued uncertainty for employers.
- There is a further proposed exemption for compensation for unfair/wrongful dismissal. At first glance, this seems fairly straightforward. However, it is far from clear how this will work in practice and in what circumstances the payment will be classed as compensation for unfair/wrongful dismissal. For example, if a payment in lieu of notice is made, what will an employer need to demonstrate to show that it should be paid free from tax because it is compensation for wrongful dismissal, rather than being taxable on the basis that it is a payment in lieu.
- Any compensation connected with discrimination (including loss of earnings) would be tax free. The Government is seeking views on whether there should be a financial limit and/or whether there should be a difference in tax or National Insurance contribution treatment between awards made by a Tribunal and payments made by employers.
If these proposals are adopted, the likely impact is that employers will be faced with increased costs for terminating the employment of employees as they are likely to have to pay tax on a greater proportion of any termination payments than they do under the current regime. Employers will also face payment of National Insurance on these payments (which is a liability they currently do not incur). Employees will lose out too, particularly those with short service. On balance, the proposals appear to do little to simplify the regime, instead, providing an ever more complicated backdrop for termination negotiations and potential for dispute. In fact, the only clear winner from these proposals is HMRC.
The consultation document is currently available on the Government website and the closing date for comments is 16 October 2015.
Please get in touch with our Employment team if you have any questions about how this might impact your business.