Taxation of termination payments – major changes ahead?
The Government has announced a consultation on simplifying the tax treatment of payments made to employees upon the termination of their employment. This is welcome news, as the present system is complex and whether or not a payment is taxable is often a matter of luck as to how the contract of employment was drafted.
The current position
The current rules basically allow a payment of up to £30,000 to be made to an employee on the termination of their employment without attracting income tax or National Insurance, provided that the payment is non contractual. The £30,000 limit has been in place for many years. There are certain exceptions to it, but this is a complex area and they go beyond the scope of this article. The effect of the £30,000 limit is that statutory redundancy pay will always be tax free as the maximum amount is £14,250. More tricky is the whole area of payments in respect of notice.
When an employee leaves their employment there are a number of possible scenarios as far as notice is concerned. First, they may work their notice. In this case they will be paid their normal salary for that period and this is taxable. Second, they may be put on garden leave. This means that they remain employed but do not do any work. Again, they will be paid their normal salary and this will be taxable. Third, they may leave straight away and be paid in lieu of notice. It is in this case that the confusion often arises. If the employer has a contractual right to make a payment in lieu of notice, then the payment is taxable as the payment is contractual. However, if there is no pay in lieu of notice clause in the contract, then strictly speaking the employer is in breach of contract by not requiring the employee to work their notice. The remedy for the employee would be to sue the employer for the loss he suffers as a result of that breach, and that would of course be the amount he would have been paid. Whilst strictly the employer would only need to pay the employee their net pay because that is what their loss is, in practice most employers pay the gross pay. As this is damages for breach of contract rather than a contractual payment, then to the extent that the total non-taxable payment is below £30,000, it can be paid without deduction.
The difficulty is that it isn’t always as simple as looking at whether there is a clause in the contract – there have been examples in the past of employers being found to have developed a ‘custom and practice’ of making payments in lieu of notice, which then creates an implied term which can render notice payments taxable without there being any written term.
As we have pointed out previously, there is a common misconception that payments can be tax free if the employee signs a Settlement Agreement and that Settlement Agreements can change the tax status of payments. That is incorrect, as we explained in our article on Settlement Agreements which can be found here.
The new proposals
One of the proposals set out in the consultation is to remove the distinction between having a pay in lieu of notice clause in the contract of employment and not having one. This would get rid of the rather illogical result set out above. However, it would not help the employee who is required to work their notice – they would still have to work and pay tax on what they earn during their notice period!
A further proposal is to introduce a two year qualification period before people are eligible for any tax free payment (mirroring the qualifying period for unfair dismissal). This may then be followed by a staggered allowance depending on how long the employee has worked for the employer – for example £6,000 after 2 years’ employment, and then increasing by £1,000 for each year of employment. If this is to come in, it would mean a dramatically lower level of tax free payments for the majority of employees, and would be likely to mean that in contentious cases settlements become more expensive for employers.
It will be very interesting to see what comes out of the consultation, but it is clear that the government does want to tackle this area. This is likely to be a topic HR professionals will be watching with keen interest, so we will of course continue to keep you updated as and when more details about any forthcoming changes are given.
If you need advice on any aspect of employment law, please contact any member of the Pure Employment Law team (01243 836840 or enquiries[email protected]).