Is the end in sight for tax free termination payments?

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The £30,000 ‘tax free’ element of termination payments has long been used to structure settlement agreements to both employers’ and employees’ advantage. This may be soon to change. A public consultation on reforming tax and national insurance exemptions for termination payments has recently closed and the Government’s response is awaited. If implemented, these reforms could significantly reduce the amount of a termination payment that can be paid free of tax and NICs.

The £30,000 tax exemption for non-contractual payments has helped to oil the wheels of many a severance negotiation, enabling employers to structure settlements in a tax efficient way, providing an extra incentive for an employee to accept a deal.

All good things must come to an end it seems. The Office of Tax Simplification concluded in a July 2014 report that the current tax treatment of termination payments is “fraught with confusion and uncertainty”. This is likely to be a reference to cases where termination payments have been treated as tax free when they shouldn’t have been (typically pay in lieu of notice (PILON) payments). Employers or employees (or both) may have to pay additional tax later on and may be at risk of HMRC fines and penalties if the correct deductions from a payment have not been made.

What is being proposed?

The Government is proposing that all payments made on termination of employment will be subject to income tax and NICs in full unless an exemption applies.

The main exemption applies to redundancy payments. It would only apply to employees who have completed at least two years’ service and would increase in line with the employee’s length of service. The consultation paper suggests an exemption of £6,000 after two years’ service with an extra £1,000 for each additional year of service. By way of example, an employee with 6 years’ service would be eligible for an exemption of up to £10,000, with any remaining payments subject to tax and NICs.

This proposal is significantly less than the current £30,000 exemption that applies to all employees, regardless of length of service.

The Government is also considering introducing exemptions (possibly subject to a cap) for situations where employees lose their job through no fault of their own and for:

  • Payments for unfair or wrongful dismissal
  • Payments connected with discrimination (where awarded by an Employment Tribunal).

Payments into pension schemes would remain exempt from tax and NICs, subject to the normal pension rules.

What does this mean for employers?

If the proposals are implemented, the existing ‘incentive value’ provided by the current system will be severely restricted. Employees may press for an increased termination package to reflect the reduction in any net settlement payment. It may be that employers will have to look at other ways to reduce liabilities for tax or NICs, such as making payments into pension schemes or staging payments over two tax years.

The Government has also confirmed it is actively monitoring the use and growth of salary sacrifice schemes given that such schemes have become increasingly popular and the cost to the taxpayer is therefore increasing.

If you have any questions about the proposals please contact David Smedley or Andrew Rayment in our employment team.